Fixed Income Forum

2011 Year in Review

2012-01-06T13:25:00.000-06:00

Four Years

In the summer of 2008 there was a kid who graduated from high school somewhere in this country. His parents likely told him how lucky he was to be going to college because the job market was getting bleak. They likely told him to study hard, have a good time, and that things would be better when he graduated college in 2012.

So our man graduated high school and like the sea-of-youth that surrounded him he drove off to college where he passed the time studying diligently. Now…he may have skipped a few classes and he might have even gone to a bar or two, spoken with some girls, hunted and fished all he wanted, and occasionally had to run from the campus police…but I’m confident that he at least studied a bit. Ultimately he was in a position to side-step the economic carnage, study for four years, and then take the job market by storm when he graduated.

That kid is now 6 months away from graduating college…and his job prospects are even worse today than when he started as a freshman 3.5 years ago. In the summer of 2008 the Unemployment Rate was at 5.80% and was just starting its climb to 10.00%. If he is a business major he might even know that this is the fourth consecutive year we’ve entered with Fed Funds at zero percent.

You heard that correctly…2009, 2010, 2011, and 2012 all began with Fed Funds at zero percent. If this kid is on the honor roll he might also know that the Fed is telling us that 2013 will start that way too! That makes me feel very old all of a sudden…someday I’ll be saying things like “I remember when the Fed kept rates at zero percent for five years!” And I think I might be lucky if I’m saying it was only five years.

Today our college graduate is facing some bleak prospects…the worst of which might be having to transition from a life of keg parties and dating, to moving back in with his parents…who are likely not having keggers and could also be unwilling to finance his dating schedule. Oh the humanity!

This kid is going to grab his diploma, walk off the campus, and wade into a huge pool of unemployed Americans where he will tread water and hope to be rescued quickly. As he works to stay afloat he may strike up a conversation with some of the others in the pool…almost half of the people he talks to will tell him that they’ve been in this pool for more than 27 weeks.

Our man will now begin to wonder how long he can keep his head above water. Almost half of these people have been unemployed for more than 6-months. His mind now starts to wander toward thoughts of Grad School. If he can find the money he can be back in the comfort and safety of an academic/party setting by September.

If our man was a member of the national honor society he might even be aware of the fact that it takes roughly 150,000 jobs a month just to absorb people like him (the new entrants to the work force). Given the fact that there are 12.9 million people on the “official” unemployment rolls, and that only 9 of the past 36 months have posted more than 150,000 non-farm payroll additions he can do the math and see that it is going to take a long, long time before everyone that wants a job can get one. This economy can’t even generate the jobs needed to absorb the new entrants to the job market…much less to start digging into 13 million unemployed that are treading water in the unemployment pool.

So what is our man to do? What is the outlook right now? Is the data telling him to stay in the pool because the economy is coming back and a job should float along shortly? Or is the data telling him that the economy is bad enough that he should go back to Grad School pronto before he misses the application deadline?

Given what we know about the economy we should be in a good position to help this kid make a decision.

Let’s start off with a very brief review of 2011 (not necessarily in chronological order)

- The year started with Fed Funds at zero percent

- Unemployment started at 9.8 and ended at 8.6

- Tsunami in Japan

- Nuclear Meltdown in Japan

- 8% of total unemployed apply for McDonald’s position in April!

- Fed commits to keep rates low ‘til 2013

- Refi story keeps coming back to us

- The “Arab Spring” sweeps across the middle east

- The Fed shuffles their maturities with Operation Twist

- Fed routinely says things should pick up in second half

- US gets downgraded by Moody’s

- Moody’s confused when Treasury prices RISE after the downgrade!

- It’s good to be AA+ in a BBB world

- Goldman says it could be end of decade before rates rise

- Greece causes problems in the Eurozone

- Austerity and riots in the streets in Greece

- Second half finally got here…and brought no growth with it

- Italy, Portugal, and Spain, begin having problems too

- MF Global goes under (a US Primary dealer)

- Osama Bin Laden gets to meet SEAL Team 6

- Meredith Whitney no longer remembered as the gutsy, genius analyst that predicted that Citigroup would cut their dividend

- Year ends with Fed Funds at zero percent

You’ll notice that there wasn’t a tremendous amount of good news on that list. That fact didn’t escape the Fed either…which is why we still have Fed Funds at zero percent and the Fed searching for new and improved ways to tell us that rates will remain there for a while longer.

If you read all of the FOMC statements…and it’s an unfortunate fact that I have…the tone you get is that we are in the midst of a very modest and fragile recovery where any bit of positive data that they can conjure up is offset by a laundry list of risks that offset it. There is no glaring positive news that they can put on a pedestal and say “that right there is a very good sign for this economy”.

Instead they say things like this:

“The unemployment rate dropped to 8.6 percent in November, and private nonfarm employment continued to increase moderately during the past two months. Nevertheless, employment at state and local governments

declined further, and both long-duration unemployment and the share of workers employed part time for economic reasons remained elevated. Initial claims for

unemployment insurance moved down, on net, since early November but were still at a level consistent with only modest employment gains, and indicators of job openings and businesses’ hiring plans were little changed.”

That paragraph came from the most recent FOMC minutes and it’s typical of recent descriptions of economic activity from the Fed. You’ll notice that they have to dig to find data that is somewhat positive…and after they lay it out there they come back and hedge it until you lose any excitement you might have had.

It’s a bit like a doctor telling you he was wrong when he told you that you only had 18 months to live…and you start to get excited and then he cuts you off and says “I should have said 24 months.” The news is “less bad” but it’s certainly a long way from “good”. That’s kind of where the economy is right now.

What will 2012 bring?

As you begin to ponder what the next twelve months will bring, and you hold board meetings and make forecasts…keep in mind that the Feds job is to maximize employment and maintain price stability. Those two things will dominate much of their thinking as we move forward.

There are certainly other things they will have to deal with as the global crisis ebbs and flows. They will continue to be involved with the global issues but keep in mind that their primary focus will be jobs and inflation.

So…where are those things right now?

Everyone on the FOMC committee says the same thing with regard to jobs…because it’s obvious…the unemployment rate is too high and it is falling at a rate that is unacceptably slow. Too many people are out of work and they have been that way for far too long and will likely stay this way for a long time to come. Boom…on to the next part of the dual mandate.

With regard to inflation, the Fed isn’t worried. They continue to state that long run inflation expectations are stable and that they are below their long term target levels. We are free to agree or dis-agree with their opinion on this matter…but the fact is that they are the ones who set the target Fed Funds rate and that’s the way they see the inflation picture. If we want to have the slightest hope of figuring out what they are going to do with rates then we need to know what page they are on.

The outlook for low and stable inflation coupled with the high rate of unemployment give the Fed a green light to stay on hold. In fact, at the last FOMC meeting the lone dissenter wanted MORE accommodation as opposed to less. When you take this a step further and consider that there will be new voting members rotating onto the committee this year whose outlook is more in line with those who prefer accommodation, you can get even more comfortable with the fact that rates are likely to remain low for a long time.

The most recent news from the Fed is that they will now be providing us with their internal forecasts for where they see Fed Funds going. A friend of mine laughed recently and said “so much for the Fed Funds Futures market.” I had to laugh too…what will all of those traders do now that the Fed has pulled the rug out from under them? I put out a short Market Update on 1/4/11 that gives an overview of the Feds new communication policy if you are interested in their new communication plans.

What to think about 2012

As you think about 2012 and what it might bring I want challenge you with the following task. Find a way to fill in the blank on the following question: “In 2012 economic growth will come from _______”.

If you come up with an answer that you find believable then you will likely be planning on increased economic growth and higher interest rates right around the corner.

If you can’t fill in the blank with a believable answer then you’re in good company. I don’t know what to put in that blank, and I haven’t spoken to anyone who can fill in that blank. The Fed certainly can’t…which is why they are committed to holding rates low through at least mid-2013…and there is no shortage of speculation that they could leave them there a lot longer than that.

To me it looks like 2012 will be another year full of excuses for why we won’t have any decent growth. In 2011 earthquakes and uprisings in the middle-east were the excuses for our lack of growth in the first half of the year. The longer it went on the more we were told that we’d get our growth spurt in the second half. Then the second half got here and there was no growth…and then Europe started melting down…and then everyone realized it just wasn’t going to happen in 2011.

Now we are starting 2012 with slim pickin’s for growth prospects…and a whole new slate of potential excuses for why we’re still in the ditch.

Wildcard events for 2012

Below are a few items that should haunt the headlines at some point in 2012. These all have the potential to become roadblocks to growth in 2012. I’m certain there are a lot more out there…these are just the ones I could think of with one cup of coffee in me.

Iran – There is a lot of talk about somebody smacking Iran hard before they can build a nuke. I have no idea what the odds are of this happening…but I think I’m safe in saying that if that happens we should expect a big rally in Treasuries with prices going up and yields dropping.

North Korea – North Korea just lost their leader. You might think he was just a guy with a bad haircut that wore a Members Only jacket and platform shoes…but apparently he talked/coerced many into believing that he was a god of some sort.

This is a country that launched a missile at Hawaii on the 4th of July when they had STABLE leadership. I can see why the experts are concerned about their potential for creating instability now that there is a new and untested twenty-something year old guy at the helm.

Europe – At this point it feels like the consensus is becoming that Europe will just be a big drag on everyone. It seems like a lot of the big scary stories about the breakup of the Euro and “war-on-the-continent” have faded and now it has become a game of “how long we can drag this out before we have to admit that it won’t work.”

The Election – We will surely get a non-stop drumbeat of news this year regarding the economic plans and fixes from both the incumbent and the challengers. I wish we could just fast forward to the end but it’s not that easy…we’ll have to put up with 11 months of headlines and debates that will jostle the markets along the way. This is a big wildcard for sure. I have no idea how the election will impact the markets…but I know that it will impact them. There isn’t much more color I can provide on that topic.

Military drawdown – If you’re a student of history you know that once the wars are over the US makes drastic cuts to its military. It happens after every war and given our current fiscal condition one might expect these cuts to be even deeper than usual.

This should have at least two impacts. First is that it’s a drop in government spending, which in the absence of a corresponding increase in another area will have a negative effect on GDP (this isn’t an argument for keeping the military at current levels…it’s just worth noting that government spending has been propping up GDP and this will be a reduction in that support). This spending has been on items ranging from salaries for active duty military and civilian contractors to the acquisition of high dollar weapons systems.

Many people don’t realize how expensive military hardware really is. Sebastian Junger gave a good example of the economics of conflict in his recent book about combat in Afghanistan titled “War”. He said that one day he marveled at the complexity of it all as he watched an $80,000 shoulder fired missile, get launched by a guy who doesn’t make that much in a year, at a guy who doesn’t make that much in a lifetime. The point is that governments spend a LOT on war when it happens…and that spending will soon be cut drastically.

Additionally, these cuts will transition a lot of people from government contract work and military service…into the domestic job market…where there are very few opportunities awaiting them. This will put some amount of upward pressure on the unemployment rate.

So what should we tell our recent college graduate?

So now I’m sitting here staring at the college graduate across from me and pondering what to tell him. From where I sit his choice is this…he can go out into the real world where he will likely have to wait a long time just to find a low paying job that doesn’t match his skill set…or he can go back to college, study a little, hit happy hour three nights a week, go to football games or hunting or fishing on the weekends, and ride out the worst business cycle he is likely to see in his lifetime in relative ease.

My answer is that he better apply quickly…because grad school sounds pretty sweet and I might beat him to it if he doesn’t.

What will you tell him?

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

Steve Scaramastro, SVP

800-311-0707

INTENDED FOR INSTITUTIONAL INVESTORS ONLY. The information included herein has been obtained from sources deemed reliable, but it is not in any way guaranteed, and it, together with any opinions expressed, is subject to change at any time. Any and all details offered in this publication are preliminary and are therefore subject to change at any time. This has been prepared for general information purposes only and does not consider the specific investment objectives, financial situation and particular needs of any individual or institution. This information is, by its very nature, incomplete and specifically lacks information critical to making final investment decisions. Investors should seek financial advice as to the appropriateness of investing in any securities or investment strategies mentioned or recommended. The accuracy of the financial projections is dependent on the occurrence of future events which cannot be assured; therefore, the actual results achieved during the projection period may vary from the projections. Interest rate swaps and derivatives are offered and sold via Vining Sparks Interest Rate Products, LLC. The firm may have positions, long or short, in any or all securities mentioned. Member FINRA/SIPC.

Market Udpate 12 15 11 _ Against the wind

2011-12-15T09:29:00.000-06:00

It’s been a boring few weeks around here lately. No fishing, no jumping out of planes, no mountain biking, no travelling…it was all rainy days and sick kids until Saturday. What changed on Saturday? Last week I got an invitation to go to the Bob Seger concert at the FedEx Forum here in Memphis…and these were front row seats. I immediately jumped on the invite and began counting the days until the show.

The first thing you notice at a Bob Seger concert is that Bob Seger has gotten really, really old. His hair is gray and he’s wearing orthopedic shoes, and the stage is padded/carpeted and you start to feel a little sorry for the guy when he walks out. The average age of the band looks to be about 100. The second thing you notice is that these guys absolutely rock. Halfway through the second song I turned to my wife and told her I hope I’m half as cool as Bob Seger when I get to be his age. She assured me I’m already that cool but I think she was just saying it so she wouldn’t have to walk home. It was an awesome event…many times you could hear the entire stadium singing along over the volume of the band. Everyone was on board and rocking in the same direction. This was a really strong performance for a guy whose first album came out the year I was born.

What does this have to do with monetary policy?

The first thing that comes to mind is that the Fed, like the members of Bob Segers band, is almost 100 years old. The Federal Reserve System was founded in 1913…the same year the Post Office began parcel deliveries…which might be an ominous parallel.

The second thing that comes to mind is that not everything ages well. Bob Seger is going to rock all the way to the grave…he will be as relevant the day he dies as the day he released his first album. The Fed, however, may not have what it takes to remain as relevant.

In fairness, the Fed has a much more difficult operating environment than Seger does. In the old “US Centric” model the Fed had a lot of leverage and could exert significant control over the system with the traditional tools they had available (Open Market Operations, Reserve Requirements and the Discount Rate). Nowadays we have a global economy, with many developed economies working to maximize their positions versus the rest of the world. Hundreds of economies and currencies, many with powerful central banks, are all working day and night to advance their own positions on the global stage. Capital can flow into and out of most countries almost instantaneously, and the exchange rate of that capital is also fluctuating in real time. This is the world in which the Fed must now operate. It is a far cry from the environment that spawned them in 1913. In 1913 most people didn’t own cars...there had never been a phone call from the west coast to the east coast…and I find it interesting to note that prior to 1913 there was no personal income tax in the United States…my what a different world that must have been. Nowadays most families have at least two cars, everyone over the age of 8 has a phone, and I don’t even want to start talking about income taxes.

Many of the tools the Fed has used for the past 100 years are no longer as powerful as they once were. Years ago in the old US-Centric model the Fed may have been able to create a significant economic impact with a 50 basis point cut in the overnight rate. Now with a high-tech and fast-paced global economy we are down to zero percent on Fed Funds…and it’s still not enough. The Fed can’t get the traction they desire so they come out with various Quantitative Easing programs in an attempt to get additional leverage on the problem. Those measures have also come up short. We are now four years into this economic downturn, the fed has ballooned its balance sheet, taken the overnight rate to zero, unemployment is still hovering near 9% with many arguing that “structural” unemployment is taking hold, and just this week they reiterated their pledge to leave rates at zero through mid-2013.

Despite all of the Feds actions the economy is still in the dumps. They simply can’t jump start things the way they used to. As we enter 2012 I think it’s helpful to take a good hard look at where we are, and what we should realistically expect from the Fed over the next 12 months.

I wouldn’t count on the Fed riding to the rescue of the economy in 2012. It is readily apparent that they don’t have a magic bullet for the issues that confront us…but it will be helpful to know what their plans are none-the-less.

What can you count on?

If you can bank on one thing it’s the Feds statements. They have gone to great lengths to improve communication with regard to policy. When they’ve told us they were going to do something…they have done it. So while their monetary policy tools may not be as effective as they used to be…they at least have a solid track record of following through on their statements.

The first thing to recall is that their baseline forecast is for the overnight rate to remain at zero percent through mid-2013. If you are still holding your breath in Fed Funds hoping for a rapid rise in the overnight rate it looks like you’re might pass out before that day comes. We have an analysis that shows “the cost of waiting” to help people determine if they are better off staying in Fed Funds or investing given their outlook on rates. If you’d like to see this report just shoot me an e-mail and we can run the report. This report will show you the difference in income between your Fed Funds projection and any investment you’d like to use as a comparison.

The second big item is that they remain committed to reinvesting cash flows from their securities portfolio to fund the purchase of longer maturity Mortgage Backed Securities. The goal here is to help the housing market by keeping downward pressure on mortgage rates.

As we enter 2012 these seem to be the “constants” that we are getting from the Fed and I would certainly build them into my thinking for 2012.

So these are just some random thoughts on the Fed, their past, and our future.

Now every time I read an FOMC statement I think of their 1913 start date and I look at all they’ve done right up until yesterday…and my focus fades from the words leaving Bernanke’s mouth at the press conference…and I start to hear Bob Seger singing softly in the background…

The years rolled slowly past
And I found myself alone
Surrounded by strangers I thought were my friends
I found myself further and further from my home
And I guess I lost my way
There were oh so many roads
I was living to run and running to live
Never worried about paying or even how much I owed
Moving eight miles a minute for months at a time
Breaking all of the rules that would bend
I began to find myself searching
Searching for shelter again and again

Against the wind
A little something against the wind
I found myself seeking shelter against the wind

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

Steve Scaramastro, SVP

800-311-0707

INTENDED FOR INSTITUTIONAL INVESTORS ONLY. The information included herein has been obtained from sources deemed reliable, but it is not in any way guaranteed, and it, together with any opinions expressed, is subject to change at any time. Any and all details offered in this publication are preliminary and are therefore subject to change at any time. This has been prepared for general information purposes only and does not consider the specific investment objectives, financial situation and particular needs of any individual or institution. This information is, by its very nature, incomplete and specifically lacks information critical to making final investment decisions. Investors should seek financial advice as to the appropriateness of investing in any securities or investment strategies mentioned or recommended. The accuracy of the financial projections is dependent on the occurrence of future events which cannot be assured; therefore, the actual results achieved during the projection period may vary from the projections. Interest rate swaps and derivatives are offered and sold via Vining Sparks Interest Rate Products, LLC. The firm may have positions, long or short, in any or all securities mentioned. Member FINRA/SIPC.

