The talking heads are freaking out

Well if you haven’t heard the news…the Bailout Bill failed. If there is one thing we can all count on its partisan bickering. Word is that the bill will come back up for a re-vote on Thursday. The market clearly wasn’t happy with the outcome. The Dow closed down 777 points, the 10-year Treasury was up over 2 points in price to yield 3.57%. Money flooded the entire length of the Treasury curve today. The 4 week Bill is back down to a yield of 5 basis points, the long bond was up 4.5 points…throw a dart at the Treasury curve and any point you hit was higher in price today. Oil was down over $11 a barrel on the news this afternoon reflecting increased concern of a global economic slowdown.

A LOT of things moved today on a flight to safety. Congress should get over their interpersonal/party hang ups later this week and we should see this bill pass.
When that happens I would expect the “flight to safety” component of today’s move to reverse.

At some point the market will get back to looking at the fundamentals of the economy and making decisions on the economic data. That hasn’t been happening recently due to the volatility surrounding all of the bailout talk. There has been a lot of poor data released on the fundamentals. Again a lot of it hasn’t been written about because everyone has been dealing with the biggest problems first. Watch for the news to shift back to the data a week or so after this bailout passes.

The Fed Funds futures market have taken a big turn recently. One month ago this market was pricing in zero percent probability of a cut at the 10/20/08 FOMC Meeting…this afternoon that probability stands at 100%.

Below you will see a comparison of the Treasury curve as it closed on Friday compared to this afternoons close.


Many of the talking heads are screaming about the sky falling…”The biggest one day point drop EVER!”

“AAAAAAAGGGGGGHHH!” they scream. 700 points is nothing to ignore but today calls for some perspective. You know it’s a heck of a day when a BOND GUY is appealing for calm. The graphic below shows that today’s decline in the Dow isn’t even in the Top 5 one day declines in history.

Most people remember October 1987 and use it as a benchmark for things hitting the fan. The Dow dropped 508 points in October 1987. The talking heads would have you believe that it wasn’t as significant an event because after all today we had “the biggest one day point drop in HISTORY”.

Percentages matter here. The 508 point drop in 1987 was 22% of the Dows starting value that day. 22% in one day. Today’s drop of 777 points is roughly 7.0% of the Dows beginning value this morning. It’s a big move but it is in no way as significant as the talking heads would have you believe.

I just wanted to give everyone some ammo to talk to customers about the remainder of the week.

Big news on the left coast

Yep…UNRANKED Oregon State beat Number 1 USC. USC hasn’t been beaten by an unranked team since the 1980’s. And speaking of records that haven’t been broken since the 80’s…Washington Mutual failed yesterday. WaMu became the largest bank failure in US history yesterday as the regulators shut them down and sold their deposits to JP Morgan. The good news is:

1 - I own JP Morgan stock, and

2 - the problem bank list just got shorter

WaMu had $310 billion in assets…that dwarfs the second place holder (Continental Illinois, 1984) that had $83 Billion in assets in current day dollars according to Bloomberg. WaMu had significant exposure to sub-prime loans. The following quote from Bloomberg news provides a nice snapshot:

“WaMu was the second-biggest provider of option ARMs, behind Wachovia Corp., with $54 billion held in its portfolio in the first quarter, according to Inside Mortgage Finance. Of the $230 billion in loans secured by real estate at the end of the second quarter, $16.9 billion were subprime mortgages. WaMu, which ranked sixth among U.S. mortgage companies last year, was the 11th-biggest subprime lender in 2006, according to Inside Mortgage Finance.
WaMu estimated losses of as much as $19 billion in the next 2-1/2 years. Standard & Poor's cut the bank's credit rating twice in nine days as chances decreased that any deal wouldn't be a buyout of the whole company, leaving creditors of the holding company to face substantial losses. “

JP Morgan bought WaMu’s assets for $1.9 Billion. JP Morgan did not take any of the liabilities, and they say all branches will open as usual in the morning and they expect full integration by 2010.

JP Morgan:

- Gets roughly $188 Billion in deposits
- Becomes the largest US Bank by deposits with more than $900 billion
- Is buying all of WaMu’s assets and will take a $31 Billion write-down on those assets

We’ll know more later but this is how the deal stands now. At the moment the market is taking this news pretty well. We’ve said for a while that this market wants to start seeing deals get done via the normal market mechanism. WaMu going down is a big deal but at least the market is doing the deal and not the government. The Treasuries $700 Billion plan is still taking center stage and I can’t see the market doing anything huge until that decision is made final.
Treasuries are up at all points on the curve pushing yields a bit lower. There is not a tremendous amount of volume. It feels like we are in a “wait and see” mode with the market just waiting on Congress.

The Fed Funds Futures market is pricing in a 100% chance of a cut at the next two meeting. There is currently Zero probability assigned to rates staying unchanged or rising.


If you have any questions or if there is anything I can do for you just let me know.

