Today's Tidbits

Subprime Contagion Fears
From Dow Jones: “The riskiest tranche of the subprime mortgage-based derivative index, the ABX, hit another low Tuesday. The BBB- tranche was quoted at 44 cents on the dollar early afternoon… Further downgrades of securities tied to the subprime mortgage meltdown will put pressure on public pension funds and insurance companies to sell off their holdings, but the rules under which they operate generally give them the flexibility to avoid a fire sale. That could provide some reassurance to Wall Street, which is concerned hasty sales could sharply lower market prices on mortgage bonds and the complex securities that banks have constructed based on them, so-called collateralized debt obligations. A sharp drop in prices could force other buyers to record big losses, spooking investors and causing a sharp spike in risk aversion - which could threaten the stability of the financial system.”


Private Equity Firms May Have to Utilize Bridge Loans to Fund Pipeline Purchases
From TheStreet.com: “…bankers financing big leveraged buyouts are fretting over …handing over billions of dollars in so-called bridge loan commitments to buyout-happy private-equity shops. Bridge loans are hardly lucrative for investment banks -- they are not usually even drawn down. Instead they serve to "bridge" the gap between the announcement of a buyout …and the receipt of permanent financing. But with the debt market having soured recently for leveraged buyouts, banks are starting to worry that private-equity shops might opt to actually draw upon these hefty loans -- possibly leaving the banks with billions of unwanted loans on their books, unless they can syndicate them out to buyers including hedge fund investors…Complicating the picture is growing resistance from hedge funds and managers of collateralized loan obligations, which pool and manage portfolios of commercial debt… one firm pushing back against banks and eschewing loans that lack the covenants that would protect investors if they tank. "Until recently there has been no organized consortium among managers to push back on poor covenant quality and credit agreement terms," …Although markedly different from CLOs, subprime has put a spotlight on loans made to borrowers with questionable credit. Excesses emerging there have caused buyers of loans to demand better underwriting standards. Highland has doubled the number of loans it rejects in structuring CLO assets from 25% to 35% to around 65%, …Such resistance has put a strain on banks and pushed bankers into the negotiating room with private-equity firms, which are trying to ensure that the buyout-friendly terms they received earlier don't change. But if they do, they are willing to consider asking the banks to fund these billion dollar bridges.”
From Dow Jones: “Private equity firms hoping to skimp on investor protection when they raise funds for their buyouts in the debt markets in the coming months could be in for a rude awakening. A particularly risky type of leveraged loan - debt that is sliced up and sold to investors - has borne the brunt of selling in the last three weeks as investors have grown less enamored with speculative debt. Covenant-lite loans - ones that carry
minimal protection for debt holders should a company run into trouble - have under-performed more traditional, safer loans as investors rethink risk. This doesn’t bode well for large deals looming, like First Data Corp.’s (FDC) expected $14 billion covenant-lite loan to finance its leveraged buyout. If sold as covenant-lite, it would be the largest ever deal of its kind in the market…. According to S&P’s data, about 17% of the loan universe is covenant-lite. First Data’s deal alone would grow that number to 20% if investors agree to a deal without such protections. But recent aversion to covenant-lite loans could have lasting repercussions in the market, which is expecting $200 billion of new supply in the next six to nine months to fund the massive amount of leveraged buyouts that have already been announced.”

Central Banks Becoming More Aggressive With Investment of Excess Reserves
From Bloomberg: “In a confidential poll, UBS surveyed its guests about several key issues, including predictions about where U.S. interest rates, bond yields and the dollar will be at year's end, and anticipated changes in asset allocation over the next decade. The reserve managers' responses made it clear that the world's biggest pool of cash will be invested more aggressively than in the past. That means they will buy fewer U.S. government securities, which is bad news for U.S. interest rates. What's more, the responses illustrate that regardless of their financial muscle, central banks are no better than the private sector when it comes to predicting market moves… Central banks traditionally have invested their reserves in highly liquid, low-yielding securities, such as U.S. Treasuries and equivalent German government bonds. The goal is to have quick
access to the funds to defend a currency under attack, cover short-term debt obligations, finance imports and counter any runs on domestic banks. Yet, having amassed reserves well in excess of prudential needs, central banks are under increasing pressure from
politicians and public-interest groups to earn higher returns on their hoards by investing in riskier assets. To that end, several countries, including China, Singapore, the United Arab Emirates, Kuwait, Norway and Russia, have established or announced their intention to set up sovereign wealth funds… The UBS survey asked the reserve managers what the biggest change would be in the way they allocated assets over the next 10 years. Thirty-six percent said they would invest more in so-called spread products, which include swaps, agency bonds andcorporate debt -- fixed-income securities that trade at a spread to government bonds… Eighteen percent of reserve managers responded with more equities, another 18 percent with fewer U.S. dollars and 12 percent said alternative investments. Bottom line: The more money that the countries with big reserves invest in corporate bonds, stocks and other risky investments, the less they will put into Treasuries. Asian central banks and oil exporters, which are large buyers of U.S. government securities, have helped restrain U.S. interest rates in recent years. ``The dominant story is more risk: People are looking for higher rates of return, and that will only come with more risk,''… One percent of the respondents voted for more gold, while 3 percent said less gold.”
From Morgan Stanley: “The composition of buying in May was geared towards riskier assets more so than safer assets. Increased risk appetite was definitely the name of the game as the data indicates that foreign accounts took major stakes in US corporations
during May. The majority of these flows were private based, but foreigners purchased both a record $41.9 billion in US stocks and $72.6 billion in US corporate bonds. This trend bears watching, given the prospects of excess official reserves flowing into sovereign wealth funds (which would be difficult to tag as official flows by the TIC system and would instead be viewed as private account transactions), which are mandated to seek higher returning assets …Granted, there was a rebound in foreign buying of safe assets as purchases of Treasuries rebounded in May up $21.6 billion. However, the majority of the flows into Treasuries were from private accounts (bulk UK and OPEC) as central banks actually sold $4.6 billion (the second time that FCBs have sold this year). In 2007, foreign official purchases of Treasuries have been diminutive at best (only $3 billion in 2007), as FCB purchases of US fixed income assets are now concentrated more in Agencies and MBS (up $63 billion in 2007).”