Market Update 11 29 11 _ Holiday Cheer

2011-11-30T10:26:00.000-06:00

Yaaaay…it’s all better!

Yesterday morning we had snow here in Memphis, TN. Normally just the forecast of snow would mean car crashes and snarled traffic in this town...but yesterday it was magical…there were no traffic problems at all and I arrived at work remarkably un-stressed from the commute.

After I parked my eco-friendly 5,500 lb, 4x4, V8 powered pickup truck I walked through the parking garage where I could see the snow falling outside and the intercom system was playing Bruce Springsteen’s “Santa Claus is Coming to Town” and the air was just crisp enough to remind you that it’s early winter. I sipped my coffee as I walked and took in the sights and sounds and I felt very much in the holiday spirit for the first time this year. I even passed a sign near the front door that read “Santa Parking Only”. Geez…this is perfect.

For a moment I thought I had landed in Mayberry. Then I came inside, sat down at my desk, and saw the headlines. Troubles continue to rage in the Eurozone…a breakup is being rumored…businesses and governments are making plans on how to deal with the potential disaster. A co-worker then pointed out what had to be the quote of the day. It came from Poland’s foreign minister Radek Sikorsky. He was giving a speech about the euro and he expressed that Poland’s largest threat wasn’t an attack by a neighboring country or rogue state…their biggest threat was the collapse of the Euro; and he viewed Germany as the one player that could avert that disaster. He said:

“And I demand of Germany that, for your own sake and for ours, you help it (the Euro) survive and prosper. You know full well that nobody else can do it. I will probably be first Polish foreign minister in history to say so, but here it is: I fear German power less than I am beginning to fear German inactivity.”

I frequently joke that if I were Greece I would be very uncomfortable having my fate in the hands of the Germans due to historical precedent. But that’s just little-ol-me…a fixed-income salesman and former Marine from Memphis TN with a dark sense of humor…nobody cares what I think. Here, however, we have no-less-than the foreign minister of POLAND…the country that hosted Germany on their first away-game of WWII…saying something not too far removed from my quip on Greece. Poland now sees Germany as its best chance of survival. I’m starting to hear tones of Princess Leia ringing in his statement: “Help us Obi-Wan, you’re our only hope”.

So, yesterday went from “winter wonderland and Christmas music” to seeing the victims of the Blitzkrieg begging for help from the Germans of all people. Just when I’m confident that this crisis can’t get any weirder this happens.

What a difference a day makes

Today we have a much different set of stories in the market. On September 9th I wrote a piece titled “Smells like Coordination”. That piece basically said that based on what I was seeing at that time it seemed like another round of coordination between Central Banks might be in the offing. As it turns out it appears that they were in fact scheming along those lines…this morning we see the results…six Central Banks have announced coordinated efforts to help ease pressure created by the crisis in Europe.

The Fed, ECB (European Central Bank), Bank of Canada, Bank of England, Bank of Japan, and the Swiss National Bank have all coordinated their efforts. The short story is that they are essentially providing guarantees of cheap liquidity in a number of currencies through February.

European banks had seen their cost on dollar denominated loans increasing recently as potential lenders watched with alarm as problems in Europe escalated. Fear not…the Central Banks are riding to the rescue with more cheap money. This is a continuation of the recurring strategy of “buying time” that has come to define much of this business cycle.

It’s like Broadway

I don’t often go to see a “play”…you know…like on a stage in a theater. I have however been to one or two in the distant past so any of you who like to call me completely uncultured will have to dial it back just a notch.

Today’s market activity reminds me of the theater. On stage right now I have a group of actors who are singing about a recovery. The songs are all about the ADP Employment figures being higher, and Pending Home Sales rising, and Black Friday Sales going through the roof...and the Dow is up 400 and the 10-year is up to a 2.09%, and all of the actors are happy and singing and everything is great. But backstage behind the curtain the stagehands (represented by the Central Banks) are fighting like mad to put out a fire that is threatening to burn up all of the props needed for the next scene…and maybe even the theater itself.

Seen from this point of view it’s difficult for me to get excited that the play is going to be a great one. Normally what would happen is that during the intermission I could try to talk the wife into going to a sports bar instead of seeing the second half of the play…but I’m afraid this one will end like the others…I have no hope of getting out of watching the whole thing unfold. Good or bad we’ll all have to stay here and watch the rest of the play.

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

Steve Scaramastro, SVP

800-311-0707

Market Update _ Grocery shopping and sector analysis

2011-11-07T11:18:00.000-06:00

Last night I was in the kitchen when the wife came home from the grocery store. As she was putting the groceries away she announced that she had just bought some special apples that taste like grapes. Curious, I asked how much she paid for them. She responded with “I don’t know…why?”

“Because if they’re more expensive than grapes we just got robbed.” I replied. After all, why would I pay up to get something that “tastes like” grapes if I can get the actual grapes cheaper? She quickly brushed aside my economic commentary on our groceries and left the room. Tough crowd.

Many people will look at the “apples that taste like grapes” story as tale of a unique culinary/scientific achievement…but when I see these grape-flavored apples on my counter-top I see a sector-analysis story.

Why do these funky apples remind me of sector analysis? Because if I like grapes, but grapes are expensive, I might be able to find a really good grape-substitute in another part of the fruit world. In this case if I can get the grape-flavored apples cheaper than grapes themselves then there is some value available there and I’m willing to purchase them. Same grape taste in a little bit different package at a lower price? Great…sign me up.

This in turn leads me to the investment portfolio. If I’m an Agency Callable buyer, but callable yields have dropped, maybe I can find some yield in another product that has the same maturity/average life/price volatility characteristics.

How about an example?

A very recent example is in the world of Callable Agency bonds. Consider the following numbers:

A 3 year non-call 1 year with a one-time call will bring you a 0.75% yield today

A basket of 3 year CD’s with no call options, and zero risk weight will bring you a 1.50% yield (with the convenience of DTC delivery)

You get a lot more grapes for your money with the CD than with the callable. In fact you get twice as many grapes for the same price. Supplies are limited on the CD side so there is a limit before you have to go back to buying callables but it shows that you can occasionally get some shots off at much better levels if you keep looking in all areas.

Another example would be:

A 4 year non-call 3 month brings 1.125% with -11.00% price volatility this morning

A 10 year 3.00% MBS currently brings 1.65% yield in the base case with -11.00% price volatility

Again we get more grapes for our money.

Wrapping it up

If you’re looking to put money to work as we head into the end of the year remember to look around and pick up value where you can find it. Compare sectors and make sure you’re getting the most bang for your buck.

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

Steve Scaramastro, SVP

800-311-0707

Market Update 11 1 11 _ Show me the money

2011-11-01T10:58:00.000-05:00

If you’ve been following these Market Update pieces you have been reading about how the recent pullback has been a buying opportunity and how I suspected the Treasury yields might not last for long at the lofty and optimistic levels we had recently attained.

Two stories are impacting the market today

The first is that politicians in Greece are doing some things that are putting the rescue plan in doubt. Despite the markets upbeat attitude toward Europe’s plans…reality is creeping back in. The Greek government is considering putting the EU’s bailout plan up for a vote…which could cause the plan to be derailed. I don’t understand politics in my own country so I won’t even try to guess how Greek politics work. Perhaps the best summary I can find of what’s going on in Greece is the following quote from Societe Generale:

“What the Greeks are considering doing would result in about as disorderly a default as you can get. That threatens to return Europe to the maelstrom”

That should sum up things on the European bailout front. A disorderly default will cause a lot of problems…it might cause the type of problems that make me glad there is an ocean between us. Germany’s Angela Merkel openly warned of war coming to Europe if the Euro is allowed to fail. When a head of state is making statements like that I tend to listen. It would be different if it were the leader of some third world, ragtag, banana republic country…but this is the leader of Germany so you have to pay attention.

The second story is that the MF Global plot continues to thicken. Before we talk about the problems at MF Global we need to do a quick review of “margin calls”. A margin call is where a position has moved against you and your broker or counterparty calls and demands you put some more money into the pot to cover the increased loss/risk. Normally you’d cover the margin call with cash or by selling something to generate cash. Then you sit back and hope the position comes your way…if it moves against you again you get another margin call and you’ll have to raise more cash and/or sell more positions. Many of you will remember this cycle from late 2008 and 2009 when the hedge funds were all getting destroyed. Their trash positions were moving against them and they had to sell their high quality paper (GSE debt). Spreads widened as supply was dumped on the market and we were all able to buy MBS at huge spreads as we took advantage of the geniuses that were running hedge funds.

Show me the money

This brings us to current day Wall Street. MF Global began getting margin calls as some of their positions began moving against them. At first they covered with cash…then they ran out of cash. Apparently somebody notices that while the firm was out of cash, they still had a lot of customer money lying around. I don’t know how the next chain of decisions gets made…but I picture it going something like this:

Trader 1: “Hey, we’re getting more margin calls on these European bonds…and I just used up the last of our cash.”

Trader 2: “Dude if we can’t meet these margin calls our counter-party is going to liquidate the positions and the losses will go from “un-realized and un-nerving” to “immediate and tragic”. We are going to get canned. What are we gonna do?”

Trader 1: “Well…there is a ton of cash sitting in these accounts that we manage for customers…they’re not using it right now, they’re just sitting on it. They’ve been sitting on it for like two years…it’s just sitting there doing nothing.”

Trader 2: “Great idea…we just need it to cover until our positions come back. Once things calm down and prices recover we’ll just pull some equity out of our positions and put the money back. Their cash will be back in the account before anyone knows what’s up.”

Trader 1: “Sweet….grab me a few hundred million of it to cover these margin calls…then we can get back to surfing the net.”

Trader 2: “Done.”

I don’t know how the actual conversation went but I have no idea how you could get to a point where stealing customer funds to cover your own mistakes sounds like a good idea. I’m tempted to ask “Where has “integrity” gone?” but in reality the people that do these types of things never had it to begin with.

Many years ago the Marine Corps taught me that the quick and easy definition of “Integrity” is that “you do the right thing even when no-one is looking.” That rule has served me well over the years…and it sounds like MF Global could have benefited from it as well. Another big lesson that looks to be coming from this is that MF Global lacked appropriate controls…after all…integrity is great and all but when there is a lot at stake trust should go out the window and verification should take its place. This leads me to another phrase that is famous in the military…”Trust me with your life…not your money or your wife”. Trust is great…but verification is even better.

If hundreds of millions of dollars of customer cash are unaccounted for at MF Global it is just one more giant sign that things were poorly run.

Is this the first time a trader has stolen money?

The history of finance is littered with stories of theft and fraud. Without having to look anything up I can think of several cases. Barings PLC (Britain’s oldest investment bank) was brought down in 1995 by a rogue trader named Nick Leeson who was trying to cover losses and using the firm’s weak internal controls to do it. In that case a single trader in a far flung branch office in Singapore was able to bring the entire bank down because of poor controls. Leeson generated losses that were more than twice the amount of capital the bank had available.

More recently Societe Generale got smacked with a $7.2 billion loss by a rogue trader named Jerome Kerviele. That one was so shocking that people internally thought at first that it was a joke. Another was hedge fund Amaranth Capital that got torpedoed by one of their own natural gas traders who generated a $6.6 billion loss.

I guess it surprises me a lot that customer money could be misappropriated at MF Global after we’ve had so many big firms destroyed by employees operating in an environment with poor internal controls.

Maybe I’m jumping the gun…maybe the hundreds of millions of dollars of customer money will show up…perhaps it was just put in the wrong drawer. We’ll see how it turns out…but if you had money at MF Global I’d start making some calls to see if you’ll be getting it back.

From the bad timing file

Another interesting fact from MF global is that a group of investors were so enamored with John Corzine’s leadership abilities that they bought $650 million in bonds from the firm just a few months ago. In what has to be just about perfect timing, the firm will be bankrupt before they make their first interest payment on those bonds. This reminds me of the scene from Vegas vacation where the guy takes Clark (Chevy Chase) to the second-rate casino’s that are “off the strip” and have some familiar games like rock-paper-scissors and flip-a-coin.

Clark walks up to a table where the game is called “guess the number”. He puts his money on the table and the dealer says “I’m thinking of a number between 1 and 10” Clark says “seven”. The dealer says “nope” and then promptly takes his money. That scene just became a lot less funny to investors in MF Global debt.

The end

So…MF Global and Greece are the latest news…its’ now “Game off!” and people are rushing to the sidelines with their money. The 10-year Treasury is up over a point this morning, pushing its yield down to a 1.97% currently. It’s yield has dropped 43 basis points in the last three trading days.

People are starting to realize that things haven’t changed. Anytime we see yields pop up with no change in the underlying fundamentals I think we should view it as a buying opportunity. That’s all the news to report for now. I think I’m going to call my broker and make sure he’s not inter-mingling my funds to cover his losses. This should be a fun one.

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

Steve Scaramastro, SVP

800-311-0707

Market Update 10 31 11 _ It's Halloween and the market is spooked

2011-10-31T12:01:00.000-05:00

What better day to announce the failure of a primary dealer than Halloween?

Remember the old movie “Wayne’s World”? There were some scenes in the movie where Wayne and Garth would play street hockey out in front of their house. They’d put the goal right in the middle of the street and one would be the goalie and the other would take shots. When a car came down the street one of them would yell “Game off!” and they’d run for the sidelines, then when the car passed they’d yell “Game on!” and they’d come back out and play. This scene reminds me of our current market. Each time a danger comes close, market participants yell “Game off!” and run to Treasuries. Then some amount of time will pass and it’s “Game on!” again and Treasury prices fall and yields bump up a bit but inevitably another car comes down the street and it’s back to “Game off!” and yields drop down again. The economy just can’t get any sustainable momentum…each time you think it’s safe to play in the middle of the street another car comes by.

Today someone was playing in the street and they got flattened by a European car. Today’s big news is the failure of MF Global…a US Primary Dealer. Here is the description from the NY Federal Reserve website of what a Primary Dealer does:

“Primary dealers serve as trading counterparties of the New York Fed in its implementation of monetary policy. This role includes the obligations to: (i) participate consistently in open market operations to carry out U.S. monetary policy pursuant to the direction of the Federal Open Market Committee (FOMC); and (ii) provide the New York Fed's trading desk with market information and analysis helpful in the formulation and implementation of monetary policy. Primary dealers are also required to participate in all auctions of U.S. government debt and to make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account-holders.”

MF Global will no longer be performing any those functions listed above. I don’t know what the “MF” in “MF Global” stands for…but I’m pretty sure I know how “MF” was used this morning behind closed doors when the NY Fed realized that one of their primary dealers was going bankrupt.

MF Global was not only a Primary Dealer; they were deeply involved in derivatives and commodities trading. It will be very interesting to see how the ripples from this failure affect other markets and market participants. Apparently the firm suffered very large losses from their holdings of European sovereign debt. This will remain a very interesting story as the recent plans in Europe are to force haircuts on debt, then backstop their own banks with a big liquidity fund so they don’t get hammered like MF Global did.

Anyone who thought that the European problems were just going to go away with the new announcement of some plans last week just got a shocking wake-up call…the problems are still here and they are big enough to take down big important firms run by really smart people. The good news is that if anyone was looking to become a primary dealer…there is now an opening.

Market reaction

The Treasury curve is up sharply at every point on the curve. The 10 year is up a point and five tics to trade at 2.18%. The 30 year bond is up over 3 points to trade at 3.21%. The Dow is off about 200 points currently. This story has to have a lot of people thinking that we are pushing a very shaky apple cart. How far and fast can the global recovery go? Who will be the next to fall? How widespread will the damage be? How much money will flow back into the safety of the US Treasury markets and how low will it drive yields? What does this mean for economic recovery? What about market liquidity? Does this affect our year end planning outlook?

These questions will be wrestled with as we go forward…for now I’m going to just assume that more people will succumb to problems coming out of Europe and I also have to assume that those stories will help keep a lid on interest rates. Fear will continue to have us yelling “Game off!” and running for the sidelines.

For now I’ll leave you with words of encouragement from Wayne’s World to help get you through month end…“Party on, Garth”.

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

Steve Scaramastro, SVP

800-311-0707

Market Update 10 28 11 _ On second thought....

2011-10-28T13:24:00.000-05:00

From: Steve Scaramastro [mailto:SScaramastro@Viningsparks.com]
Sent: Friday, October 28, 2011 10:52 AM
To: sscaramastro@viningsparks.com; 'Lisa Butler'
Subject: Market Update 10 28 11 _ On second thought....

News out of Europe was greeted with great enthusiasm yesterday. After the announcement was made that a plan was in place to “fix” the problems the market breathed a huge sigh of relief and stocks went up and bond prices went down and all was well. In fact things were so good it looked like the Texas Rangers might even win the World Series...first Europe is saved and now the Rangers will win the series…how much better could a day get, right? Then everyone went home and after the buzz wore off they got a chance to think about things…and then reality started to creep in…and maybe they realized “hey…Europe is still pretty hosed right now…and this business they announced looks a lot like our QE1 plan…and that didn’t really fix anything here when we tried it…maybe I shouldn’t get too excited by all of this.” And then they watched in disbelief as the Texas Rangers lead began to slip and the sure-thing win was now in doubt…and then they had to stay up late because things got ugly and the game went to extra innings…and then the Rangers lost and they went to bet angry.