Steve Scaramastro
800-311-0707

FDIC takes Bloomberg to school

Open Letter to Bloomberg News about FDIC Deposit Insurance Fund

FOR IMMEDIATE RELEASE September 25, 2008

Media Contact: Andrew Gray (202-898-7192)

Mr. John McCorry Executive Editor Bloomberg News

Dear Mr. McCorry:

Bloomberg reporter David Evans' piece ("FDIC May Need $150 Billion Bailout as Local Bank Failures Mount," Sept. 25) does a serious disservice to your organization and your readers by painting a skewed picture of the FDIC insurance fund. Let me be clear: The insurance fund is in a strong financial position to weather a significant upsurge in bank failures. The FDIC has all the tools and resources necessary to meet our commitment to insured depositors, which we view as sacred. I do not foresee – as Mr. Evans suggests – that taxpayers may have to foot the bill for a "bailout."

Let's look at the real facts about the FDIC insurance fund. The fund's current balance is $45 billion – but that figure is not static. The fund will continue to incur the cost of protecting insured depositors as more banks may fail, but we continually bring in more premium income. We will propose raising bank premiums in the coming weeks to ensure that the fund remains strong. And, at the same time, we will propose higher premiums on higher risk activity to create economic incentives for poorly managed banks to change their risk profiles. The fund is 100 percent industry-backed. Our ability to raise premiums essentially means that the capital of the entire banking industry – that's $1.3 trillion – is available for support.

Moreover, if needed, the FDIC has longstanding lines of credit with the Treasury Department. Congress, understanding the need to ensure that working capital is available to the FDIC to provide bridge funding between the time a bank fails and when its assets are sold, provided broad authority for us to borrow from Treasury's Federal Financing Bank. If necessary, we can potentially raise very large sums of working capital, which would be paid back as the FDIC liquidates assets of failed banks. As per our authorizing statute, any money we might borrow from the Treasury must be paid back from industry assessments. Only once in the FDIC's history have we had to borrow from the Treasury – in the early 1990s – and that money was paid back with interest in less than two years.

Finally, Mr. Evans' suggestion that the "government" could ever be "on the hook for uninsured deposits" demonstrates a misunderstanding of FDIC insurance. To protect taxpayers, we are required to follow the "least cost" resolution, which means that uninsured depositors are paid in full only if this is the least costly option for the FDIC. This usually occurs when a bidder for the failed bank is willing to pay a higher price for the entire deposit franchise. We are authorized to deviate from the "least cost" resolution only where a so-called "systemic risk" exception is made. This is an extraordinary procedure which we have never invoked. And again, any money we borrow from the Treasury Department must be repaid through industry assessments.
I am confident in the strength of the FDIC's resources to make good on our sacred pledge to insured depositors. And, remember, no depositor has ever lost a penny of insured deposits, and never will.


Andrew Gray
Director Office of Public Affairs Federal Deposit Insurance Corporation

---------------

Congress created the Federal Deposit Insurance Corporation in 1933 to restore public confidence in the nation's banking system. The FDIC insures deposits at the nation's 8,451 banks and savings associations and it promotes the safety and soundness of these institutions by identifying, monitoring and addressing risks to which they are exposed. The FDIC receives no federal tax dollars – insured financial institutions fund its operations.

FDIC press releases and other information are available on the Internet at www.fdic.gov, by subscription electronically (go to www.fdic.gov/about/subscriptions/index.html) and may also be obtained through the FDIC's Public Information Center (877-275-3342 or 703-562-2200). PR-84-2008

Food for thought

As I was reading the news today I saw that the NASA chief says space exploration is vital for mankinds survival. If he's right I think I'd rather spend Paulsons $700 billion on NASA.

http://www.breitbart.com/article.php?id=080925122953.ty01k9qm&show_article=1

Paulson and Bernanke come up short

Today was spent with one ear on the phone and the other on the TV listening to Paulson and Bernanke try to get $700 Billion out of Congress. The contrast was remarkable, Paulson the former Goldman CEO the consummate leader/statesman/salesman and Bernanke looking like a geek sitting in the principal’s office after getting caught for participating in a cafeteria food fight.

Every time a Senator asked a question that was WIDE open for a B. S. answer Paulson fielded it and Bernanke tried not to make eye contact with anyone. When the question called for a straight forward definition of some economic principle Bernanke stepped up. If it weren't such a serious moment it might have been comical.

They took all questions, even the stupid ones, and presented a pretty good case for the government intervention in this crisis. They didn't come away with the sweetheart deal they penned on Saturday but hey. . . in negotiations you have to start high because you know they're going to grind you down at the negotiating table.

I caught a lot of both sides asking each other for the impossible. Bernanke and Paulson asking for $700 Billion that they can use for whatever purpose they see fit and to answer to no one while doing it, and Congress asking them to predict the future and tell them that this will work and that they won't need any more money later.

I learned nothing today about how the assets in question will be valued and at what price the government will buy them from troubled banks. The way I see this there are two options:

Option 1 - The government will have to pay more than the assets are worth to help the banks, but that is detrimental to the taxpayer.

Option 2 - The government somehow figures out what the fair value of these instruments are and pays that price, which protects the taxpayer but kills the bank. The problem with this option is that if the bank could afford to sell at that price it would have done so already. Taking that low price means a big write-down for the bank which will waltz through the income statement, march directly onto the balance sheet and punch Capital right in the kisser.