Concentration of Credit Derivatives Risk May Amplify Volatility Says Fitch Study
From Bloomberg: “Hedge fund borrowing to invest in credit derivatives may magnify volatility in a market slump, according to a Fitch Ratings survey of 65 banks and insurers. A ``dramatic'' increase in hedge funds' use of credit derivatives has pushed their share of trading to 60 percent of credit-default swaps, and about 33 percent of collateralized
debt obligations, Fitch said in the report today, citing data from Greenwich Associates. U.S. corporate bond risk premiums reached the highest in almost two years last week as hedge funds bought credit-default swaps to offset potential losses from the subprime mortgage rout… In a market slump, large deals financed with borrowed money, or leverage, may ``result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side,''… Banks and money managers bought and sold about $50 trillion of credit derivatives in 2006, more than twice the total in the previous year, Fitch said. The market has grown 15-fold since
Fitch started the survey in 2003, the ratings company said. The contracts, based on bonds and loans, are used to speculate on the ability of companies to repay debt. ``Until all of this recent volatility, investors had been forced down the credit quality ladder, and up in leverage to meet investment targets,'' …``Now it appears hedge funds are deleveraging'' to meet demands from their lenders. Hedge funds typically leverage their assets by five to six times, Fitch said in a report in June. The funds' holdings of corporate debt reached more than $300 billion in 2005, Fitch said, citing International Monetary Fund data. In-depth, up-to-date data on hedge fund investment in corporate bonds, loans and their derivatives ``remains elusive,'' Fitch said in today's report. In credit-default swaps, the buyer pays an annual premium to guard against a borrower failing to pay its debts. In a default, the buyer gets paid the full amount insured, and hands over defaulted loans or bonds to the swap seller. Morgan Stanley was cited as the most frequent trader of the contracts, followed by Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., Fitch said. The top 10 firms accounted for 89 percent of credit derivatives bought and sold in 2006, up from 86 percent in the previous year, Fitch said. ``For better or worse, counterparty concentration appears to remain a feature of this market,'' Fitch analysts wrote. Credit-default swaps based on the debt of General Motors Corp., the largest U.S. automaker, were the most frequently traded single-name contracts last year, … Prices of the derivatives typically decline when creditworthiness improves, and rise when it worsens.”

MISC
From Merrill Lynch: “…real consumer spending was depressed by the surge in food and energy prices in 2Q-07 (growing just +1.31% SAAR)…We expect substantial price discounting from general merchandisers in the ‘back-to-school’ sales period in August and September.”

From Barclays: “On a regional basis, Asia preferred US agency debt to Treasuries, with net purchases of $22.5bn of the former versus net sales of $0.8bn of the latter. [Based on May TIC data]”

From Dow Jones: “…recent figures from the Chicago Mercantile Exchange show that short speculative positions in the U.S. currency have risen back to their highest level in nearly three years…”

From Merrill Lynch: “The NAHB index is now just 5 points shy of making a new all-time low. The last time it was this low in January 1991, housing starts were 798,000 units (vs. 1.5 million now) and new home sales were 401,000 (vs. 915,000 now).”

From Time: “The average U.S. home size was 2,434 square feet in 2005, up from 983 square feet in 1950, according to the National Association of Home Builders.”

End-of-Day Market Update
Treasuries fell for the first time in three days, pushing up interest rates 2bp across the curve. The ten year Treasury is finishing the day at 5.06% after rising to 5.10% earlier in the day.
Stocks rose, pushing the Dow to another new high of 14,021 intraday, before closing up 21 at 13,971. The S&P remained confined within yesterday’s range, and closed essentially unchanged. The NASDAQ closed up 15 at 2712.
The dollar is closing unchanged after trading in a tight range all day.
Oil shot up above $75 a barrel during the morning, to an 11-month high in an outside trading day, but closed 13 cents lower at $74.02. Most other energy prices fell as well, with gasoline falling to a 34 day low.
Commodity prices were lower, with soybeans settling near limit down for the second day in a row.