Then they came in to work today and started throwing money back into Treasuries. We are rallying this morning and yields are heading lower from yesterday’s highs. The 10-year Treasury is up almost a point in price at the moment and is trading at a 2.30%. That is still a level we can live with…but it’s a sign that the market is contemplating the news and starting to hedge the bets it made yesterday.

I don’t know what Europe’s road to recovery will look like but I seriously doubt it’s going to be a smooth ride that takes them quickly from riots and tear-gas to prosperity and fiscal responsibility. I picture it being more like a rain-rutted dirt road that hasn’t seen a bulldozer in years…there will be a lot of bumps along the way, it will be slow going, and at times you will be worried that the vehicle might actually break.

That’s all the news to report so far…but they day isn’t over. Yields are moving lower and I’m thinking of dressing up as a Greek debenture for Halloween…I’ll have a very limited audience that gets it, but those that do should really appreciate it.

Have a great weekend, and if you have any questions just let me know.

Steve Scaramastro, SVP

800-311-0707

Live from Germany...it's a pullback!

2011-10-27T11:43:00.000-05:00

Just because you want it to happen…doesn’t mean it will…

The other day I was driving with my family toward our weekend getaway destination. Despite my objections we were on our way to Branson, MO for three days with the kids. When the wife told me where we were going I immediately but politely objected, stating that Branson is for old people…which is true. She responded rather quickly by saying that Branson has changed over the years…it’s not just for old people anymore. Now she had me laughing as I imagined the Branson, MO tourism board printing up new advertisements that say “Branson…it’s not just for old people anymore.” Ultimately I acquiesced to the will of the family to avoid a mutiny, and now I had my truck pointed toward Branson.

So now we were about 5 hours into the trip and we began getting hungry. Being the gentleman that I am, I inquired where she would like to eat. She stated that she had no preference and deferred the decision to me, as usual. What you need to know about me on a road trip is that if I am within sight of a Taco Bell and you give the decision to me…that’s where we are going. Taco Bell is the perfect fast food restaurant. There are only about six ingredients inside the store so it’s almost impossible to get your order wrong…no matter what you order it’s just the same stuff just in different shapes. This means that I can get good food and minimize the odds of getting the order messed up at the drive through at the same time. It’s perfect.

Decision made… “Taco Bell” I announced. Her response surprised me…”I’d rather not do Taco Bell” she said.

Hmmm…OK…”There’s a burger joint” I offered in reply

”I don’t know if I want a burger”

This exchange went on one or two more times until I finally had to point out that for a person who just said she had no preferences…she sure had a lot of preferences.

What does this have to do with the market?

The market is pulling back this morning on the most recent news out of Europe. Eurozone leaders have just completed a meeting where they came up with their plans (read that as preferences) for how to deal with their issues. The market is getting as excited as me heading toward a Taco Bell on a road trip…but as we’ll see...they could meet significant obstacles to their preferences as we move forward.

The market is a fickle friend. Just a few short weeks ago the 10-year Treasury traded down to a 1.69% on scary news out of Europe, a global slowdown, and poor domestic data. Yesterday the German government openly foreshadowed an outbreak of war if the Euro failed…that is language that would make me very nervous if I were a country that’s turning to Germany looking for aid. Today there is hope in the markets as European leaders announce that they’ve made progress in solving their regional issues. The early reports that I’m reading are that the agreement they reached involves:

1 – forcing bigger haircuts (nicer word for losses) on holders of Greek debt

2 – shoring up European banks that are about to be hit with big losses from the haircuts mentioned in “Step 1” …this sounds a lot like our QE1 but it should be good news for investors that hold bonds issued by those banks

3 – reinforcing a bigger bailout fund that would serve as a firewall to keep other countries from dragging the rest of the region down (this is the “I hope Spain and Italy aren’t next” fund)

In some respects I find it amazing that the market is pulling back on this news. Nothing has been done yet…at this point we just have plans from politicians. I’m no political analyst but history has taught me that plans from politicians are frequently ill planned and difficult to implement. I understand that investors need to move fast to be the first one into an asset so they can make money…but what I’m seeing right now feels like an over-reaction.

The 10-year Treasury was at a 1.69% a few short weeks ago…this morning it stands at a 2.30%. I love the fact that we’ve pulled back to this level…and if things do indeed get better in Europe we will see yields move higher still as investors reverse the prior flight to quality that drove us to these lows.

But I’m left with the question…what makes the market think that Europe’s issues will all be solved after this meeting? All of the problems are still there. Making matters worse is that many of their problems are structural in nature…these have no easy short term solutions. Structural problems can take a very long time to be solved.

The way this looks from my seat is that the initial euphoric, knee-jerk reaction to the new plan in Europe is creating a huge buying opportunity for investors who have been holding back cash and waiting for yields to pick up a bit.

You have an opportunity today to buy bonds when the 10 year Treasury is sitting at a two-month high. The 10-year Treasury is 60 basis points higher today than it was just a few short weeks ago. This is a classic buying opportunity.

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

Thanks,

Steve Scaramastro, SVP

800-311-0707

Market Update 10 19 11 _ Welcome to Mediocrity

2011-10-19T16:42:00.001-05:00

Expanding…kind of…

The Fed released its Summary of Commentary on Current Economic Conditions this afternoon. This is also known as the Beige Book, partly because it’s easier to say and partly because that is the actual color of the front cover on this report. This is a report that summarizes business activity in the various Federal Reserve Districts as measured by anecdotal evidence gathered by the various Fed Presidents.

Today’s Beige Book brings tidings of mediocrity. Reports from the 12 Fed districts indicate a slow motion expansion in September with many districts describing the pace of growth as “modest” or “slight” with mention of “weaker or less certain outlooks for business conditions”.

Historically the Fed hasn’t been known for its crystal clear communications. At times I think it might be more effective for them to play a game of charades where we try to figure out what type of economic data they are acting out. I want them to put someone on the committee like the old CEO of Toll Brothers (home builders) who said in a conference call a few years ago “this year is going to suck…all 12 months of the calendar year…there is no other way to put it.” THAT is the type of communication I appreciate…and I wish the Fed would be as clear.

I understand however that the Fed doesn’t care about my wants and needs….so we have the Beige Book. And today the Beige Book is telling us in modest tones that things aren’t great, but they aren’t terrible. I thought it might be informative to break the report out by sector with a brief summary of the activity in each. I know you all have been dying to learn what all of the sectors are in the report so this method will help scratch that itch as well. Here we go:

Consumer Spending and Tourism – Up slightly with most districts reporting an increase in auto sales. Greater availability of new models is now evident, and indicates an easing of the market disruptions wrought by the Japanese earthquake

Business Spending – Increased somewhat from the previous report

Nonfinancial Services – Mixed

Manufacturing & Transportation – Increased in most districts

Real Estate & Construction – Little changed in all 12 districts

Banking & Finance – Weakened some since last report

Ag & Natural Resources – Crop conditions at harvest were less favorable than a year ago

Employment, Wages, and Prices – Labor market conditions were little changed (interpret this as “unemployment ain’t going down anytime soon”)

Look at those descriptions….up slightly, increased somewhat, mixed, little changed, weakened some, less favorable...I’m starting to hear my old friend from Toll Brothers echoing in my mind.

Recent discussions with bankers

The overall tone of the conversations lately has been somewhat depressed. This is unusual…as tough as things have been for the last few years most people could still manage a laugh or two and shrug off the bad news. Lately the mood has become a shade darker. I had one friend tell me that he’d rather get my fishing reports than economic reports. I don’t know if he thinks I’m a good fisherman or a bad economist. The fishing reports are entertaining, and as much as I was tempted to take the boat to the lake I figured I’d go a different route.

Maybe what we need now is a reminder that things won’t always be bleak…that they haven’t always been terrible. Rather than go fishing (and it was very tempting) I decided to spend some time doing historical research on economics. How’s that for fun?

Where were you on June 16, 2004?

The first half of 2004 could serve as a benchmark for good economic times. Since most people recall time periods based on cultural references rather than based on cold economic data I thought I’d throw out a mix of pop-culture and historical references for 2004 so you could recall where you were at the time. After all…you never sit around with friends having a drink and telling old stories when someone asks “remember where we were that time when GDP hit 3.8%?” Thankfully it doesn’t work that way. So…here are some reminders….and feel free to shoot me an e-mail letting me know where you were in 2004. We could get some interesting responses to that one.

1/4/04 Brittany Spears gets married, and has annulment in under 55 hours.

2/1/04 Janet Jackson coins the term “wardrobe malfunction” at Super Bowl XXXVIII.

2/13/04 The Harvard-Smithsonian Center for Astrophysics discovers the universe's largest known diamond, white dwarf star BPM 37093.

2/14/04 Despite the discovery of an entire planet made of diamond, prices in earths diamond market are unaffected…I guess an increase in supply only affects prices if you can actually get your hands on it.

2/16/04 The Pittsburgh Penguins set an NHL record by losing their 12th consecutive home game.

3/1/04 Pavarotti announced his last opera performance.

3/2/04 George Michael announces that “Patience” will be his last commercial album…thankfully.

3/08/11 US hands power over the interim Iraqi Government.

4/1/04 Google introduces its Gmail product to the public (I just got a gmail account this month…I’m not what marketing guru’s would call an early-adopter or “trendsetter”).

5/6/04 the final episode of the TV show “Friends” is aired…and no I didn’t see it.

6/02/04 Ken Jennings begins his 74-game winning streak on the syndicated game show Jeopardy!

Where have all the good times gone?

Hopefully that headline got a little Van Halen started in your head and now as you listen to the tune in your mind I wanted to point out what the Beige Book looked like in June 2004…our bench mark for good times. Below are the Beige Book sector summaries from June 16, 2004.

Consumer Spending 6/16/2004 – Reports on overall retail sales in most Federal Reserve districts were generally positive. Sales were strong at discount and drug stores.

Manufacturing 6/16/04 – Overall manufacturing activity increased in all Federal Reserve districts. There was particularly strong growth in defense, semiconductor, food processing, paper, lumber and other building products, textiles, automotive parts, furniture, heavy and other industrial equipment, metal products, transportation equipment packaging, and recreational equipment.

(editor’s note…basically everything was strong)

Real Estate and Construction 6/16/04 – Residential Real Estate remained robust in most districts.

Banking and Finance 6/16/04 – In most Federal Reserve districts, lending activity increased.

Agriculture 6/16/04 – Conditions across the nation were generally favorable

Natural Resources Industries 6/16/04 – Activity in the mining and energy sectors remains strong.

Labor Markets, wages, and prices 6/16/04 – Most districts indicated strengthening of labor markets. Many districts experiences “increasing employment, plant expansions, and plant openings across many sectors.

I like these descriptions a lot more…increased in all districts, generally positive, robust, remains strong, strengthening…we’ll eventually see these return to the beige book.

What next?

The optimist in me says that the good times will return, the government will get out of our markets, the regulators will retreat to a more proper role, and banks will get back to making money and we’ll all be going to happy hour and talking about how dreadful it was “back when…”

The pessimist in me says we’re on the road to Greece…except we don’t have a Germany to bail us out.

Who is right? Time will tell…but whichever is right we need to keep our banks well positioned. Until then the plan needs to be “live to fight another day.” We don’t know if the good times are coming back in 2012 or 2016. This brings me to our current position…year end.

4Q 2011

It’s time for some year-end planning. The 4^th Quarter of 2011 is underway and the Fed just recently told us that they are keeping Fed Funds rate at zero until the middle of 2013. I believe them.

I don’t agree with many of the things they have done…but they haven’t lied to me yet with regard to what they plan to do. If they’ve announced a plan of action at an FOMC meeting they have followed through on their word. That should serve as our baseline.

We will enter 2012 with Fed Funds at 0% and a commitment to keep them there through the middle of 2013.

Regulatory burdens will continue to be hefty. It’s important to know that you don’t have to shoulder that load alone. We have developed a lot of tools to help you satisfy recent regulatory requirements.

Need post purchase analysis on your muni portfolio? We can do it at no cost.

Need help tracking news and ratings on corporate bonds? We can do it at no cost.

Need to beef up Investment, Liquidity, Contingency Funding, or A/L policy? We have sample policies available at no cost.

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Need help finding investment solutions that fit your needs? We can do it at no cost.

Need help on Asset/Liability modeling or calculating EVE? We can help.

Need help raising capital in a management friendly fashion? We can help.

The short story here is that as you begin your year-end planning process…you don’t have to go it alone. Time is expensive and we’ve created tools to help you save a bunch of it.

If you’re curious as to what else we might have to help you, consider registering for our website. This will allow you to search our arsenal of tools on your own time…you can register as many people from your bank as you’d like…there is no cost. And if you’re worried that someone will begin calling you and hassling you because you registered…put your mind at ease…I’m already doing that so it won’t be any worse than it is now!

The 4^th quarter has begun and we are ready to help you tackle the issues ahead. Call me if you have any questions or if there is anything I can be doing for you.

Steve Scaramastro, SVP

800-311-0707

Market Update _ Is everything better?

2011-10-13T12:44:00.000-05:00

The Data

Today’s economic data show that both initial and continuing jobless claims remain a huge drag on the economy. The survey expectation for Initial Claims was 405k…we posted 404k. The expectation for Continuing Claims was 3.710 million…the actual release was a bit lower at 3.67 million.

Are the problems in Europe fixed?

With yields rising in the Treasury market it might be tempting to believe that everything is getting better…that the sun is coming out and the rain is going away and that the Europeans are going to find a bunch of money and Germany won’t have to pay for other countries’ ability to retire early and that the flight to quality that hammered our Treasury rates is going to reverse, and that higher rates are just around the corner. It’s a feel-good story that’s easy to believe when rates improve as much as they have in the last two weeks. But is it true?

How much risk is there? The Credit Default Swap market (CDS) offers us a way to gauge market sentiment on risk. Credit Default Swaps are essentially a form of insurance. They are a contract you enter with a counter-party whereby you pay them some fees up front and an annual premium measured in basis points, and in the event of default you get your par value back. Most investors are not familiar with these instruments because they buy high quality bonds and rarely feel the need to buy “insurance” against default. The nice thing about the CDS market is that we can use levels from this arena to get a feel for risk.

A quick look at credit default swaps shows that the market is still pricing in a lot of default risk in Europe…specifically on Greek debt. As a benchmark we can look at sovereign debt from the UK…which has a CDS spread of 84 basis points. This means that market participants are willing to pay 84 bps annually to get “insurance” against default on UK bonds. If you want to buy a CDS on UK debt it would cost you roughly $8,400 per million dollars insured…not much. Germany’s CDS spread is 89 basis points...or $8,900 per million insured. These aren’t shocking numbers…there isn’t much of a premium because there isn’t much perceived risk from these issuers.

What does the market tell us about the “troubled” countries in Europe? Here is a quick list of CDS spreads on some other countries in the region:

- Spain cost 356 bps

- Italy cost 425 bps

- Ireland cost 705 bps

- Portugal cost 1097 bps

- Greece costs 5,197 bps

At a cost of 5,197 basis points this means that to get “default insurance” in the form of a credit default swap on Greek debt…it would cost you $519,700 in premiums PER YEAR to insure $1,000,000 worth of Greek debt. That is what you need to know to get a feel for how the market feels about the situation. Given that the market is still pricing in this much risk…it’s difficult for me to believe that Treasury yields are moving appreciably higher from here with this much risk still being priced into the system. For the last few months every little hiccup out of Europe has caused a big flight to safety that drove our Treasury rates lower…I see no reason why that won’t continue.

Buying opportunity

Two weeks of pullbacks in the Treasury market created a wonderful buying opportunity. The 10 year Treasury yield had gotten as high as a 2.26% for a brief moment. This morning we have a rally pushing prices higher and taking away some of the value that has been created recently. The 10-year is currently trading at a 2.13%. At the moment we can still get bonds a lot cheaper than we could two weeks ago…but the market seems to be recognizing that some of this selloff is a bit premature.

If you’ve been waiting on the sidelines for a better time to buy…this is the “better time” that you’ve been waiting for. There is a lot uncertainty in the markets, rates are at the high end of the recent range, and if you have cash you have an opportunity to buy at better levels than we’ve seen in weeks.

If you have any questions on this material just let me know.

Thanks,

Steve Scaramastro, SVP

800-311-0707

Market Update 10/6/11 _ Two Years

2011-10-06T15:45:00.000-05:00

Market Update _ Two Years

Recently I was asked (told) not to write anything derogatory about politicians in these Market Update pieces anymore…at a minimum I need to not call out anyone by name for doing something stupid (like Barney _____ or Maxine ______) . Given the current level of fiscal incompetence that is being displayed by our elected officials I’ve found this to be a difficult constraint to live with. But since I like my job more than I like pointing out the incompetence of our elected officials I think I’ll try hard to live up to this challenge (order).

Recent Fed activity

Bernanke spoke to the Joint Economic Committee of Congress this week. This meeting is now one where a Fed Chairman who has no hope of fixing our problems, outlines what he is doing to a group of people who have no hope of understanding our problems. As far as I can tell the only constructive thing that comes out of this meeting is that the rest of us get to hear what is on the mind of the Fed Chairman.

For the first nine months of the year the Fed told us “all is well, growth is on the way in the second half, this slowness is transitory”. We are now deep into the second half of the year and the Fed is realizing that the cavalry ain’t on the way. Many of us didn’t believe that our troubles were transitory and now, two years into the “recovery” the Fed no longer believes it either.

Two years into the “recovery” unemployment is still running at 9.00%

Two years into the “recovery” housing is still in the dumps.

Two years into “recovery” Initial Jobless Claims are still above 400,000 per week.

Two years in the recover the Fed is still searching for the Holy Grail of monetary policy that will jump-start the economy.