This hit to capital will leave many institutions under-capitalized. . . which is exactly what the government is trying to avoid. So how do you do the un-possible? How do you protect the taxpayer AND take garbage assets off the hands of the banks? In my view the answer is a new government issued Trust Preferred type security. If a bank wants to sell troubled assets to the government it will have to take the fair value price that the Treasury comes up with (it shouldn't be hard to come up with a price for these securities with the right people on board). We know that if the bank hits that low-ball price it's going to take a big write down, and if the write-down takes them below a well capitalized level the government can extend them a loan that counts as capital. . . that should sound familiar because that's what Trust Preferred Securities are.

This path will provide the banks with a way to get rid of their bad assets, it will give the taxpayer a great price on those assets (and one that should allow the taxpayers to actually MAKE money on this deal), the offending bank will be given enough capital to survive and become profitable again, then the bank will have to pay off the loan with interest (the taxpayer wins again). At this point that seems to be the best alternative. All of the plumbing so to speak for Trust Preferred securities already exists, the lawyers that used to do them could probably use the work, and everyone knows how to account for them. The Trust Preferred market has been dormant since last August when CDO's started blowing up Bear Stearns hedge funds. . . they became a dirty word and everyone avoided all CDO's. . . even the good ones.

One other thought that we had today concerned mark to market accounting. It may be that if we suspend mark-to-market accounting we can allow banks to avoid the capital write-downs that will be so punishing. We realize that this stands in stark contrast to the principle that financial accounting should provide the end user with a level of transparency that allows them to make informed decisions about the profitability of the company but there may be a way that both of these ideas can co-exist.

Analysts are concerned about the earnings power of a company. They want to get down to the bottom line and determine what a company’s earnings are. If you allow a company to suspend mark-to-market accounting but require them to shock their earnings statements to reflect say a 25%, 50% and 75% impairment of a certain bucket of assets, you could in theory avoid the capital write-downs that mark-to-market accounting would require and at the same time provide the investor with useful information about the financial health of the company. I in no way doubt Paulson and Bernanke's intentions.

I think they are both smart and capable men who were handed a bag full of seemingly impossible problems and are sorting them out as best they can. They've laid out their vision of what will happen if we do nothing. . . a new Great Depression. If they are correct then it is a very sobering thought. A story that received very little news was that the day after the Primary Reserve Fund broke the buck; investors pulled $89 Billion out of money market funds. The next day the clearing firms that execute these trades called the Fed because they were looking down the barrel of $500 Billion of sell orders. Armageddon was at the door, and they wanted to let the Fed know that they were about to let it in. These firms said we were 500 Trades away from the Dow trading at 8,300.

Here is a link to the story:

http://www.nypost.com/seven/09212008/business/almost_armageddon_130110.htm

that story should be required reading for anyone wanting to understand the severity of the problems we faced last week.

I can certainly say that it was the only time in my career that I've seen "fear" ruling the market. It was one of the few times I've looked around at the people around me and we wondered aloud. . . will we still be here next week? What if OUR liquidity lines get pulled? What do you do? Old and storied Wall Street firms like Merrill Lynch and Lehman were having their lines cut. . . if it can happen to them it seemingly could happen to anyone. . . and this would be the market that did it.

By the end of the day we were thinking that maybe we could get by with less than the $700 Billion plan. After all no money has been spent yet and the markets were calmed, fear was on the back burner. Liquidity didn’t seem to be an issue.

The big wild card at this point is quarter end. This has all the makings of what could be the Mother of All Quarter Ends. That is going to press this issue hard as we move through this week. Many types of financial institutions are looking at write-downs of their Agency Preferred stock now that Fannie and Freddie have been put in conservatorship and had their dividends halted. There were roughly $38 Billion of those securities in existence. Those securities alone will deliver a massive blow to balance sheets at quarter end…and there are many other bad assets lined up behind them.


I think our consensus by the day’s end was that if we leave the money market insurance plan in place, create a government sponsored Trust Preferred plan, and perhaps suspend mark to market accounting we could really minimize the cost to the taxpayer…and still get this job done.

So there you have it...that's what your broker does when he's not calling you. He sits around and thinking up ways to avoid the next great depression and protect the taxpayer at the same time.

I don't want to discourage anyone but after the testimony we didn't get any phone calls from senators, congressman, Treasury Secretaries, or Fed Chairmen asking for our opinion on things.

Paulson becomes most powerful man in the world

Below is the $700 Billion proposal to authorize the US Treasury to begin buying troubled MBS assets. There are some huge numbers involved here. Most notably is that this proposal bumps up the limit on public debt by approximately 16%... from $9.7 Trillion to $11.3 Trillion. Additionally it provides the Treasury Secretary with discretionary authority to buy and sell these assets at times and prices of his choosing, and provides that decisions made by the Treasury are “non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency” …there will be NO second guessing Paulson. That’s probably a good way to keep all of these congressmen and senators that claim they didn’t realize they got a zero-interest home loan from a mortgage company that gave heavily to their campaign from inserting themselves into this for political gain.

The Treasury Secretary will have to provide testimony semi-annually on the program to various government oversight committees.