There is nothing ground-breaking in Bernanke’s speech this week…we’ve heard all of it before. The general theme of the speech is that “we thought things would be better by now, clearly they are not.” Growth is low, inflation is low, job growth is slow and likely to remain that way for the foreseeable future, and the government sector (state and local) continues to shrink which exerts a drag on the economy as they reduce the work force and curtail activities and spending. There is no bright light at the end of the tunnel.

Tellin’ congress what to do

From there Bernanke moves on to beat the dead horse of fiscal responsibility. He lists four points for policymakers to consider as they create tax and spending policies…he told Congress to:

1 –Achieve long-run fiscal sustainability (I hope he could say this with a straight face)

2 - Avoid fiscal actions that could impede economic recovery (i.e. don’t do anything stupid)

3 – Promote long-term growth and economic opportunity

4 – Improve process for making long term budget decisions, create greater predictability and clarity, while avoiding disruptions in the financial markets and the economy (sounds like a fairy tale)

He summed up with:

“In sum, the nation faces difficult and fundamental fiscal choices, which cannot be safely or responsibly postponed.”

That is a nice way of saying “we are about to have the stagnation of Japan coupled with the violence of Greece if you don’t get a handle on this situation.”

His summary was good but I think it will be largely ignored by the electorate.

The FOMC members are making their rounds on the speaking circuit and we’ll be hearing more from them as the month progresses. As we hear from them I’ll be sure to decipher the Fed speak and send out a summary.

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

Steve Scaramastro, SVP

800-311-0707

Market Update _ Time to pay attention

2011-09-21T10:34:00.000-05:00

Is it time to pay attention?

It has been a long time since we sat around in this office talking about what the Fed might do at the next meeting. It’s not been uncommon in recent months for us to realize only after the fact that the Fed was meeting at all. Monetary policy has been very well telegraphed as of late so there hasn’t been much reason to pay attention on the FOMC announcement date. There has been no need to pick up the phone after recent FOMC meetings and frantically call all of your customers to let them know that the Fed did nothing, just like they’ve been saying they would do for the last two months.

That has begun to change. The buzz on the street lately is the concept of “Operation Twist”. Interestingly the Fed hasn’t really been talking down the plan in public…which leads to speculation that it might actually be in the works. What this plan entails is the Fed pushing their Treasury purchases further out along the yield curve to push interest rates lower. You heard that correctly…the Fed is widely seen as contemplating a plan that would push rates even lower than today’s levels.

I don’t know about the rest of you, but from where I sit I don’t see our number one economic issue as being that interest rates are too high. It’s not like we’ve got truck-loads of growth that could be unleashed if only rates were a little lower.

We know that the powers that be would love to ignite a refi wave, and that interest rates need to drop for the refi math to work…but rates aren’t the only factor involved. It’s important to remember that while interest rates have fallen… so have home prices and FICO scores.

If the Fed is successful in lowering the 10-year Treasury rate to 1.50% (or even 1.25% as some are calling for) it is still difficult for me to see that it will help borrowers who are upside down on their current home loan or who have poor credit to begin with. It strikes me as one more ill-conceived program that might help around the edges but won’t have a material impact on our economic outlook.

What does the twist mean to me?

If you are a fixed income investor then the twist is not good news for you. If they conduct this exercise the Fed will put their own money to work on 7 to 30 year part of the Treasury curve, push those rates lower, and push the people that were already there out of Treasuries and into something else. As those investors migrate out of the Treasury curve they will be going go MBS, CMO’s, Agencies, SBA’s, stocks, commodities and many other asset classes in an attempt to generate returns. This means that prices will go up and yields will go down in those arena’s.

I don’t have a lot of people telling me currently that they are overwhelmed by the amount of yield they can get on their investments. Yields are low, and will likely be lower still if the twist plan goes into effect.

Got Savings?

As we’ve gone through this cycle I’ve kept a close eye on a metric that the Bureau of Labor Statistics produces titled “Personal Savings as a Percentage of Disposable Income”. In a nation where consumers drive 2/3’s of GDP this strikes me as an important figure. Econ 101 tells us that there are only two things you can do with money: 1 – Save it, or 2 – Spend it.

For many years we spent it, and spend it, and spent it. Then that wasn’t enough so we borrowed and spent that too. This continued until America as a nation was saving less than 1.00% of their disposable income.

At that point we had a highly leveraged consumer with very little in the way of a cash cushion. Then the Great Recession hit and a large swath of consumers who had relied on plastic for all of their needs suddenly found themselves jobless, cashless, and creditless. This is the type of shock that changes behavior for generations.

13.8 million of these consumers are now out of work (9.2% of a 150 million person work force). A total of 24.3 million people are in the “Under-Employed” column. This includes both the unemployed and those who have had their normal hours cut back due to economic factors. The “Under-Employed” rate was reportedly 16.2% in August.

Why do I care?

If we are waiting on an American consumer to start generating 2/3’s of our GDP again then we need to get a good look at where that consumer is right now. With 16.2% of your work force not making enough money to support their normal lifestyle, how much can you realistically expect them to contribute in terms of consumption? Their credit cards are gone, what little cash they had is gone, and the bills are still there but their jobs aren’t. This is not the crowd that’s going to generate enough demand to put 13 million people back to work.

The remaining 125.7 million workers still have their jobs, but they too have been shocked. Many of them were also highly leveraged…but they were lucky enough to keep their jobs through this storm. Many of these people are now what we call “savers”. They are de-leveraging, they are paying down credit cards, and loans, and they are building up a cash reserve. At some point these consumers will become comfortable that they are in a good spot and will begin to spend again…but this will take time. It’s not a transformation that the government can make happen with just a wave of the fiscal wand. This is consumer psychology at work…and it has its own pace.

The chart below shows consumer saving as a percentage of disposable income.

The Personal Savings chart jumps out at me as two distinct time periods. The first is the 1960 to 1985 period which saw an average savings rate of 9.2%. The second period is the 1985 to present which has a 4.2% savings rate.

The low water mark for Personal Savings was 0.90% in 2001 (if measured on a month over month basis we actually saw some negative savings rates). In July of 2007 this rate was 2.00%. Then we began to get hammered by bad news and the savings rate jumped up to a high of 8.3% in April of 2008 and since has settled down in the 5.00% range.

When looking at the 1985 to current environment keep in mind that our current level of interest rates is historically low, yet we have a savings rate that is above the average for the period. With rates this low consumers should be spending like drunken sailors using a stolen credit card, right? Right…but they aren’t.

Ask yourself this question…with rates at historic lows, why would anyone in their right mind ramp up their savings? It doesn’t pay to save…the Fed is absolutely punishing savers with near zero rates on the short end…yet consumer savings rates are up.

They aren’t saving because they enjoy the dismal returns they are getting…they are saving because they are scared and deleveraging.

Everyone knows someone who has lost a job. Many know someone who has lost their home too. Nobody wants to find themselves in that position with no way to defend themselves so they save. The game is now about staying power.

The solution to our problems lies not with government programs, but with those who remain employed. They will eventually deleverage to the point where they are comfortable spending again. Once that happens producers will respond to the sustained increase in demand by increasing output, which will lead to hiring, which in turn will lead to a drop in the number of under-employed. Good things follow from there to the housing market and every other corner of our economy…but it will take time.

Any attempt to rush this process with fiscal or monetary policy tricks is simply a game that creates the illusion of demand creation when in reality all it does is shuffle demand around a bit.

As I watch all of the programs we have created over the last three years it reminds me of the old saying “Oh what a tangled web we weave, When first we practise to deceive!” In my view the more we manipulate our markets the harder it will be to ever set them straight again.

That’s my rant for the day…now it’s time to sit back and wait to hear from the Fed. They release their statement at 2:15 PM Eastern. I’ll be in touch after we hear their thoughts. If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

Market Udpate 9 9 11 _ It smells like coordination out there

2011-09-09T11:24:00.000-05:00

The best laid plans

Last night I had big plans. The President was making his highly anticipated “jobs” speech and the first NFL game of the season was on TV. I figured I’d listen to the jobs speech, have a few beers, catch the game, then hit the rack around midnight. I had no work to do…it was gonna be awesome.

Just as the jobs speech began I got an important and interesting e-mail. This e-mail was full of questions that came out of yesterday’s Federal Reserve Symposium on Asian Banking and Finance. Like the nerd version Batman I grabbed my iPad and a laptop and I sprang into action answering questions and addressing these timely issues. Some amount of time later I hit save, then send, and when I looked up it was midnight. I hadn’t seen the speech or the game…and I had consumed no beer. Don’t feel too badly for me though, the exercise gave me some perspective, and if all goes well I’ll be fishing by this afternoon.

Two years after the recession “ended” our economy is still stuck at stall speed and everyone in the world is talking about ways to improve the situation. This just highlights the fact that things can stink pretty badly even if you’re not technically in a recession.

The Fed has taken drastic steps over the past few years on the monetary policy side. The Fed Funds rate is at zero, their balance sheet has swelled to over a trillion dollars, they just pledged to keep rates low through 2013…and they are STILL discussing ways to do more.

To their credit they have made a lot of noise about not being able to solve all problems with monetary policy. Fed members have repeatedly urged the federal government to take the reins on the fiscal policy side of things. It is no secret at this point that our current fiscal trajectory is unsustainable. The path we are currently on has us landing in a spot that looks a lot like Greece sometime in the not-too-distant future. Not the “Parthenon and Mediterranean” Greece…I’m speaking metaphorically about the “sovereign default and riots in the streets” Greece.

Fiscal Policy

Bernanke spoke recently on monetary and fiscal policy. With respect to the fiscal policy side of things he said that while we need to alter our fiscal course, we don’t need to necessarily do it all at once. Bernanke’s preferred method for altering our fiscal trajectory can be viewed in terms of changing lanes in your car. You don’t change lanes by jerking the wheel and trying to get into the other lane immediately. You use a turn signal and then you gradually move the wheel in the direction you want to go. This results in a smooth and safe transition from one lane to the other. I realize that there are exceptions to this rule for people that live in places like Los Angeles, DC, Miami, and Houston but please bear with me for the sake of the example.

In the Fed Chairman’s view this is what we need on the fiscal policy side…a smooth lane change. Government spending has to a large degree replaced private sector spending over the course of this recession. Given that we are still in a place where the recovery is fragile, Bernanke doesn’t want to see an abrupt end to government spending that would add to the already stiff “headwinds” that are restraining the economic recovery. This abrupt lane change would endanger our recovery and could very well cast us back into recession.

His preferred course of action would be a gradual shift with a turn signal. The turn signal would allow everyone to see where you intend to go, then the gradual shift would allow you to get there without wrecking your car. In practice this would call for the Government to signal that they are changing our fiscal trajectory, then to gradually shift toward that goal so that you don’t abruptly pull government spending away from a fragile and developing recovery.

Monetary Policy

On the monetary policy side he began with the obligatory statements on how we got the car in the ditch. From there he went on to describe how they originally thought that the slowness in the first half of the year was mainly due to transitory factors, and how they now recognize that some of those were actually persistent factors. That is Fed-Speak for “we thought things just stank a little…but it turns out they stink a lot”.

He names all of the usual suspects as drags on the economy in this speech; housing, unemployment, slow household spending, the downgrade of US Debt, etc. What I found interesting in this speech was the mention of “sharp volatility and risk aversion in markets” in reaction to sovereign debt issues in Europe. All of these items are mentioned to get the speech to this point: “…there seems little doubt that (these events) have hurt household and business confidence, and that they pose risks to growth.” Linking European sovereign debt concerns to risks to domestic growth gets my mind working overtime.

At this point I’m looking at the puzzle pieces arrayed before me and I’m trying to figure out how they fit together. Two years into the “recovery” we have yet a new plan to generate jobs, a Fed stating that they have more tools in their monetary policy arsenal, sovereign debt problems raging in Europe, and a Fed drawing linkages between Europe’s problems and our problems. It has the look and feel of an environment that could bring about another round of coordination among the world’s major economic powers.

You might recall that in the aftermath of the Lehman Brothers failure we saw massive global coordination aimed at keeping the world’s financial markets from freezing. One such program had the Fed making enormous dollar denominated swap lines available to other central banks to keep liquidity flowing. Our Fed had arrangements in place with the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank among others. This type of coordination was considered essential to tackle the problems at hand.

All of the pieces I see in front of me make me wonder if the Fed is talking with other central banks about a new round of global coordination to address the problems we collectively face. It’s easy to see the temptation involved with a plan that combines coordinated international fiscal and monetary actions to address the various issues that are restraining the global recovery. I’m not saying it’s a good idea, and I’m not convinced that they’ll do it…but it’s starting to smell like coordination is in the air.

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

Steve Scaramastro, SVP

800-311-0707

Market Update 8 25 11 _ The Refi-Boomerang

2011-08-25T12:55:00.000-05:00

The good ol’ days

Do you remember the go-go days in the first half of this decade? It was a rare day that you checked the mailbox and didn’t see an offer from someone telling you to refinance your house. It was so easy a caveman could do it. It worked all the way up to the point where the wheels came off the bus. The dual bubbles of housing and credit popped and it all grinded to a halt.

Borrowers lost their jobs, they struggled to repay loans, home prices plummeted, LTV’s were out of whack…we all remember the story. When the dust settled we were left with a landscape of shattered dreams. A lot of people dusted themselves off only to find that they owed a lot more on their home than it was now worth. Many others lost their jobs at the same time. Refinance opportunities dried up as credit scores and home values fell in tandem.

In that environment many people pushed the idea of buying high premium MBS because the risk of refinance-driven prepay activity was gone. We were not among that group…we bought discounts as long as we could. After all…the definition of “Risk” is that more things can happen than will happen. Why expose ourselves un-necessarily?

That was fine while it lasted but as rates dropped further it became almost impossible NOT to buy MBS at a premium…there were no coupons low enough to provide discount prices. Now even those investors who tried to avoid high premiums are forced to operate in a world that is filled with them.

It’s like a Boomerang

The refi story is like a boomerang…every time you think it’s going away it turns around and comes back…and you’d better be ready to duck.

This refi-boomerang story brings to mind one of what I suppose could be called “foundational phrases”. These are bits of wisdom that I’ve gleaned from people in my life over time. These nuggets are usually encapsulated in a catchy phrase that makes it easy for people like me to remember and digest. One example is from Major Lissner, USMC, who used to throw this phrase out a lot in times of pain and difficulty; “do you think anyone gives a “bleep” that you’re miserable?” I loved the phrase for its Spartan simplicity. It said “I care” and “I don’t care” all at the same time…it was brilliant.

But that’s not the phrase that comes to mind with regard to the mortgage refinance issue. The phrase I’m thinking of today is by coincidence from another Marine Corps officer who used to caution us that “If you run your butt up a flagpole it’s gonna get shot off”. It’s a bit of wisdom that at its most basic level addresses a topic near and dear to us…risk management. Years after I first heard the phrase I got to see the practical application. I was watching the news one night and they were covering one of the many riots in the Middle East when I actually saw a guy shimmy up a flagpole. Guess what he got…yep…shot. At that point I understood that this was a generally accepted principle and that I could rely on its wisdom going forward. So with that in mind I reflect on our current predicament…which is one of exposure…and how to not get our hind-end shot off.

Standby for impact

We’ve frequently discussed the impact that a wave of mortgage refinancing would have upon the economy. From our viewpoint the first effect would be that investors who purchased MBS at large premiums would be burned, secondly investors who purchased MBS at lower levels and rode them to gains would see those profits erode, and lastly it would put huge amounts of money into the pockets of homeowners which they could use to stimulate the economy. There are many other effects that would ripple through other areas but those are beyond the scope of today’s article.

The first two issues on the list above (those that affect investors) are likely to be considered collateral damage…few people outside of our industry will care that your yield burned down or that your bond accounting gains have disappeared. You will be viewed as greedy investors, and as Major Lissner used to ask “do you think anyone gives a “bleep” that you’re miserable?”

It’s the last item on that list that is the really shiny and attractive prize in this deal: money in the pockets of homeowners/consumers/voters.

Can they do it?

From the governments standpoint this has to appear to be an almost magical solution. By pushing and pulling on the levers of power they might be able to create a landscape where many of the hurdles to refinance are removed. This would allow a lot of capital to roll right into the pockets of spenders. This would in theory help to bring back the good ol’ days where everyone spent, everyone had a job, and there were no problems too big to borrow our way out of. All of this just a year before the election, what’s not to love?

A few things are clear. One is that the programs put in place thus far to “help” homeowners haven’t been nearly as successful as their creators had hoped. Next is that there is no shortage of people who would love to refi but can’t. Another is that rates are low enough to pull it off…you just need to bully the rest of the pieces into place. Lastly the incentive is there…people in Washington are getting desperate for some positive momentum in the economic data. Estimates of how much discretionary income would be created by pulling this off run well into the tens of billions of dollars per year.

One big piece of this puzzle is already in place…the Fed has driven rates to historic lows. Obviously this is not the only piece of the puzzle…many people can’t refinance because they owe more than the home is worth. Others are prohibited because they have a habit of paying people late, less than what they owe, or simply not paying them back at all. There are still hurdles that need to be cleared for this refi wave to take shape…but some of the important pieces of the foundation are there. The longer rates stay low the longer the government has to come up with a way to make this work. This is a concern that is stalking the markets currently.

What can you do?

In what has become an almost annual evolution in the investment world we are reviewing MBS holdings to determine which bonds are most at risk for negative yields based on refinance-driven prepay activity. We have created analytics that will identify bonds that hold the potential for negative yields based on your book price along with Bloomberg projected speeds and the actual speeds being posted by each bond.

This report can help you identify bonds that you might not be comfortable holding. The report can also provide some peace-of-mind if you discover that your portfolio doesn’t have the potential to deliver negative yields.

We run this report on a complimentary basis. If you would like us to run your portfolio just send me your latest bond accounting report and we’ll get it done. For those of you that are already on our bond accounting system just shoot me an e-mail and I’ll pull the data and get it done.

If you have any questions on this material or if there is anything I can be doing for you just let me know. Until then…don’t run your hind-end up a flagpole.

Steve Scaramastro, SVP

800-311-0707

Market Update 8 17 11 _ Stampede

2011-08-18T09:23:00.000-05:00

Stampede

Hey everybody…Europe is back in the headlines! I never thought I’d say it…but I miss the days when all of the news out of Europe was about the royal wedding. As new concerns arise over sovereign debt in Europe we have yet another flight to quality. The 10-year Treasury is up over a point to trade at a 2.03% and the Down Jones (yeah…I know how I spelled that) is off 350 points to trade at 11,063.

Other news this morning was that Initial Jobless Claims posted 408,000 new claims vs. an expectation of 400,000. CPI was a bit higher than expected but that is being discounted completely amid this stampede to safety.

Even the records are setting records

The 5-year Treasury set another record low today of 86 basis points…but before I could type that it went down again and hit another new record low of 83 basis points…I’d better quit typing.

Gold hit another record high and oil is down to $83 a barrel. This is the markets way of preparing for a global slowdown.

From the “interesting timing” section

Two weeks after S&P downgraded US debt, news is hitting the headlines that the US Justice Department announced that they are investigating S&P. I have a friend at a bank in Florida who asked me right after the downgrade “what do you think S&P will look like a year from now?” At the time I didn’t understand the question…now I do. Payback can be rough.

Surprise at the end

As I wrap this up I just got the Philly Fed index release. This index tracks manufacturing trends in the Philadelphia Federal Reserve district. A positive number indicates expansion in manufacturing, a negative release indicates contraction. The expectation was for a positive 2.0 level which would indicate a very modest expansion. The actual release that got posted this morning was a negative 30.7. I don’t know that words can adequately express the magnitude of the index missing the mark by that much. Sound effects might be more descriptive. When that number was released I pointed it out to the rest of my office and the collective gasping/groaning that commenced made it sound like everyone in the office had been punched in the stomach at the same time.

The market, which was already it full-bore rally mode, drove prices even higher and pushed the 10-year yield down to a 1.99%...which may also be a new record…but I’ll have to research that.

The Dow is now off 500 points to trade at 10,900. Just when I was hoping that this would be a less volatile week the captain turns on the seat-belt sign and asks us to not move around the cabin…the turbulence looks likely to continue.

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

Market Update 8 10 11 _ The Morning After

2011-08-10T14:12:00.000-05:00

The Treasury market continues to move lower today. The 10-year Treasury is up over a point to trade at a 2.12% currently and the Dow Jones has given back all of yesterday’s gain…it is off 434 points right now.

Where to start?

One of the first things to be aware of as we settle in to our new operating environment is that there will be a large spike in the volume of called bonds. In a phone call with FHLB this morning our traders were told that recent called bond volumes over the past few months were around $60 billion but that number is expected to jump up to $90 billion very shortly.

Given the drop in rates and the increase in the number of bonds that are now “in the money” to be called I wanted to highlight a report that we have available to you. We have a Predicted Call Report that we run to show customers the dates on which bonds they hold are likely to be called based on the current yield curve. This has historically been a very accurate and very helpful report for those who manage fixed income portfolios. This is a very good way to get a handle on the amount and timing of cash flows that will be coming out of your portfolio in the form of called bonds. If you would like to receive this report just shoot me your most recent bond accounting data and I’ll run the analytics for you.

Now is a great time to review the structure of your investment portfolio and make sure it’s aligned with your Asset/Liability needs, expectations for interest rates, and cash flow requirements.

The commitment

Yesterday afternoon was a whirlwind. It’s difficult to describe the energy level that existed in the aftermath of the FOMC statement. Now that things are slowing down a bit we can start to really look at what this means. One of the first things to consider is that the Fed just pledged to keep the overnight rate low for at least the next two years. Can they do it?

Keep in mind that the reason the Fed made this pledge is because the economy is transitioning more toward another recession than toward expansion. Given the macro-economic background the Fed not only looks to have the ability to keep rates low for a long time, but it looks like they will have a lot of company on the Treasury curve that will help keep rates low along the length of the curve. Now if you throw the European problems into the mix you have even more pressure on Treasury prices which will force yields lower still. Certainly the Fed can’t keep rates low by themselves…but the global economic picture looks like it will be their partner in keeping rates low for quite a while.

What if they need to tighten?

Can they just go back on their pledge to hold rates low through at least mid-2013? If the macro-economic picture suddenly gets rosy and the Fed feels the need to remove some of the accommodative policy they can certainly do so…and they can do it while staying true to their mid-2013 pledge.

The astute reader might recall that in a Market Update piece a few weeks ago I asked you to print out a list and tape it to your wall...in case you didn’t tape to the wall I’ve included it again below. This is the framework the Fed had outlined for tightening monetary policy when the appropriate time comes. You’ll notice that the step labeled “Raise the Fed Funds Target Rate” is pretty far down the list.

1 – They will stop reinvesting their portfolio cash flows

2 – At the same time (or shortly after) they will change the guidance in the FOMC statement

3 – Initiate temporary reserve draining operations

4 – Raise the Fed Funds target rate

5 – Sometime after they’ve begun raising rates they will begin outright sales from the portfolio

Now there weren’t many people who expected to hear the Fed put a hard timeline of “at least two years” on the prospect of rates going up…but in the event that the economy gets heated up prior to mid-2013 you can see that they have three actions they can take to take that will tighten policy without raising the overnight rate. I don’t want you to hold your breath waiting for this to happen…I just wanted to point out that nothing is written in stone. They Fed acknowledged yesterday that the recovery is in real trouble, and they are likely to be accommodative for a long time. Unless the rest of the world disagrees with this perspective, and/or European sovereign issues suddenly get better, one would expect longer rates to remain low as well.

Thoughts on investments

Below are a few talking points on the investment side…in no particular order.

Callables

You will be getting a lot of cash back from your callable bonds. Your callable bond portfolio just became a lot shorter than you thought it was going to be. Many investors have spent the last three months trying to sell longer bonds they bought last October because they didn’t like the losses they had. In a week’s time they have gone from looking at taking losses on those bonds to wanting to keep them and worrying that their big yields will go away. The point here is that your callable portfolio just became a whole lot shorter than it was last week.

There are a lot of longer maturity bonds out there that will effectively be 1 to 6 month pieces of paper. If you know you have cash coming back on certain dates (ie you sent us your portfolio and we provided you with a very helpful Predicted Call Report) it might make a great deal of sense to buy replacement securities today rather than wait for the actual cash flow date to arrive and be forced to reinvest after the rest of the world has already pushed yields lower.

MBS

Traders are expecting a lot of prepay activity going forward in our new rate environment. If you paid high premiums for MBS paper with 15 year or longer finals you might want to consider your exposure to prepays. Bids are strong on MBS paper right now and there will be cases where it makes sense to unload and reposition into lower coupon paper. Yes…reinvestment rates will be lower…but you also need to consider what is going to happen to the yield on your current MBS if they get hit with a prepay spike. I’ve seen a lot of bonds in the last year or two who have negative yields once the prepay speeds hit 40 to 50 CPR. While reinvestment yields may be low…they aren’t negative…its’ something to consider.

WE HAVE A REPORT that will quickly show you which of your MBS are exposed to a prepay spike. If you shoot me a copy of your bond accounting reports I can run this MBS report and help you identify the bonds that might make sense to sell.

SBA’s

The busiest desk this morning has been our SBA floating rate desk. I’ve not yet received a lot of color yet but Full Faith and Credit floating rate product is in high demand.

What to buy?

As always we need to consider our Asset/Liability, cash flow, yield, and policy constraints when making decisions. Once those are met it will provide more direction…but in the absence of such direction we can make some general observations.

MBS premiums will remain exceptionally high. Moving into lower coupons such as 15 year 2.50% paper begins to make sense.

Fixed to Float structures should come back to the market as investors will begin to adjust to the 2-year time frame the Fed has outlined. These can come in the form of Agency ARMs or straight corporate fixed to float paper. Generally these structures can get you a fixed rate for 2 to 5 years that then begins to float over an index such as Libor, Fed Funds, or Prime. Structures will vary but these will remain popular.

Agency bonds are a mainstay of bank investment portfolios and will remain so. I would expect the main shift in this arena to be toward step-ups and longer final maturities as we settle in for a long wait at these levels.

Final thought

I think the new unit of measurement for the Dow Jones is 400 points. Up or down 400 is no longer news worthy.

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

Steve Scaramastro, SVP

800-311-0707

Market Update 8 8 11 _ The aftermath of the downgrade

2011-08-08T09:47:00.000-05:00

Here’s a riddle for you: How do you get the price of the 10-year Treasury to jump up a point at the open? It’s easy…you just cut the credit rating.

This is gonna be huge

When I was a kid I remember hearing stories about the fabled M80 firecracker. Legend held that these things could blow up toilets and mailboxes and nothing could cooler in the mind of a 9-year old than that. We were all experts on the destructive force of the M80 despite the fact that none of us had ever actually seen one. That all changed one day when we one of our friends went on vacation and came back with a whole bag of them. Fate had smiled upon us. We suddenly found ourselves in possession of a big plastic bag full of fire-engine-red M80 firecrackers with thick green and white fuses sticking out of them. It was a bag of mayhem if such a thing ever existed.

We couldn’t wait to start blowing things up…nothing was safe from our plotting…toilets, mailboxes, trees, dumpsters, cement trucks…nothing. We held a power more awesome than any group of 9-year olds had ever held in history…and we were about to use it. We figured the first one ought to be set off just by itself so we could witness the sheer power of it…to establish a baseline of sorts before we began the real experiments.

After a few seconds of trying to decide how far back we should stand, and who would light it, we got underway. The fuse was lit, I was running for cover, everyone was plugging their ears in anticipation of the huge explosion that was coming…and…pop. We got virtually nothing. Something was wrong…our M80 didn’t really do anything. We lit another one with almost as much anticipation as the first…and pop. Same result. No earth shaking explosion, no asphalt raining down on our heads…just a pop and the smoking cardboard wrapper of the M80 laying in the street.

We were crushed.

It didn’t work like we expected

The folks at S&P must be feeling the same type of disappointment this morning. Late Friday afternoon they mustered up the courage to downgrade the long term credit rating of the USA. They likely had a vision of borrowing rates sky-rocketing, politicians scrambling for cover, and creditors howling on TV demanding solutions…basically they had visions of exploding toilets and mailboxes.

Rather than cause yields to move higher and politicians to beg forgiveness and come up with fiscally responsible solutions…borrowing levels are dropping as investors buy up all the freshly downgraded Treasury debt that they can. Our trading desk relayed to us this morning that desks around the country have been given orders by large customers to buy all they can on the dips. If prices drop, people want more.

If you were holding your breath in anticipation of an M80 type explosion in the Treasury market you might want to relax a bit…early indications are that it’s going to be a pop…not a boom.

The markets

There is a tremendous amount of liquidity in the market, there are still huge problems in Europe, and people still view the US debt market as the safest place to be…so we rally. The 10-year is currently up over a point and a half and is trading at a 2.37%.

Stocks are off across the board with US indices down anywhere from 1.5 to 2.5 percent at this point…and it will likely be a bad day…all day…for stocks.

Oil is off $2.66 a barrel to trade at $84.15.

That’s the short story…I’ll keep you informed as things change. If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0770

Market Update 8 4 11 _ The Heat is On

2011-08-05T20:23:00.000-05:00

For those who might be thinking about a quick summer vacation to Memphis, allow me to paint a picture for you. I park my truck in the underground portion of our parking garage here at the office. It is a dark and cool place that is well protected from the routine summer threats of tornados and hail. Yesterday evening I left the office at 6:00 PM and when I turned the key in the ignition, my onboard thermometer read 105 degrees…and it was underground in solid shade all day. If anyone in a cooler part of the country has a small office that's not being used I'd be happy to sublease it for the next few months. I know, I know…what could be better than having a bond salesman right there in your own office, right?
Memphis isn't the only place experiencing the heat now-a-days. The market is taking its share as well lately. The headlines have been dominated recently by the high-drama and glamour of a political showdown over the debt ceiling and the future of our fiscal trajectory. This is really good fodder for reporters because you can get lots of hype out of it without really having to understand much of what you're reporting on.
Given the high profile nature of the debt story there has been an enormous amount of reporting on the topic…much to the detriment of some other newsworthy items that are being pushed to the back burner. Two of the more significant recent events have been the downward revision of GDP and the declining manufacturing data that we reported on earlier.
Where is the Fed?
The Fed meets next week and I promise you that they are having some prolonged and heated discussions about those two numbers even as I type this. It is now August 4^th. Every time the Fed has addressed the state of the economy this year they have had to address the "soft patches" that have prevented us from achieving robust growth. Each time they describe the negative factors as "transitory"…meaning that these events will be temporary in nature and don't pose a risk to sustained economic growth, and that they expect activity to pick up in the second half. The longer they stick to this story the better the second half has to be to make up for the first...and given the recent economic data the second half doesn't look like it's gonna be a rock-star.
There has already been a growing choir of voices discussing the potential for QE3. I'm not in that camp at this point. If you read the Fed you know that the feelings about QE2 from the start were that it would have only a modest impact at best. Given that QE2 was expensive and managed to underperform their already low expectations I think it will be difficult to find much support for another round of it.
That's not to say they won't ever do it…there are a few within the Fed who have already mapped out a course that would lead them to vote for more Quantitaticve Easing…I just think that those members will have an uphill fight against the rest of the FOMC who don't want to throw good money after bad. It's not hard to find FOMC members who have publicly stated recently that monetary policy can only do so much…at some point the Fed has to be done.
The Market
Market reaction this week has been like a run-a-way train. It's almost become a joke around here that the 10-year is up a point every 24 hours. We are just a few short hours into the trading day and the 10-year is up 3/4's of a point to trade at a 2.52% yield, and the Dow is off 225 points to trade at 11,671.
What does this mean to investors? It's tempting to hold our breath and try to wait this rally out…hoping that we can put off some investment decisions until the market comes back. However it could very well be that when the market finally reverses it could "snap back" to levels lower than where we are now.
Roughly a week ago the 10-year Treasury traded at a 2.99% yield level…right now it sits at a 2.52%. Watching the 10-year drop 47 basis points in a week is uncomfortable to say the least. More worrisome is the fact that the drivers of this rally could push us far lower.
Some reference points might be helpful here
The low point for the 10-year Treasury in 2010 was 2.38%. The lowest GDP print we had in 2010 was 2.5%...our most recent print was 0.40%.
The low water mark on the 10-year for this business cycle was 2.04% in December of 2008. GDP figures in 2008 ranged from 1.3% to -8.9%. It's also important to note that in November of 2008 the NBER made the "official" declaration that we were in a recession, the markets were falling apart, and there was legitimate concern about a full-fledged depression. If you really want to review the tone of the market from December of 2008 just go through your old inbox files and pull up the e-mail I sent you back on 12/19/08 titled "Bernanke is Fighting Depression and he's not using Zoloft". I have it handy if you can't find it so just let me know if you'd like me to e-mail you a copy.
Why does this matter?
The most recent economic data are sliding toward recessionary levels. They aren't there yet but if they keep mounting up in a recessionary fashion it's easy to believe we could see the 10-year trading somewhere between the "it's almost the end of the world level" of 2.04% from late 2008 and the "we think we're starting to recover" level of 2.38% from 2010.
I just looked up to see the 10-year just went up over a full point in price on the day…it's now trading at a 2.47%. The Dow is now off 354 points, and the 2-year Treasury just posted a record low of 27 bps. Where she stops…nobody knows. I have to wrap this up and go check on my truck to make sure it's not melting downstairs in the garage.
If you have any questions on this material, or if there is anything I can be doing for you just let me know.
Steve Scaramastro, SVP
800-311-0707

Market Update 7 29 11 _ Momma said there'd be days like this...

2011-07-29T11:06:00.000-05:00

The markets can remain irrational longer than you can remain liquid

First there was concern over a default of US debt…and Treasuries rallied. Then there was concern over a downgrade…and Treasuries rallied. Then we got a brutal downward revision of GDP which should kill anyone’s expectations for robust corporate profits…but after only a very brief drop…stocks rallied back to be slightly up on the day. It’s like it’s “opposite day” in the markets. The headlines would have you think that our market is like the Titanic…but the way money is flocking to us you’d think we were the last helicopter leaving the top of the embassy.

The 10-year Treasury is currently trading at a 2.86% (after hitting a 2.84% this morning) and the NASDAQ is up 2.8 points on the day. Unemployment is high, housing is in the dumps, GDP is falling, and the NASDAQ is up…if anyone can explain the stock market to me I would really appreciate it.

In the words of super-spy Maxwell Smart we “missed it by that much”.

GDP was released this morning at 1.30% vs. a survey estimate of 1.80%. As bad as that is…it’s nothing compared to the downward revision of the prior number that we also received this morning. GDP was released last quarter (March 2011) at 1.90%. At that time the comments from the Fed were that this indicated that the recovery was underway but not as robust as they’d like, and that they viewed the sluggishness as transitory in nature. This morning we got the revision of 1Q GDP. It was released in March at 1.90%...the revision today showed the actual number was 0.40%. That is a dismal figure. You’ll recall that the technical definition of a “recession” is two consecutive quarters of negative GDP. I was going to say we inched closer to that threshold today with this revision but that would be inaccurate. We took a hop-skip-and a jump toward that threshold with todays downward revision.

As we’ve written in the past there are a few FOMC members who have outlined their triggers for another round of quantitative easing. These triggers revolve around the Feds dual mandate of maximizing employment and controlling inflation. A GDP figure of 0.40% will not create jobs, and it won’t push inflation up to levels that the Fed feels is consistent with their mandate. This type of GDP figure is going to make some FOMC members talk a little more boldly about another round of QE. I don’t view more QE as imminent as there doesn’t appear to be much appetite among the majority of FOMC members for such a plan…but at the least the timeline for the Fed raising rates looks to be even further away than it did last month.