All powers granted in this legislation shall terminate two-years from the start date. Additionally it looks like the Treasury can HOLD the securities longer than the 2-year window during which he has discretionary authority to buy and sell. I’m no lawyer, nor did I stay in a Holiday Inn last night, but that’s the way I interpret the proposal below. So Paulson has a two year window to buy, he reports every six months, and at the end of two years Congress reviews.

There’s a short sentence about protecting the taxpayer included but it reads like it’s an afterthought.

I’ve not seen ANY talk yet about how these assets will be valued. There are hundreds of billions of dollars of “Level 3” assets sitting on the books of financial institutions right now. These are the infamous “mark to model” securities. In a normal market there is information conveyed in prices...there is no market in which these “Level 3” assets trade so you have to use assumptions and models to determine a price. This led to some wildly optimistic prices for assets on the books of many firms. Picture a guy that gets millions of dollars in bonuses for creating and trading these new and esoteric securities that are rich with nuance (read that as nobody else in the firm understands) and that are the envy of the Street for the returns they generate. One risk of carrying this paper is that if it gets impaired the firm will have to write-down billions of dollars and his bonuses and his job will go away. Now the interesting part is that the firm relies on this same guy for the prices to use for evaluating impairments because there is no market they can look to for such information. This guy creates the assumptions and runs the model that kicks out the price that essentially determines whether or not he keeps his high paying job and huge bonuses. I can’t be the only one seeing a conflict of interest here. At any rate, there will have to be a reckoning on the prices of these Level 3 securities, and this is a big issue for the taxpayer.

If the Treasury buys them at above fair value prices, the tax payers take the hit. If the Treasury buys them below fair value prices the firm takes the hit but this will put them in a spot that the Treasury is desperately attempting to avoid with this whole “Bail out the whole world” plan. That in my mind is the central issue to how this whole thing works out…HOW do they determine fair value, and who takes the hit from the write down?

This proposal doesn’t address those issues and they are the ones most in need of an answer.

The proposal is below I’ve highlighted some sections of importance and inserted a note or two where I thought . If any questions let me know.


-------------------------------------------------------------------------------------------------------------------------------------------------


U.S. Treasury Proposal to Buy Mortgage-Related Assets: Text

Sept. 20 (Bloomberg) -- Following is the text of a legislative proposal by the U.S. Treasury to buy mortgage- related assets from financial institutions:

LEGISLATIVE PROPOSAL FOR TREASURY AUTHORITY TO PURCHASE MORTGAGE-RELATED ASSETS

Section 1. Short Title.

This Act may be cited as ____________________.

Sec. 2. Purchases of Mortgage-Related Assets.

(a) Authority to Purchase.--The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States.

(b) Necessary Actions.--The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this Act, including, without limitation:

(1) appointing such employees as may be required to carry out the authorities in this Act and defining their duties;

(2) entering into contracts, including contracts for services authorized by section 3109 of title 5,
United States Code, without regard to any other provision of law regarding public contracts;

(3) designating financial institutions as financial agents of the Government, and they shall
perform all such reasonable duties related to this Act as financial agents of the Government as
may be required of them;

(4) establishing vehicles that are authorized, subject to supervision by the Secretary, to purchase mortgage-related assets and issue obligations; and

(5) issuing such regulations and other guidance as may be necessary or appropriate to define terms or carry out the authorities of this Act.

Sec. 3. Considerations.

In exercising the authorities granted in this Act, the Secretary shall take into consideration means for--

(1) providing stability or preventing disruption to the financial markets or banking system; and

(2) protecting the taxpayer.

Sec. 4. Reports to Congress.

Within three months of the first exercise of the authority granted in section 2(a), and semiannually thereafter, the Secretary shall report to the Committees on the Budget, Financial Services, and Ways and Means of the House of Representatives and the Committees on the Budget, Finance, and Banking, Housing, and Urban Affairs of the Senate with respect to the authorities exercised under this Act and the considerations required by section 3.

Sec. 5. Rights; Management; Sale of Mortgage-Related Assets.

(a) Exercise of Rights.--The Secretary may, at any time, exercise any rights received in connection with mortgage-related assets purchased under this Act.

(b) Management of Mortgage-Related Assets.--The Secretary shall have authority to manage mortgage-related assets purchased under this Act, including revenues and portfolio risks therefrom.

(c) Sale of Mortgage-Related Assets.--The Secretary may, at any time, upon terms and conditions and at prices determined by the Secretary, sell, or enter into securities loans, repurchase transactions or other financial transactions in regard to, any mortgage-related asset purchased under this Act.

(d) Application of Sunset to Mortgage-Related Assets.- -The authority of the Secretary to hold any mortgage- related asset purchased under this Act before the termination date in section 9, or to purchase or fund the purchase of a mortgage-related asset under a commitment entered into before the termination date in section 9, is not subject to the provisions of section 9.

Sec. 6. Maximum Amount of Authorized Purchases.

The Secretary's authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time

Sec. 7. Funding.