While we may not slip back into a recession it’s important to keep our perspective. Even if we avoid the technical definition of a recession, there will be plenty of pain to go around if we just limp along at low levels of GDP.

That’s the news for this morning. If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

AA+ in a BBB world

2011-07-28T12:50:00.000-05:00

Kick the Can

Many people have recently (and correctly I believe) compared the government’s current actions with regard to fiscal policy to playing a game of kick the can where we push all of our problems down the road, make some very optimistic assumptions and hope it all works out in the end.

When I think of this it reminds me of the first (and only) time I ever played kick the can. I was in the fourth grade and the teachers brought out a big Folgers coffee can and explained the game to us. Being in the fourth grade we thought this was wonderful…we get to run around and kick something. What I remember most is how the game ended. It ended with Felicia Martin running toward the can with outstretched arms and a big smile when someone else booted the can as hard as they could…right into her face. Felicia (representing the average American taxpayer) went along with the kick-the-can game only to leave the field bleeding and crying. The rest of us stood looking at each other in stunned silence until one of the teachers announced that the game was over. She took the can and we never played it again.

I can’t help but look at my experience in the fourth grade as a metaphor for the current game we’re playing. Will the government keep kicking the can down the road until the tax payers are bleeding and crying and sitting in the nurse’s office? Will they play ‘til the point where someone forcibly takes the can (i.e. foreign central banks quit funding our current account deficit at very low Treasury yield levels) and announces that the game is over? I don’t have the answer but it sure feels a lot like the fourth-grade playground right now…we’ve got just the right mix of energy and lack of common sense to get someone hurt.

Downgrade?

We’ve previously covered our thoughts on the probability of a default on US Debt. In short, we don’t see it as something to worry about. The market doesn’t see it as something to worry about, and if you’d like the more full blown commentary just let me know and I’ll make sure you get some of the prior commentary on the issue.

Now let’s turn our attention to a downgrade and what that might mean.

What does a downgrade mean?

A downgrade indicates deterioration in an issuer’s ability to repay its obligations. It doesn’t necessarily mean that they can’t repay them…it just means that the financial condition of the issuer has deteriorated to some degree. Essentially, it means that the debt of this issuer is more risky today than it was before the downgrade.

Going back to Finance 101 we need to answer the question “how does the market compensate me for taking more risk?” The answer is that the issue must provide increased returns for increased risk.

For example, how much money would it take to get you into the ring with Mike Tyson? I’m guessing it will take a higher amount than to get you in the ring with…say…Tim Geithner. Clearly there is more risk involved with fighting the former heavy weight champ and ex-con Mike Tyson than fighting welterweight Treasury Secretary Tim Geithner…therefore you need more money to compel you to get in the ring. This is a basic view of the risk/reward structure of a downgrade. Your AAA fight is against Geithner…if your fight schedule gets downgraded to BBB then you have to fight Tyson…and you’ll need more return to take the risks that come with that fight.

Despite the massive government intervention of the past few years this next law of finance might be one of the few that they’ve not managed to turn on its head…bond yields have an inverse relationship to bond prices. If the price goes up, the yield goes down and vice versa.

So if today I wake up to find that my bonds have been downgraded (risk has gone up)…the prices of the bonds I own will drop to reflect that new level of risk. When the price drops the yield rises until it hits a level that entices new buyers into the market. This is the natural effect of a downgrade….falling prices.

Is that it?

In the case of a downgrade on a normal corporate bond, the effect of a minor downgrade will generally be limited to the price adjusting in the market to reflect the new information. Everyone then gets on with their business.

US Treasury debt however is not normal corporate debt. The US Treasury market is the world’s safe haven…it’s where people flee when there is a storm in the financial markets. The US Treasury market serves as the very benchmark for almost all other risky assets. The US Treasury curve serves as the “risk free rate” in countless financial valuation models. A downgrade of this debt would certainly cause ripples to run through every other area that prices off of this curve. Will the ripple become a tsunami? Nobody knows. It is certainly a very scary proposition to consider…but we need to consider both the theory of asset pricing as well as the reality of asset pricing.

In reality we are just a few short weeks away from the deadline that decides if we default, get downgraded, or fix things…and the market shows very few signs of concern. How could this be?

How could we be looking straight down the barrel of a default or downgrade of the world’s most reliable debt market…and still have huge demand for the paper?

In the theoretical world of asset pricing models we would expect that the default/downgrade news in the markets would be causing Treasury bond prices to fall as investors moved to protect their assets. In reality we continue to see robust demand for US Treasury debt. What should we make of this?

The market doesn’t appear to be pricing in any chance of default, and very little chance of a downgrade. It’s easy to see why nobody is concerned about a default…but why isn’t there concern about a downgrade?

Shouldn’t we be selling off ahead of a downgrade?

It would appear that the market’s view is that even if we get downgraded to AA…we’ll still be the biggest and best market around. It’s good to be AA+ in a world of BBB markets. Relative to the rest of the world…and despite all of our shortcomings…we’re still rock-stars by comparison. Market participants recognize this and they still view our markets as a safe haven.

Can’t investors just go somewhere else?

Whether they are rated AAA or AA+, our debt markets are deep, liquid, and safe. The size of the US Government debt is roughly $14 Trillion. The next largest AAA rated sovereign behind the US is the UK. The total available government debt in that market is $8.9 Trillion. Behind the UK are Germany and France with roughly $4.6 Trillion apiece in public debt. After that the supply of AAA debt falls off sharply to the point where the markets get so small that Bill Gates or Warren Buffet could single-handedly buy the entire supply of debt of some of these issuers.

While there may be poorly fitting substitutes available for those searching for high quality sovereign debt, there are no perfect replacements for our debt markets. Like Richard Gere’s famous line in “An Officer and a Gentleman” investors may end up crying “I’ve got nowhere else to go!”

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

Steve Scaramastro, SVP

800-311-0707

Politically motivated story of the week _ Treasury Debt Downgrade?

2011-07-14T10:01:00.001-05:00

In a world of indecision and timidity Moody Investor Services has taken a bold and decisive stance (please note the sarcasm)…after years of recession, fiscal irresponsibility, political corruption, and cronyism they have decided to place the credit rating of US Government debt on review. The timing just happens to be right before the government has to make a big decision on the debt ceiling. Moody’s has taken the bold stance that if the US defaults they may downgrade our debt…way to go out on a limb guys. Normally I’d just ignore stories like the one that hit the screen today, but in the digital age information can spread rapidly and I thought I’d provide some clarification before this story got out of hand. Moody’s said that the US has been placed on review for possible downgrade because there is a possibility that the debt ceiling won’t be raised in time and the Treasury will default.

There are a few funny things going on here. First is the timing…which is obviously aimed at prodding politicians into getting something done. The second is the logic being used…” we are going to downgrade the U.S. if they don’t raise their debt ceiling”. In other words…if you don’t borrow more money we are going to downgrade you. I understand what Moody’s is saying, but on a fundamental level how much sense does this make? Moody’s thinks we are in terrible financial shape and the only way they see to keep our high quality credit rating is to borrow more. This is like the cops at a DUI check point telling you “unless you drink a few more beers we’re gonna give you a ticket.”

I’m not at all concerned about the US Treasury missing a payment on an obligation…in my opinion that is a zero probability scenario. However, I understand that everyone on this distribution list is sure to get some questions on this topic over the next few weeks and I thought I’d provide some ammunition to help you answer these.

A CFO’s survival guide

Over the last few years we’ve fielded the following question in one form or another “is FNMA/FHLMC/US Treasury going to default?” Today’s article from Moody’s will only serve to increase the number of phone calls you get from directors and shareholders on this topic. These inquiries will likely be of two types…the first will be concerned and very interested in hearing your answer, the second will be in a near-panic and frantically seeking your answer. Given the probability of you having to field such phone calls I wanted to provide a primer/refresher on the topic of “Why the GSE’s/Treasury won’t default”. I’ve answered the question so many times that it prompted a Market Update piece in March of 2010 which I’ve attached for reference.

Much of the attached write-up centers on the GSE’s…but the U.S. Treasury is even higher on the totem pole so anything you read about the importance of the GSE’s will count doubly so for the U.S. Treasury. Without much further intro…here is the write up from back in March of 2010 that discusses the likelihood of a default by the GSE’s…if you have any questions just let me know.

Steve Scaramastro, SVP

800-311-0707

March 2010 write up

Why Barney Frank is wrong…and I am right

Barney, Barney, Barney…today Mr. Frank is in “fear monger” mode. I don’t know if he is trying to flex a little muscle to get some attention or if he is trying to prove that ignorance truly knows no bounds inside the halls of Congress. This morning he made a statement to effect that the future of Fannie and Freddie debt holders might involve haircuts or bonds not being paid back at all.

Mr. Frank either doesn’t understand the nature of the global financial system, or he’s willing to look like a complete buffoon to get some attention.

Before anyone gets too worked up about Barney’s statements let me point out a few facts, and then we’ll look at why we will never see anything like what he just mentioned.

In the beginning

Fannie and Freddie were created by the by the government, they were allowed to trade in the market with lower risk premiums due to their quasi-government nature (the implied full faith and credit), and they were mismanaged by the government (think “congress appointing their cronies to positions within the GSE’s and forcing them to lower their lending standards and help create this mess in the process”). They have become so large that their debt is distributed throughout the global financial system, and I don’t know of a single bank in this country that doesn’t own their paper. If you buy bonds and you don’t own GSE paper then you are in an exceptionally small minority of institutions. Another material point is that they currently have “unlimited” lines of capital from the US Government. The government owns responsibility of the GSE’s…Barney Frank can’t come out and say he’s bailing anyone out by allowing the GSE’s to meet their commitments. The politicians created the mess at the GSE’s and they are responsible for cleaning it up.

If Mr. Frank thinks that he has the ability to force a “haircut” on the holders of this paper then he needs to be tested for drug use right now. This is a move that would destroy much of the US banking system virtually overnight…it would also extend to foreign countries…some of whom own a tremendous amount of our debt and who would quite willingly punish us by dumping it on the market and causing interest rates to skyrocket.

Secondary effect

Any failure to pay 100% principal WILL result in a downgrade. There is no way around it. Fannie and Freddie would be immediately downgraded to “D” by the ratings agencies. Now a “D” in high school was a passing grade for me…but for the GSE’s it stands for “Default” and it occupies the absolute lowest rung on the credit ratings scale. This downgrade would cause a massive secondary effect.

To help you visualize the impact of a downgrade I’d like you to think back to all of the Gulf War footage we got to see on TV. Footage where an F15 Strike Eagle drops a laser guided 500 lb. bomb right on top of a tank…you get the initial explosion which is pretty impressive, but then you get what is called a “secondary”. The “secondary” is where the fun really starts…it’s where all of the fuel and ammo that was onboard that tank blows up as a result of the first explosion. The secondary is what spreads the damage far beyond what would have been done by the initial impact.

The secondary effect from any failure to pay on the part of the GSE’s will come right after the downgrade. Every bank in the country that owns this paper will have an immediate and ginormous loss that runs straight through to capital. If you have 30% of your assets in the portfolio and 80% of that goes into default you’ve got a real problem. Imagine the impact to capital if you have to mark all of your Agency debt from 100 down to say…20.

Your losses will be compounded because you’re not allowed to own “D” rated paper which means you will be forced to realize the loss by selling it. When you go to sell your junk bonds you’ll quickly realize that a crowd has formed because everyone is selling their bonds. More and more people sell which pushes prices lower and lower in what is commonly referred to as a fire-sale. The GSE market will spiral into the deck where it will leave a giant smoking crater similar in size and historical significance to the meteor impact that killed the dinosaurs (I’m watching a lot of Discovery Channel lately so please forgive the analogy). And this is just the impact on the domestic banking system.

Now look at the situation faced by foreign central banks. Some of these folks are ALREADY talking about selling US Securities…this type of action will solidify and accelerate those plans. This will add even more selling. “Panic selling” doesn’t really begin to describe that activity that will be taking place at this point. I wouldn’t expect US Treasuries to be the safe haven after this. I don’t think investors will continue to view debt from the same folks that just blew up the financial system with the GSE default as “safe”.

If you’d like to take it further you could even move on to how many American citizens would have their retirement savings wiped out by this move. It will be tough to get reelected after you torpedo the entire country’s banks, jobs, and retirement dreams. Feel free to come up with some more and shoot them back to me…the possibilities are almost endless.

And do you think anyone would be willing to buy a US “Housing Finance” bond EVER in the future after this fiasco?

Prove it

Lest you think I am merely being an alarmist look at the “secondary effect” we got from the failure of Lehman Brothers. Lehman is a much smaller institution than the GSE’s yet their demise pushed the US financial system to the verge of collapse. When the powers-that-be decided that Lehman was where the bailouts stopped it set in motion a very unintended set of consequences.

Lehman’s default shook the foundation of our economy because their debt was widely held by money market funds. Money markets are tremendously important pools of capital that provide the liquidity for our economy. These funds are the oil in our economic engine. When Lehman defaulted it caused losses in money market funds. Money market funds aren’t supposed to “do” losses. You put a dollar in and you get a dollar out. If you get less than a dollar than the fund “broke the buck” as we say. Breaking the buck is the death knell for a money market fund. So Lehman caused a lot of losses for money market funds. Losses were so widespread that concern that began as a ripple from a corporate bond default, then formed waves, which in turn became a tsunami.

Half of the liquidity in money market funds in the country was poised to leave OVERNIGHT. The sell orders were on the books and ready to be executed when the firms that run the order books raised the alarm. Treasury got a phone call describing the carnage that was about to unfold and they immediately put a Full Faith and Credit Guaranty on all money market funds to avoid the panic. Think about that for a moment…they let Lehman fail and in turn were forced to insure all money market funds in the country against loss. This huge impact was just from the default of a single corporate issuer…Lehman Brothers. This example should provide some very recent insight into what type of events can be triggered by a default of a big institution. If Lehman can do that much damage just think of what the GSE’s hold in store.

In summary

SO…the GSE’s fail to pay or force a haircut, they kill most of the banks in the country in the process (through OTTI capital write-downs on their GSE debt), they anger foreign central banks to the point that they sell their holdings partly out of self-defense and partly as a punitive measure, the secondary effect that we love so much roils through to the rest of the investing world in the form massive liquidations in response to the downgrade to “D” and giant swathes of the American public see their retirement portfolios wiped out.

In my opinion there is nobody in politics that is going to light the fuse on that scenario. If your goal were to destroy the US economy and set us on an equal economic footing with say…Kurdistan…then I’d say it’s a good plan. Short of that…ain’t gonna happen.

I believe that my view on the GSE’s is far closer to reality than Mr. Franks’. It seems to me that the most likely scenario is that existing debt of the GSE’s gets “grandfathered” into a Full Faith and Credit status, then they can re-invent the GSE’s and release them into the wild as healthy institutions whose debt going forward will have a much clearer status.

This allows you to avoid nuking the financial system, and at the same time privatize a function that should have been private this entire time anyway. It moves a few trillion worth of obligations onto the Federal balance sheet but hey…that doesn’t seem to bother anyone nowadays.

Wrap it up already

In summary the GSE’s do not have the ability to miss a payment or force a haircut on bondholders. The markets seem to agree with this assertion as well…they are unmoved by Barney’s blabbering today. Don’t lose any sleep over the misguided ramblings of one Congressman.

I’m sorry if I’ve gone on longer than you or I wanted…but I can get passionate about these topics. Halfway through this piece it began looking more like a manifesto of some sort rather than a market update but some things just need to be said. In my view it is pure ignorance for someone of Frank’s stature to be spouting off in such an irresponsible manner on a topic like this. I can only imagine the phone calls his secretary is fielding this morning…most of them from people far more important than me. “Congressman Frank you’ve got Bernanke on line 1, Geithner line 2, Obama line 3, and some fixed income guy from Memphis on 4…”

I hope everyone has a great weekend. If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

Market Update 7 13 11 _ Bernanke's Testimony

2011-07-13T16:54:00.000-05:00

Testimony

Chairman Bernanke delivered his testimony to the Committee on Financial Services in Congress this morning. There won’t be many surprises in the testimony for those who have been following our Market Updates. Much of what was delivered was a re-hash of prior speeches from the various Fed Presidents.

One of the most obvious traits of recent Fed speeches has been the idea of “transitory” or “temporary” setbacks for the economy. Everyone acknowledges that the pace of the recovery is “moderate”. The Fed strongly believes that most of the factors that are currently dragging on the economy are temporary in nature and they are doing much of their planning on that assumption. If that assumption proves to be incorrect then they will have to make significant adjustments to their plans.

What if we weaken?

A few courses of action have been mentioned recently as potential responses to deterioration in our economic prospects (i.e. if our current obstacles turn out to be something less than transitory).

The first plans is that the Fed could tell us in more explicit terms what “extended period” means and how long they will keep their balance sheet at current levels. This one makes me laugh a bit because it implies that they’ve been intentionally avoiding the topic so far. It’s like when the wife asks me if I want to go see the new chick flick at the theatre. My standard response is to initiate a round of delaying tactics. It’s always easier to delay answering the question until her girlfriends arrange a girls-night-out to the movies rather than take the hit on my own. I usually say something like “let’s talk about it later…” and then I sneak off to the garage. If the situation deteriorates (i.e. she gets more persistent about it) I can provide her with more detailed guidance on the odds of me going to that movie…but if I’m not forced into that spot…why put myself there? So that’s the Fed’s first tactic for dealing with adverse economic developments …we’ll call it the “Chick-Flick strategy” of monetary policy…where they only provide more guidance on intentionally vague statements against their will.

Another tactic mentioned was to reduce the 25 bps that the Fed is paying on reserves held with them. They don’t mention the magnitude of the impact they expect this action to have…most likely because it will be immaterial.

Finally the FOMC minutes that came out earlier this week mentioned that a minority of the members were in support of QE3 if conditions deteriorated. I guess they didn’t want to name names but we know that Minneapolis Fed President Kocherlakota has already gone on record as saying a drop in PCE (the Feds preferred gauge of inflation) from his 2011 forecast of 1.50%, along with unemployment remaining elevated would be a trigger point for considering QE3. There doesn’t appear to be a huge following at the FOMC for more Quantitative Easing. Everyone acknowledges that at the start of the program they didn’t expect spectacular results…it was a big program which at its best was expected to deliver marginal results. The Fed has acknowledged that monetary policy has its limits…and QE2 was pushing them, so I don’t expect a huge appetite for more quantitative easing in the near term.

Keep in mind that the Feds dual mandate is to foster maximum employment and price stability. They have to be feeling more than a bit insecure about their performance on these fronts so far. I’m not trying to imply that monetary policy has all the cures for these issues because it certainly doesn’t. The point is that the Fed is the only entity standing in the spotlight trying to fix these issues and so far the economy is about as squared away as a soup sandwich. Month after month they spend more money and things don’t get better. At this point they’ve got to be feeling like Rodney Dangerfield…they’re not getting a lot of respect.

What if we strengthen?

In the best case scenario where all of the obstacles turn out to be transitory and the economy finds itself picking up steam with people going back to work and inflation on the rise, the Fed will be in a spot where they have to tighten. With the tangled network of programs that currently exist there have been a lot of questions regarding HOW they will tighten if and when the time arises. Questions such as:

- Will they raise the overnight rate first?

- Will they sell bonds out of their portfolio?

- What will they do with their portfolio cash flows?

- Will they execute these steps concurrently?

- Do they favor one tactic over another?

Bernanke said today that the FOMC has reached a “broad consensus” on how they will begin tightening monetary policy once they decide that it’s the appropriate time. Those steps are listed below. Print this off and tape it to your wall.

1 – They will stop reinvesting their portfolio cash flows

2 – At the same time (or shortly after) they will change the guidance in the FOMC statement

3 – Initiate temporary reserve draining operations

4 – Raise the Fed Funds target rate

5 – Sometime after they’ve begun raising rates they will begin outright sales from the portfolio

At the end of this road they would be in a spot where the Fed Funds target rate has been returned to its normal role as the primary driver of monetary policy. You have to have a plan…and that is the one the Fed has come up with. The timing of any such plan will of course be “data dependent”.

The item that jumps out at me immediately is that “raising the Fed Funds rate” is pretty far down the priority list. So not only does the economy have to see huge improvement before we get to a point where tighter monetary policy is appropriate…but once we get there you won’t be getting immediate relief from the pain of selling Fed Funds.

That’s all for today. If you have any questions or if there is anything I can do just let me know.

Steve Scaramastro, SVP

800-311-0707

Market Update 7 8 11 _ Lipstick on a pig and strategic blunders

2011-07-08T10:58:00.000-05:00

Chaos, mayhem, disorder…my job here is done

Bloomberg reported a few weeks ago that Geithner was considering leaving the U.S. Treasury. For his part Geithner said he’s not going anywhere, but on mornings like today it must be tempting to consider it.

Economists expected Non-Farm Payrolls to add 105,000 jobs…it only delivered 18,000. The Change in Private Sector Payrolls was expected to be 132,000…but the private sector could only scrounge up 57,000 positions. The Unemployment Rate increased from 9.1% to 9.2%. Those are terrible numbers no matter what light you try to view them in.

Politics and economics

If you are on the current administrations economic team you’ve got a long weekend ahead of you. I feel badly for them…their job is to spin the economic news in a positive way yet there’s no amount of lipstick you can put on this pig to make it look good.

Today’s numbers made me think of Christine Romer, the former White House economic chief who stood before the camera and told us that if congress passed the stimulus bill that the Unemployment Rate would not go above 8.00%. I remember staring slack-jawed at the screen after she said it…mouth agape in disbelief…wondering why the White House didn’t have a compliance department that would keep such a statement from ever being uttered in public. In my mind the statement ranks right up there in the history of great strategic blunders alongside statements like the following:

- “Don’t worry…the Americans will never come here and fight.” Al Qaeda

- “I think a frontal assault might work this time” Robert E. Lee, Gettysburg

- “Just take out Pearl Harbor and they’ll be out of the war for good.” Someone in Japan

- “I’m gonna look cool on the jumbotron.” Dallas Cowboy Leon Lett right before Don Bebe stripped the ball in Super Bowl XXVII

Many of the people on this list are no longer with us…which leaves me with a picture of former White House economic advisor Christine Romer sitting in a Starbucks somewhere with former Cowboys defensive tackle Leon Lett commiserating about how things could have been different for them both if they could just have a do-over.

The Market

Market reaction to the data was sharp. The 10-year Treasury is up almost a point, pushing its yield down to a 3.02%. The Dow is off 121 points to trade at 12,592. With no rebound in the employment market and a housing market that is still in the dumps it’s difficult to paint a realistic picture of where the growth will come from. I’m reminded of the old Wendy’s commercial with the two little old ladies asking “Where’s the beef?” Our current question is a derivative of that… “Where’s the growth?”

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

Steve Scaramastro, SVP

800-311-0707

Market Update 6 30 11 _ Austerity begins

2011-06-30T10:50:00.000-05:00

Austerity

My son is eleven years old, and while he is certainly very helpful around the house he is still what I would term a source of negative cash flow. As such, I was surprised to hear that he was expecting some serious perks on a recent trip to the barber shop.

A few weeks ago he went for a haircut with his uncle to a sports-themed barber shop here in town. They've got some flat screen TVs and there is always a game on...it’s a pretty good gimmick for a barber shop. While they were there his uncle treated my son and his cousin to the barber shop’s “VIP Package”. This is a deal where you not only get your haircut but you get a hot towel on your face while they give you a shoulder massage. As it turns out the kids loved it...and they now expect it.

A few weeks later it was time for another haircut. When my wife told me that my eleven year old was wanting the VIP package at the barber shop I stared blankly at her, then I asked her what that meant. When she explained to me what the VIP Package was (and then to my astonishment re-confirmed that my son really was expecting this treatment), I almost fell out.

My recollection of the barber shop when I was his age was of getting my hair cut by a balding, cigar-smoking old man who I prayed would not lop one of my ears off with his incredibly noisy and painfully sharp shearers. Nowadays kids want/expect a hot towel on their face and a massage. Ha! This was going to be a fun talk. I figured an early reality check would be a lot less painful for him than letting this VIP stuff go on for months before putting the brakes on it. I took a moment to explain to the child that the haircut is on me but if he wants the VIP Package he’ll have to use his personal funds for that. It was the last I heard of the VIP treatment. I assume that after a brief analysis of his statement of cash flows he decided that he’d rather use his allowance money for purposes other than a hot towel on his face. This simply reinforced in my mind that people like free stuff…risk free perks. When you have some skin in the game…the decisions are sometimes made differently.

I’m not the only one dealing with austerity issues now-a-days. Greece has had two votes this week to decide if, and how, they will implement their own austerity measures. To receive financial assistance from their European neighbors Greece needs to reign in some of their financial excesses. Yesterday they agreed that the austerity plans must begin, today they voted on a package of how to start. In other words, yesterday they agreed that people were going to get hammered, today they decided who and in which order the hammering would begin. There are more riots in Greek streets as the “hammerees” voice their displeasure at having their perks taken away. Clearly there will be a lot of friction as people see their standard of living cast in doubt.

The markets

The markets on the other hand like the outcome of the votes. As we’ve discussed in the past, there is a lot of money parked in Treasury bonds as a result of fear over the Greek situation. As investors struggled with the probability of a sovereign default in Europe they drove a “flight to quality” trade that pushed US Treasury yields to recent lows. While the US certainly has its share of fiscal issues we are still a great place to park your cash when there is trouble on the horizon. The last two days have seen a bit of a reversal of that flight-to-quality trade. As investors see solutions being implemented they begin to get more comfortable putting money to work. At some point they become comfortable enough to sell their Treasury holdings (or avoid purchasing more at the auctions) and reinvest in areas that were too scary to touch while a sovereign default was stalking the markets. As a result we’ve seen the 10-year Treasury move up 30 bps in yield since last Friday’s level of 2.88%.

This would normally be a quiet week for the markets as we are rolling into a long holiday weekend at quarter end/month end in the middle of the summer. Contrary to the quiet week that we might expect we have the 10-year Treasury trading up to a 3.18%, the Fed wrapping up QE2, and Greece initiating austerity measures. There is no shortage of factors that might upset the markets.

As we head into the weekend we are seeing that austerity is the new thing. Luckily for me my eleven year old is the rule-following type…there were no riots at my house over the suspension of his barber shop VIP Packages.

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

I hope you have a great Fourth of July.

Steve Scaramastro, SVP

800-311-0707

Market Update _ The Fed and their "extended period"

2011-06-22T15:26:00.000-05:00

FOMC

Here is the quick story: recovery continues (albeit more slowly than we thought), jobs still stink, QE2 will end on time, we’re not thinking about QE3, we’ll keep reinvesting the cash flows from our portfolio, our forecasts for growth are now lower, we expect things to pick up in coming quarters, and rates will remain exceptionally low for…wait for it…here it comes…you can guess it…an extended period of time. If you don’t have a lot of time you can go back to work after reading this first paragraph…you now have what you need to know about today’s meeting.

Extended Period

Bernanke has been asked in the past what “Extended Period” means. It came up again today and he repeated his earlier thought that the phrase means “at least two or three meetings…but depending on the data it could be considerably more.”

On the surface his answer sounds pretty good…”extended period” equals two or three meetings. There are eight meeting per year so “two or three meetings” means less than half a year. That math is so easy a caveman could do it. Where it gets complicated is that they have been saying it for almost two and a half years. At some point I have to question what they’re really thinking.

I’m reminded of the scene from the movie “The Princess Bride” where Vizzini (the main villain) is counseled by one of his comedic sidekicks. Every time something bad happens, Vizzini exclaims in his high pitched nasally voice “Inconceivable!”, because in his mind he is so smart that nobody could possibly outwit him. After this happens five or six times, his sword-fighter Inigo Montoya (one of his comedic underlings) approaches him and says to him in his Spanish accent “Señor, you keep on using this word…I do not think it means what you think it means.” This scene sums up where I am with the Feds “extended period” language. If you’re telling me that “extended period” means two or three meetings…but here we are two and a half years later and they’re still using it…I don’t think it means what they think it means.

The phrase “extended period” is beginning to take on the connotation “we have no earthly idea when we’ll be able to raise rates. I understand that they can’t come right out and say in explicit terms that they’ve no earthly idea when things will get better…maybe I’m just wanting a bit of variety in the way they give me the news. After all variety is the spice of life…but the Fed keeps giving me the same bland phrasing every six weeks.

I’ve got half a mind to go home and watch “The Princess Bride” tonight, but last night during our wrestling match the dog knocked my beer out of my hand and I don’t think either one of us are allowed back in the living room for “an extended period”.

Steve Scaramastro, SVP

800-311-0707

Market Update Friday afternoon _ Everything is dragging on

2011-06-17T14:08:00.000-05:00

I saw a headline a few minutes ago saying that Libya’s Qaddafi doesn’t intend to resign. Resign? NATO has been fighting this third world dictator for weeks and they STILL haven’t kicked this guy’s butt yet. I promise that if you gave me one stadium full of European soccer fans and a beer truck I could have ended this Libya thing in three days time.

It seems like lots of things are dragging on lately. The problems in Europe continue to affect the Treasury market week after week. The economic data in the US continue to come in poorly week after week. The Fed continues to hold their position that rates will remain low for “an extended period”. As some of you are aware even my boat has been in the shop week after week…I’m ready for a change.

Six weeks ago the 10-year was trading at a 3.20%, today the 10-year is heading into the end of the week at a 2.94%. This marks the 5^th consecutive week that the 10-year has ended the week at a lower level than it began (feel free to use that fact for Friday afternoon office trivia).

Maybe we’ll see some improvement next week. There seems to be some headway in finding a “solution” to the Greek debt crisis. If this happens we should begin see a reversal of the flight to safety trade that has hammered Treasury yields lower over the past weeks and months. This would ease some of the pressure on bank portfolio managers that are trying to get money to work in this environment.

Next week is looking up already…the shop just told me my boat will be ready Monday.

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

Steve Scaramastro, SVP

800-311-0707

Market Update _ When Bernanke speaks...people listen

2011-06-07T16:25:00.001-05:00

Today’s episode of government efficiency

A failing, uncompetitive GM has been receiving taxpayer money for the last two years. NASA is having their budget cut at the same time. My last GM product made it about 70,000 miles before it broke down. I read today that NASA’s Voyager 1 vehicle is currently 11 BILLION miles away from earth...and still working fine. It would appear to me that if we are going to give anyone money to be making vehicles…it should be NASA…not GM.

On to more relevant matters

Bernanke speaks

Chairman Bernanke gave a speech on monetary policy to the International Monetary Conference today. For those of you that like the short story here it is:

The job market stinks, there is no inflation, don’t blame the Fed for rising commodities prices, and we’re keeping rates low for a long time.

You can stop reading right here if you are a “just give me the short story” type of person.

For those that want more detail…read on…

The song remains the same

Much of what Bernanke had to say today has been said ad nauseam for the past two years. There are too many people unemployed, and too many have been that way for too long. Housing is in terrible shape. Individuals are reluctant to spend due to all of the pressures they face. Who wants to go blow a bunch of cash on a new TV when they know they could lose their job tomorrow? I love a big screen TV as much as the next guy, but they don’t work too well when you’re forced out to curb. Housing prices have fallen and become more affordable…but the pool of qualified buyers has shrunk tremendously.

The Fed sees a modest recovery underway that was hampered in first quarter by a major disaster in Japan and rising fuel costs. Fuel costs get a lot of attention but Bernanke points out that of the inflation that has shown up recently most of it is attributable to one item…gasoline…and that they expect this to be a transitory issue. The Feds outlook is that gasoline prices will moderate later this year and help fuel growth (no pun intended).

He is somewhat positive on the business sector. As many have noted this year, business spending on equipment and software has been expanding. Firms associated with the export industry have one well.

With regard to the construction industry just envision him putting his palm to his forehead and mumbling something along the lines of “don’t even get me started…” The housing market is in bad shape and will likely remain that way for a while.

There’s no crying in central banking

Bernanke’s speech was 15 pages long. I don’t say this to try to get some sympathy for having to read a 15 page paper on monetary policy…well…I might want a little bit of sympathy…but the main point is that of the 15 pages….a full 6 pages of it were dedicated to discussing commodities prices. Why spend so much time on commodities prices?

It’s always interesting to hear a discussion on the determinants of price performance in the global commodities markets. My wife can wait for me to come home each night with new and exciting stories about emerging markets impacts on global copper supplies. I’m kidding of course…my wife has to use 30 thousand words per day…there is no room in the traffic pattern for my commodities discussions.

Bernanke on the other hand had a lot of room for commodities discussions. He essentially said that emerging market demand along with failure of supply to keep up is the main culprit in the meteoric rise of prices. Furthermore he insinuated that these countries need to stop crying about our domestic monetary policy being to blame for their inflation woes…they each have their own central banks who could…and should…be doing something about their issues. They have the tools necessary…they just need to act.

He went on to point out that while the Feds activities have caused some erosion in the foreign exchange value of the dollar that their policies have not had a material impact on commodities prices. While it is true that a drop in the value of the dollar causes dollar-denominated assets to rise in price, the rate at which the two have moved is not highly correlated. George and I did the same math one day here in the office…if the dollar is off 15% and oil is up 160% it becomes very difficult to argue that the dollar’s drop is causing oil to rise.

Furthermore he points out that monetary policy is not the only factor that affects the FOREX value of the dollar…this fact will reduce even further the impact the Fed has had on commodities prices.

Bernanke concludes:

· Recovery proceeding at moderate pace

· Job situation far from normal

· Inflation up some but should moderate

· Conditions likely to warrant exceptionally low levels of Fed Funds Rate for extended period

· Economy still producing well below its potential

· Accommodative policies still needed

· Won’t consider recovery sustainable until we see “sustained period of stronger job creation”

So…get used to low rates. The end.

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

Steve Scaramastro, SVP

800-311-0707

Market Update 6 6 11 _ Middle of the road

2011-06-06T11:03:00.000-05:00

The Fed is getting squirrely

The mercury pushed up toward 100 degrees in Memphis yesterday, and the humidity seemed determined to keep pace. It can get so oppressively hot in this part of the country that people just go inside and stay there when the sun is high. I joked to the wife last week that this must be one of the few places where you can occasionally have a legitimate fear of dying of thirst in your own front yard. These are some of my favorite days though because it means I’ll have all of the local mountain biking trails to myself. There will be no crowds at all and I can fly through the woods with very few distractions.

It was on one such ride yesterday that I saw what might be an omen. We’ve all seen squirrels wrestle with the “do I run left or do I run right” dilemma. This usually occurs as you barrel toward them in your car. It’s easy to see how the squirrels have a tough time with the decision. They have eyes only on one side of their head and the car is coming pretty fast…maybe it looks different out of one eye than it did the other…this way…no that way…and so it goes until it becomes a very close call.

Well yesterday on my afternoon ride there were a ton of squirrels on the ground. To my surprise the squirrels had some trouble with the “left or right” dilemma even with threats moving as slowly as me on a mountain bike in 100 degree heat. Some of this I figure was due to the fact that they are in a state park…they are used to seeing lots of people and maybe they get complacent about the magnitude of the threats they face.