For the purpose of the authorities granted in this Act, and for the costs of administering those authorities, the Secretary may use the proceeds of the sale of any securities issued under chapter 31 of title 31, United States Code, and the purposes for which securities may be issued under chapter 31 of title 31, United States Code, are extended to include actions authorized by this Act, including the payment of administrative expenses. Any funds expended for actions authorized by this Act, including the payment of administrative expenses, shall be deemed appropriated at the time of such expenditure.

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Sec. 9. Termination of Authority.

The authorities under this Act, with the exception of authorities granted in sections 2(b)(5), 5 and 7, shall terminate two years from the date of enactment of this Act.

Sec. 10. Increase in Statutory Limit on the Public Debt.

Subsection (b) of section 3101 of title 31, United States Code, is amended by striking out the dollar limitation contained in such subsection and inserting in lieu thereof $11,315,000,000,000.
(My Note: THE OLD LIMIT WAS ROUGHLY 9 TRILLION)

Sec. 11. Credit Reform.

The costs of purchases of mortgage-related assets made under section 2(a) of this Act shall be determined as provided under the Federal Credit Reform Act of 1990, as applicable.

Sec. 12. Definitions.

For purposes of this section, the following definitions shall apply:

(1) Mortgage-Related Assets.--The term mortgage- related assets means residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008.

(Note: That is a WIDE OPEN definition…they can buy the worst of the worst if they chose)

(2) Secretary.--The term Secretary means the Secretary of the Treasury.
(3) United States.--The term United States means the States, territories, and possessions of the United States and the District of Columbia.
For Related News: For news on the credit crisis: NI CRUNCH BN For finance news: NI FIN

Paulson brings a bigger hammer

The US Government is set to undertake the largest expansion of power over the financial system since the Great Depression. The “Great Depression” comparisons are piling up like promises in an election year.

It will take days and maybe weeks to get all of the details on what the Treasury has planned but clearly they aim to bring a big hammer to this problem. They do not want this problem to fester and they are going to take action on a scale we may never see again in our lifetimes. In Paulsons words this package will entail “hundreds of billions of dollars”.

A very brief review is in order here. In the last year it became apparent that if you lend to people who don’t have the money to pay you back…they generally won’t. Mortgages made with poor underwriting standards first took down two Bear Stearns hedge funds, then they took down Countrywide, then they took down Bear Stearns itself, they crushed Lehman Brothers, brought Fannie and Freddie to their knees, forced Merrill Lynch to the negotiating table, killed AIG, are about to kill WaMu, might take out Morgan Stanley and crushed too many smaller banks to list.
So that leads us up to this week. The cancer spread to new areas this week as Lehman’s bankruptcy delivered a blow to some money market funds that they can’t recover from. The snowball of funds breaking the buck started with the Primary Reserve Fund earlier this week. We reported on this and gave everyone a heads up to check their exposure. A $22 Billion Bank of New York institutional money market fund was the next to break the buck, then Putnam Funds shut a money fund down, then another broke the buck. In one day investors pulled $89 Billion from money market funds. This massive liquidity drain was only going to bring further pain to a market in the middle of a record liquidity crisis.

Paul McCulley of PIMCO says “It’s the ultimate nightmare to have a run on the money markets—that is truly the Armageddon outcome—and they’re not going to allow that to happen”. The Treasury will insure money market funds for one year for those that pay a fee to enter the program.

There is broadly based political support for the plans that the Treasury and the Fed have come up with. All legislators say they expect a very quick passage of these packages. Barney Frank said they will act on the plan within two weeks. Additionally he said he hoped it would include another stimulus package with money for Medicare and infrastructure…but no money this go round for US families. Some are beginning to question whether the US Government has deep enough pockets to handle this problem.

Clearly the purchase of garbage assets from investment houses and banks poses some serious questions regarding the price at which those assets are valued. We eagerly await more details on that.

Lawmakers are saying at this early stage that this ultimately won’t cost the tax payers a lot. They’ll have to forgive me for being skeptical.

Below is a quick list of facts and points for consideration:

- Treasury tapped all $50 Billion in the country’s Exchange Stabilization Fund to insure money market deposits. This fund was used in 1990 to bailout Mexico and is one way Paulson can act without the consent of Congress

- Officials are considering an $800 Billion fund to purchase “failed assets” and a separate $400 Billion pool at the FDIC to insure investors in money market funds…$1.2 TRILLION total under consideration there

- Treasury has pledged to buy up to $200 Billion of Fannie and Freddie stock earlier this month

- Fed recently gave AIG an $85 Billion loan

- Treasury previously committed to buy $5 Billion of MBS debt for this month

- Goldman Sachs increased its estimate for the 2009 US budget deficit to $565 Billion from a prior estimate of $465 Billion

- The Congressional Budget Office estimates the 2009 deficit at $438 Billion, up from prior of $407 Billion

- 4th Quarter GDP estimated at 0.55%

- SEC announces a ban on short sales of 799 stocks through Oct. 2nd

- UK puts similar restrictions on short sales

- WaMu had 22% of its float sold short

- Analysts are calling this the “mother of all short squeezes”

- 2-year Treasury notes fell the most in 23 years


The market’s reaction to these plans has been dramatic. The Dow is up almost 400 points and every spot on the Treasury curve is up in yield. The market’s perception of this plan could change dramatically as more detail comes out. If you were waiting on a pullback to put money to work…now might be the time.

An astute point was made this morning regarding the timing of this massive plan…who’s going down this weekend?

We’ll keep you up to speed as this develops.

Market reaction is below:

Stocks are up strong. Treasury yields are up along the entire length of the curve. Fed Funds effective rate is in line with the target rate early in the day which is a huge sign that we’re seeing enough liquidity in the short term borrowing markets.

Fed Funds futures are indicating that the market has mixed feelings about these developments and that those feelings are cautiously optimistic to negative.

To highlight just how much volatility we’ve seen in the last few months I’ve attached a graph of the 10-year Treasury yield from March of 2008 to this morning. It’s been a wild ride and that might continue into 2009.

If you have any questions or if there is anything I can be doing for you just let me know.

Rally at the close

So the end of todays trading brought us a big rally. It was one of those days when the guy next to you says "why is the 10 year trading off?" and you look up and the 10 year is off 10 tics as the stock market is erasing losses. Inside of 2 minutes the 10 year is off 18 tics, then it's off a full point and the Dow is up 300 points and there are no headlines indicating why. So we start hunting for an answer...Wachovia is up big...JP Morgan is up big...hell all the financials are up big.

Then we get the headline that Calpers said they are no longer going to lend shares to short sellers. OK...people covering short sales might account for a good bit of the stock market activity but why are bonds selling off acros the length of the curve?

Then we get the headline about the RTC. Senator Schumer (the same one that leaked the "internal" FDIC memo that caused a run on IndyMac) is talking about a plan by the Treasury to resurrect the RTC to handle all of the bad mortgages that are festering on bank balance sheets.

The market reacted very positively to the news if for no other reason than somebody was being proactive. This market was looking for hope and it got a ray of it this afternoon.

I've not seen any of the details of the plan but I hope it punishes the appropriate parties...the taxpayer shouldn't foot the bill for poor underwriting standards.

The mood at the end of the day was one of relief. Not so much of relief that everything is better (we're a long way from that) but relief that there was an interuption in the seemingly never ending stream of bad news. Things were so bad this week that I only got a cursory look at the economic data that came out. Normally that news is like the drum beat that moves the fixed income world. What is the data telling us, what does it say about the economy, what will the Fed do, etc. It's Thursday night and the only thing I can recall about the numbers is that the Philadelphia Fed Index was better than expected...I recall seeing a survey estimate of -10.0 and I think it posted a positive 3 and change. The point here is that things were happening so quickly that nobody had the time to stop and look at the data...there were so many other problems to deal with that the economic data simply didn't matter.

Money market funds are starting to break down. The hallmarks of a money market fund are liquidity, modest return, and safety of principal. The fallout from Lehman Brothers going bankrupt is roiling the money market funds. Primary Reserve Fund was the first to break the buck...several more funds did it today. This is the kiss of death for a money market fund. Safety of principal means that you get a dollar back for every dollar you put in...you earn a modest amount of interest on that money because the money market fund invests in high grade, short term fixed income securities. Lehman's bankruptcy hit a lot of funds that held short Lehman paper.

Even funds with no exposure to Lehman are getting hammered due to guilt by association. If one money market fund is hurting people they are all considered capable of it, and you don't want to be the last guy to request a redemption.

The corporate bond market is still locked up. I saw a AAA rated GE bond with 60 days to maturity trade today at a 6.00% yield. That is a ridiculous level for short AAA paper. That is roughly 580 basis points over the 2 month T Bill. The money market buyers are running for their lives and they are taking their liquidity with them. They want the safety of Treasuries so badly that they are leaving 6.00% AAA rated GE paper on the table in favor of a 0.07% return on a T bill. THAT is what fear looks like.

Thats it for today.

Central Banks oil the machine

Central Banks around the world last night devised a plan to inject massive amounts of liquidity into the financial system. The amount of dollars available for auction around the world this morning stands at $247 billion. As investors around the world hoard cash, central banks are stepping in to replace those funds. There is broad based participation from central banks in the US, the ECB, the Bank of England, the Bank of Canada, the Swiss National Bank, and others.

You'll notice below that despite the massive injections earlier this week we still have the Fed Funds effective rate trading 100 bps over the Feds target rate. Funding pressures have eased some over the course of the week but the market obviously still has problems.

The 3-month T-bill yield is up 300% from yesterday...it's now trading at 9 basis points.



I've attached a graph of 1-week Libor to point out how dramatic the funding issues became this week. With almost $250 billion in liquidity being provided by the central banks of the world over, we should begin to short term borrowing costs begin to fall shortly.






Equity Index futures indicated a slightly higher open for US stock markets and that appears to be holding as the markets open. The Dow, S&P 500, and NASDAQ are all up at the moment.

What I'm seeing and hearing is that Wall Street trading desks are still sitting on their hands. There are plenty of willing sellers, but nobody is buying. People are trying to shrink inventories. Everyone is watching to see what happens to Washington Mutual, Wachovia, and Morgan Stanley. At the moment I don't see anyone else on the radar, but that could change. Headlines are beginning to print that WaMu may be purchased in pieces by Bank of America, JP Morgan and Goldman Sachs.

The FDIC still has 116 banks on the problem bank list. The Deposit Insurance fund is still woefully underfunded. If you'll recall, IndyMac took down 17% of the available insurance funds in the FDIC's pool. That was one of 117 banks on the list. Granted they were a $32 billion bank but there are 116 banks behind them...all of which will use a piece of what's left. I imagine this will begin to get headline status over the next few weeks.

Expect more volatility this week and next. I'm hearing that trading desks around the country may not get back to normal until after quarter end. And oh what a quarter end it should be. We'll keep you posted.

It's a buyers' market right now. Be on the lookout for cheap bonds as Wall Street firms are forced to sell into a market with no liquidity...they'll have to start dropping prices to entice someone to take bonds off their hands. I'm always a fan of doing unto them as they would do unto me.

If you have any questions or if there is anything I can be doing for you just let me know.

Why is the 3 month bill yielding only 3 basis points?

The 3 month Bill is trading at almost zero percent. You read that...almost zero percent. Why?

Primary Reserve Fund is/was the oldest Money Market Fund in America. Yesterday they broke the buck and halted redemptions. Investors in that fund will ultimately receive less than a dollar for each dollar they put in. That is the kiss of death for a money market fund.

Preservation of principal, a modest return, and instant liquidity are the hallmarks of a money market fund. Typically a fund like this invests in very short notes and bills issued by the US Treasury and high rated commercial paper.

The investment objective of this particular fund was "...to seek as high a level of current income as is consistent with preservation of capital and liquidity". On this I would give them a 1 out of 3 as they didn't preserve capital and they are currently experiencing severe liquidity problems.

When the news hit last night I looked up their holdings and was surprised to find a money market fund holding 39% asset backed commercial paper, 18% bank/corporate commercial paper among others. I read nothing on their fact sheet about Treasuries. This fund had a lot of exposure to Lehman Brothers and they took a massive hit for it.

My understanding from speaking with traders this morning is that this fund is leading the charge into the short end of the curve. They and many other money market funds are liquidating all types of short paper and absolutely sprinting to the safety the Treasury Bills. As I type this the yield on a 3 month T Bill is 2 basis points. I'm not a math major but that appears to be awfully close to zero.

Now would be an ideal time to check the prospectus on any money market fund you have exposure to, whether offering it to customers through the bank or holding it on a personal basis. It might also be a good opportunity to speak to your public funds accounts about their money market exposure. Last year Florida was the first to experience this problem when the state run investment pool for schools and local governments was forced to halt redemptions. When that fund siezed up some schools had to take out loans to pay their teachers. If you have public fund accounts that keep money in the a state investment pool they are getting the second huge sign in a year that they need to keep on top of their money market accounts. Know whats in them, don't take the word of the state employee that runs the shop...look at the prospectus, and know that if things hit the fan they might halt redemptions. It seems like the safety of an FDIC insured bank might offer them some comfort in this market.

If you have any questions on this or if there is anything I can be doing for you just let me know.

AIG and the continuing saga of government intervention

The title of this episode in history will likely be The Great Liquidity Crisis, and the catch-phrase is going to be "we just need to buy time". When a big financial firm begins to fail everyone wants to see an orderly liquidation of the firms assets, and there are some very compelling reasons for this. The biggest reason is that liquid assets have continuous real-time pricing, and those prices affect others in the industry that hold similar liquid assets. If a fire-sale occurs it affects not only the liquidating firm but can have a material impact on firms that are far removed from the one that's in trouble.

To explain the difference between an orderly liquidation and a disorderly liquidation we can use the example of a ship needing to unload it's cargo. A disorderly liquidation is akin to the ship's cargo getting unloaded by a violent storm that smashes the ship into every other boat in the harbor then destroys the vessel on the rocks and leaves the cargo strewn along the beach. An orderly liquidation is more like the ship pulling up to the dock, the deck hands unloading the cargo, and then they sink the ship. Bernanke and Paulson (who I may have to begin referring to as the dynamic duo) are committed to the orderly variety of liquidation for firms that pose systemic risk.

Systemic Risk is a risk that poses a danger not only to those involved in a particular enterprise but to the entire system itself. Systemic risk is evidenced by a firm that through it's size, scope, or it's position at a strategically important junction in the market can pose such risk that if they fail they would create a far wider swath of destruction than the size of their footprint might suggest. In the governments view AIG is such a creature.

AIG is reportedly the largest insurance company in the world, they are one of the top 10 largest companies of ANY type in the world, and if not for the Fed and the US Treasury they would have been the second firm this WEEK to break the record for "Largest US Bankruptcy in History". Two world records in a week. That is a staggering fact. The financial sector is becoming the Michael Phelps of bankruptcies.

The last two weeks have been a liquidity nightmare in the financial markets. We all saw the Fed Funds effective rate trading at 8% on Monday after Lehman fell. That was a giant flashing neon sign that we had a liquidity problem. The spread between the Fed Funds effective rate and the Target rate blew out to a 10 year high this week. In the last two weeks I've seen AAA rated corporate bonds go with no bid, I've seen $10 million blocks of TBA mortgages have 3 out of 4 street firms pass on bidding, I've seen a $5 million block of 20 year 5% MBS go with no bid at all. In short I've seen very liquid instruments hit a brick wall when it came time to sell them this week. There are only two things you can do in this situation: wait until the market calms down, or lower the price to try to unload it. To this short list of options the government has added a third; they might give you a loan you can use to buy enough time to pull off an orderly liquidation. If they loan you 50 billion against your 70 billion portfolio the theory is that you'll have enough time to sell your assets at a pace the market can digest without causing prices to drop. It's a great theory, just typing it made me feel better and it soothed my frazzled fixed-income nerves. The problem is that the entire market knows you're in trouble, the entire market knows there are more firms in trouble behind you, and the number of potential buyers for your product is getting smaller every month...Bear is gone, Lehman is gone, Merrill is gone, Countrywide is gone...

So back to our liquidity problem: why didn't the street want to bid on bonds? Why wouldn't anyone position inventory? In part it was because everyone saw Lehman and AIG and Washington Mutual all teetering on the edge of bankruptcy. If someone was asking you to position $50 million of a bond in your inventory, and you KNEW that three large players might have to sell everything they own in a matter of days at fire-sale prices, would you start building inventory today? Heck no you wouldn't. You'd get your head handed to you when those firms began dumping massive volumes on the market and pushed prices through the floor. A much more attractive alternative is to step onto the tracks after that train has passed.

Here is a pretty typical example of how the liquidity trap goes. A firm gets downgraded due to any number of reasons. When your credit rating gets cut your borrowing costs go up and your creditors will eventually begin calling your liquidity lines. If you need liquidity you have to sell securities. In a credit crisis, market liquidity goes away and if you are the guy that is forced into selling (think margin calls) you will see all support fall out from under you. The more you have to sell the faster the prices will fall, the more prices fall the less your collateral is worth which triggers MORE margin calls and you'll have to sell even more to generate sufficient liquidity, which pushes prices down further and so on and so forth until you spiral into the deck. This situation will become a self sustaining and all consuming process of destruction. It's like trying to swim with an anvil on your back. So how do you avoid this? You buy time. Unfortunately you can't really buy time...you have to beg for it or sell your soul for it.

In the case of AIG they begged first, and then still had to sell their soul. Their first attempts to get a loan from the Fed were met with a deaf ear. Paulson and Bernanke were adamant that no public funds would be used to help the beleaguered firm. The dynamic duo then turned to JP Morgan and Goldman Sachs and asked them to come up with a way to raise the money needed. I envision a conversation that went something like this:

Dynamic Duo: We need you to round up $75 Billion by midnight eastern to help save AIG

Street firms: You want us to go find $75 billion to put into a firm that's about to become the "new" largest bankruptcy in history?

Dynamic Duo: Yeah.

Street firms: We'll get back to you...if the phone ain't ringin'...it's us.

Now the Dynamic Duo is back to looking disorderly liquidation straight in the face. When the sun comes up and the world sees AIG getting smashed on the rocks there will be panic selling, there will be mark to market losses everywhere, there will be capital write-downs, there will be a lot of failed firms left in their wake. There will be many otherwise sound institutions and investors that had nothing to do with this behemoth getting dragged down in it's draft. That is the reason an orderly liquidation is needed. RBG estimated yesterday that the damage from AIG failing would have been around $180 Billion. AIG provided insurance on $441 Billion worth of fixed income investments.

I don't like it, and I imagine this event will keep lawmakers and regulators busy for years, but I'm in the camp with the folks that "reluctantly accept" the Treasuries decision as the best decision that could be made from the group of ugly choices presented. The shareholders of AIG are getting wiped out, so it doesn't look like the government is rewarding the risk takers. In December of 2000 AIG was trading at $100 a share, it closed yesterday at $3.75 and last night the government took over 80% of what's left.

Paulson laid down a plan where the government could keep a huge number of innocent bystanders from getting crushed, while at the same time providing for an orderly liquidation and letting the stockholders meet the fate they created for themselves. AIG got an $85 Billion loan, and the Treasury got an 80% ownership stake in AIG. So Paulson will loan you the money, but you don't get to steer the ship anymore. And oh by the way...the loan is Libor + 8.50% (11.50%) and management is fired...hardly a sweet deal.

Ultimately I think Paulson and Bernanke are playing the hand that was dealt to them as well as they can. The shareholders of Bear Stearns, Lehman, and AIG have all been driven to the poor house, and the fallout to the innocent has been minimized. If all goes well the loans will get repaid and the taxpayer impact from these events will be minimized. I know that's a big IF and my gut tells me that even if the Treasury does make money doing this congress will probably take it all and the taxpayer will still be on the hook.

It's almost midnight Eastern time currently and I picture Bernanke and Paulson knocking back long-necks in a smoke filled piano bar somewhere in the nations Capitol wondering how they will EVER top a week in which they spent over $200 billion. As the camera begins to fade they share a knowing look and simultaneously agree...Vegas...