Squirrel after squirrel darted back and forth in front of me as the miles went by. Ultimately though, one squirrel took far too long deciding if it would be “left or right.” Indecision paralyzed this squirrel as he darted back and forth in a tighter and tighter range until it was too late. It was left, right, left…and then right into the path of my bike. As he went under the front tire I realized that I just joined what must be a very small group of people in this world…people who have run over a squirrel while riding a bike. What struck me most about the deal was that he not only got hit squarely by the front tire, but that he bounced off the chain, and then got the rear tire as well…it was an abrupt and pointed lesson on the dangers of complacency and indecision.

As I finished my ride I couldn’t help but compare the squirrel’s dilemma to that of the Fed. Both have to make some big decisions, both have to be timely in their decision making, and both can get run-over if they stay in the middle of the road for too long.

Where are we now?

The Fed has put itself in a precarious position. Short term rates are at zero percent and the Fed’s balance sheet has swollen to well over $2 trillion over the preceding two years.

Our current situation is one where core inflation is low, unemployment is stubbornly high, and there is a very modest recovery underway. The risk the Fed has feared most is tightening too soon and choking off a blossoming recovery before it has a chance to get deep roots. On the other hand…if they don’t act soon enough and they let inflation get out of control they could do real damage as well. The Feds “too early/too late” dilemma isn’t much different than the squirrels “left/right” dilemma.

We know that they can’t/won’t wait until unemployment is significantly reduced and inflation is off to the races before they tighten. So the question is “when will they do it?”

Several Fed officials have given us guidance recently. Most recently the Minneapolis Fed President (Kocherlakota) and the Philadelphia Fed President (Plosser) have given us some color. As we discuss this issue keep in mind that there are two ways that the Fed can “tighten” monetary policy. The first is to simply raise the overnight rate. The second is to monkey with their balance sheet via selling securities or by simply halting the reinvestment of portfolio cash flows.

When will they tighten?

Kocherlakota (Minneapolis) said recently that his forecast is for PCE (the Feds preferred inflation measure) to be at 1.50% and for unemployment to be 1.00% lower by year end (as a point of reference the unemployment rate ROSE to 9.10% on Friday so this one isn’t going his way at the moment). He went on to say that if his forecast is correct then he would argue for a 50 bps increase in the overnight rate. His statements were more long winded and full of caveats and cautions regarding the problems of forecasting such things but he at least put some numbers on the board for us to look at.

Plosser (Philadelphia) began discussing his thoughts on tightening back in the 1^st quarter. In a perfect world Plosser would like to see the Fed Funds Rate regain its role as the primary tool of monetary policy. To achieve this goal the Fed would have to shrink their balance sheet tremendously. In his 1Q speech he provided a look at how this shift might look if executed over two time frames. The first was a 12 month window and the second was over 18 months. Reviewing that data is beyond the scope of today’s update but if you would like to see it just let me know and I’ll shoot you the Powerpoint presentation where we reviewed the plan.

More recently Plosser has said that “somewhat tighter monetary policy is possible by the end of the year”. He acknowledges that the Fed will have to begin reversing course on monetary policy before all of the data look good…and that’s not a huge surprise. Nobody expects that the Fed will wait until the Unemployment Rate is back down to 5.00% before they decide “OK…now it’s time to tighten.”

What to expect?

This talk from the Fed is very preliminary. As a counterpoint to the items we just discussed we should consider last week’s statement from St. Louis Fed President Bullard. He noted that there is historical precedent for the Fed going on hold and staying on hold for a long time period. So while there is talk among some at the Fed about tightening policy, there is plenty of talk on the other side about sitting still.

In my opinion the Fed will let QE2 expire and then sit back and watch the data for a few months. They will want to see if there are any adverse effects from their departure from their role in that market. If the data are positive over that time frame we’ll hear more chatter amongst the members as to which way to go. This is not going to be a quick process…certainly not fast enough to make you feel better if you are sitting on a lot of cash…that should still be a fairly painful position as short term rates are likely to remain low for quite some time.

It’s very easy to see the first step in this process being the halting of portfolio cash flow reinvestment. This is a great way to test the waters because it’s a passive move. It shouldn’t be terribly alarming to the markets and it’s probably going to be the easiest thing to get the FOMC to agree upon.

If the markets don’t freak out over the move then you can begin a very well communicated plan to begin selling assets at a pace that the market can digest. This will be the first big step toward restoring Fed Funds to its role as the primary tool of monetary policy. If we get to a point where PCE is rising toward 1.50% to 2.00% then you should expect to hear a lot more talk about a hike in the overnight rate. Several Fed members have gone on record as saying that inflation will not be tolerated…even if it means raising rates with a high unemployment rate.

So today we have some very early discussions that are beginning to nudge the FOMC in two directions. How they proceed will depend entirely on the data…but at this point I can only hope that they are better at zigzagging than yesterday’s squirrel.

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

Regards,

Steve Scaramastro, SVP

800-311-0707

Market Update 5 25 11 _ Slow is not good

2011-05-25T17:37:00.000-05:00

It got a little slow around here during the month of May, and when things get slow we find ways of entertaining ourselves. These aren’t always the healthiest episodes. Much like when your dog gets bored and eats your wife’s purse…it helps pass the time but in the long run it’s not going to end well for him.

Fast forward from the dog’s life to my office…we have multiple Bloomberg screens in front of us all day quickly flashing a myriad of green and red numbers and pushing headlines and data to us in a staccato beat…it is the point where high tech meets high finance. When things slow down here we tend to get very bored. Sometimes we do harmless things to pass the time…like seeing who can eat the most hot-wings…and then who could forget the famous “sour kraut and spam” incident from a few years ago. Harmless stuff really. But sometimes things take a more serious turn…and we decide to do something with…the Bloomberg. In this case several of us saw all of the volatility in the silver futures market and we decided “yeah…let’s play in THAT sandbox!”

So we did. We took positions and tried our hand at trading silver futures via ETF’s. And oooooohhhh what a mistake that turned out to be. If I ignore the emotions, frustration, and financial discomfort the trades brought me I’m left only to ponder the pure stupidity of the move…which is very painful for people unaccustomed to doing stupid things.

I got a glimpse of the future on my drive in this morning when I saw a guy driving a car with vanity license plates that read “FUTURES”. It made me want to laugh and cry at the same time…ultimately I went with laughing because I’ve got reputation to uphold. What made this so funny was that these custom tags (that seemingly proclaimed participation in the fast paced and lucrative futures markets) hung on the back of a beat up old Ford Taurus.

As I drove past him I had a moment of great clarity. I realized that those tags probably used to hang on the Mercedes he lost due to trading futures and now he has to drive around with that ridiculous license plate on a beat-up, second-rate, mid-90’s domestic sedan as a horrific reminder of how his luck treated him in the world of speculative derivatives trading. At that very moment I decided to walk away from this game. So you’re in luck…I won’t be quitting my day job to become a silver trading futures baron. Next time it gets slow I’m just going to unplug the Bloomberg and eat my wife’s purse…it will help pass the time, be just as stupid, and be far less costly.

News of the day

Durable goods orders delivered bad news today posting a -3.6% vs. an expectation of -2.5%. Under normal circumstances you’d expect this to cause a rally in the Treasury market. The problem with that theory is that the Treasury market has rallied so much lately that it barely budged on this morning’s data. The 10-year Treasury is up only a single tic to trade at 3.107%.

There is still a fair amount of data to come this week. Tomorrow we get GDP, Personal Consumption, Initial Jobless Claims, and Continuing Claims. Friday we get Personal Income, PCE deflator (Feds preferred inflation gauge), Michigan Confidence and Pending Home Sales.

Déjà vu

Our current situation seems eerily familiar. We have the 10-year Treasury sitting very close to 3.00% and we have a wad of investors saying they are going to sit on cash until rates improve. It reminds me of June 2010. Roughly a year ago the 10-year was trading at a 3.05%...and by the end of August it had dropped to 2.50%.

Other stuff

Economic data lately has been disappointing and over the next few months the market will continue to wrestle with the situation in Europe. It’s anyone’s guess where rates are going but there are still significant obstacles in the pathway of global growth.

QE2 is scheduled to end next month. The Fed appears intent to let that happen and then take a wait and see approach. There has been no shortage of people forecasting rates to skyrocket after the Fed quits buying but players in the Treasury market don’t appear to be paying heed to such arguments. A month before the end of QE2, buyers are pushing Treasury yields to fresh lows. This is not the pattern of people who expect prices to drop significantly 30 days from now.

The second half

Ready or not we are about to enter the second half of 2011. Fed Funds has been at zero percent for 2.5 years and the forecast for Fed Funds rising keeps getting kicked further down the road. It’s not the prettiest backdrop but it is what it is. Many investors have registered a great deal of uncertainty as to how to deploy their excess cash. The solution is different for every bank…if you’d like someone to bounce ideas off of just give us a call. We have a lot of analytics we can deploy to help you arrive at the answer that is right for you.

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

Steve Scaramastro, SVP

800-311-0707

Market Update 5 1 11 _ Weekend at Binnies

2011-05-02T10:56:00.000-05:00

Tough weekend for Bin Laden. You KNOW he had the Spurs going past the first round in the NBA playoffs…it should be a slam dunk against the number eight Memphis Grizzlies…pun intended. He’s got satellite TV, nowhere to be, and a great hideout. So he gets his official NBA Tony Parker jersey on the black market (which is no easy feat in Abbottabad, Pakistan) and he sits down to watch the game on the dish network. The next two hours are spent calling his bookie discussing point spreads, watching Memphis dismantle the number-one-seed San Antonio Spurs, and threatening to burn his Tony Parker jersey.

Shortly after losing his shorts on the San Antonio bet he burns the jersey, settles the score with the bookie, and goes to bed hoping he’ll do better the next day with his Oklahoma City pick. Before he wakes up to catch the pre-game, SEAL Team 6 pays him a visit to settle a different score. Turn out the lights…the party’s over. It’s probably for the best…the Oklahoma City game would have given him a stroke anyway.

When I heard the news I was very well tempted to go out back and engage in a little celebratory gunfire as is so common in the part of the world where bin laden met his end. The trouble is that I live in Germantown, TN and folks here would have big problems with celebratory gunfire even in the middle of the day…much less at midnight on a Sunday. If however I were just down the road in my old North Mississippi neighborhood it would be no big deal…in fact the neighbors there would already have a beer or two on me before I managed to join them.

On to the market

Market activity is mixed this morning after the release of the ISM Manufacturing data. The survey expected a 59.5 reading and the actual release was 60.4. The 10-year is up a bit in price to trade at a 3.27%. Domestic stock indices are slightly higher on the day. Crude oil is hovering at $114 a barrel. We get a fair amount of data this week to include Vehicle Sales, ISM Non-Manufacturing, Jobless Claims and Change in Payrolls data.

With the 10 year trading under 3.30% a lot of people are revisiting the idea of selling items from the portfolio. If you would like a portfolio review to identify sale candidates just shoot us a copy of your most recent portfolio. We can then discuss what type of strategy you’d like to pursue (i.e. selling high price vol. items, taking gains, etc.).

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

Steve Scaramastro, SVP

800-311-0707

FW: Market Update 4 27 11 _ Over 1 Million Served

2011-04-28T16:33:00.001-05:00

Bloomberg ran a story today that said McDonalds just hired 62,000 people after receiving over a million applications. The thrust of the story was about how McDonalds is seeing nice growth in this environment and how they are attracting customers with new dishes such as Chipotle BBQ Bacon Angus burgers…mmmmmmm.

When I read that story… I see it from a different angle. I look right past the heart-attack-waiting-to-happen burger, and I start to ponder the real meat of the matter…the numbers they just threw out. I think the author at Bloomberg missed some very interesting material that was on his plate.

McDonalds…I’ll say that again…MCDONALDS…just received ONE MILLION job applications. The unemployment rate currently stands at 8.80%. The size of the US workforce is approximately 150 million people. 8.80% of 150 million means that there are currently 13.2 million people out of work.

McDonalds…MCDONALDS… just turned away one million of those people. Put another way…a fast food burger joint famous for its unhealthy meals and an institutional inability to properly execute drive-through window orders just turned away 7.50% of the unemployed people in this country.

They hired roughly 0.50% of the unemployed people…which tells us that 8.00% of the entire universe of unemployed workers in this country came down to the golden arches looking for work. That is a staggering figure.

It concerns me that almost 10% of the unemployed in this country see their best prospects for a job to be slinging burgers. I’m starting to think that there might be some merit to all of the stories that say America is falling behind in math and science. I gotta wrap this up…the fry machine is beeping and I don’t want them to burn. If I lose this job there are literally a million people willing to take my place.

Steve Scaramastro, SVP

800-311-0707

Market Update 4 15 11 _ Signals in the noise

2011-04-15T13:10:00.000-05:00

Tough to read the signals when there’s so much noise.

Last night I awoke to a distant clap of thunder at 2:30 AM. Shortly thereafter a tremendous wind picked up and with it came a violent thunderstorm and the requisite downpour that made so much noise that I couldn’t immediately return to sleep. As I lay there two thoughts were on my mind…how much damage would this do to the house?…and when will my daughter run from the thunder and show up beside the bed?

Before I could assign probabilities to either scenario my thoughts were interrupted by a distant wailing sound. The noise came to me in peaks and valleys as the storm’s intensity ebbed and flowed. This noise concerned me because it could be one of only two things…both very familiar to people in my part of the world. It’s either a train pushing its way through the storm or it’s a tornado siren…one requires no action and the other requires immediate attention.

Ultimately it turned out to be the wail of a freight train’s horn reaching me through the wind and rain, ultimately it took my daughter about 5 minutes to come looking for momma…and ultimately I lay there a while longer in the darkness comparing my recent train/tornado conundrum to the current state of economic affairs.

Those who are attempting to determine which way this economy and market are heading are dealing with some of the same issues that I dealt with last night. There are signals available that may help decipher the appropriate course of action but they are at times inconclusive and seemingly pointing toward different paths…each with a drastically different outcome.

In a recent webinar we discussed the Fed’s outlook on interest rates. The FOMC committee is increasingly split into two camps. One says that achieving the Feds dual mandate of full employment and price stability must come first. The other says that the appropriate action is to reverse course on QE2 and normalize rates before the dual mandate is achieved in order to reduce the risk of unintended consequences.

Who will win?

Currently there seems to be more support for those who desire to achieve the dual mandate first and keep rates “exceptionally low for an extended period”. Based on what we’ve heard from the Fed the QE2 program is likely to continue unabated through its scheduled conclusion in June. From that point it’s reasonable to consider that the Fed will wait and watch the data before taking their next step. In other words it seems unlikely that we’ll get to the end of QE2 in June and see the Fed immediately begin to tighten.

So how long will they wait? As always…they will be data dependent. I would expect that any move to tighten would be preceded by analyzing several periods of data to ensure that we have a sustainable trend of growth. Any tightening (whether a reversal of QE2 or an outright increase in the overnight rate) would also be preceded by a great deal of communication from the Fed. There won’t be any surprise moves from the Fed on this issue. They’ve gone to great lengths to let us know that communication is a high priority item for them. They understand that the complexity of their current monetary policy necessitates clear communication of any plan that begins to reverse our current course.

So after the June 2011 conclusion of QE2 we should expect some period of time where the Fed monitors the data, comes up with a plan for raising rates, and communicates that plan to all interested parties. One could easily see this process taking months or quarters. As a reference point the Bloomberg Survey data doesn’t show an expectation for higher Fed Funds levels until 1Q 2012.

What are they waiting for?

Business cycles evolve over long time periods so it’s easy to lose one’s feel for how the course of monetary policy unfolds. Given our current state of affairs I thought it might be interesting to look back at the last tightening cycle that began in June 2004. I won’t suggest that this cycle will be like any particular cycle from the past…what I’m more interested in is seeing just how much positive data the Fed had to have piled up in front of them before they decided to begin a tightening.

It is interesting to note that after the last recession we had 12 months between the first mention of “firming of spending and markedly improved financial conditions” and the first rate hike by the Fed.

In the 6/25/03 FOMC statement the Fed saw:

- Robust growth in productivity

- Firming in spending

- Markedly improved financial conditions

- Labor and product markets stabilizing

Even against that macro-economic backdrop the Fed thought that an accommodative policy was the right one and they left rates low.

Skipping forward 6 months to December of 2003 we get an FOMC statement that sees:

- Robust growth in productivity

- Output expanding briskly

- Labor market improving modestly

- Low inflation

- Considerable resource slack

Again the Fed left rates low…they have a lot of things moving in the right direction but it will still be six months before the Fed tightens.

Now let’s look at our most recent FOMC statement from March 2011:

- Recovery on firmer footing

- Conditions in labor market improving gradually

- Spending continues to expand

- Housing and non-res. Investment depressed

- Long term inflation stable

- Short term inflation subdued

While our last FOMC statement looks somewhat similar to the Dec 2003 statement there are a host of very important distinctions between the two time periods.

Capacity utilization, consumer spending, and inflation expectations are fairly similar when compared between the two periods. In 2004 however the Fed was in a pretty good spot with regard to their dual mandate…unemployment was 5.6% and inflation was running at 2.2%. Both numbers were manageable if not optimal. Another major difference is the fact that the housing market wasn’t in shambles in 2004.

These are just a few of the items we could look at when studying this issue but I think it helps to note that in June of 2004 the Fed was starting from a much less perilous position than they are today…by comparison it was easy to raise rates in the summer of 2004.

Today they are failing on both counts of their dual mandate…the unemployment rate is at 8.9%, and inflation is below their 2% comfort level as measured by Personal Core Expenditures (PCE) at 0.9%. Additionally they are still actively engaged in easing as they are 3 months from completing their most recent monetary easing plan (QE2).

Based on history and our current position it’s easy for me to see how it could be 1Q of 2012 at the earliest before they begin tightening. As always they will be data dependent and they will continue to telegraph their plans before they take action.

I wish I could get to the end of this Market Update with a smoking gun in my hand and say “The Fed will raise rates on (insert date here)” but the issue is far too complicated. The best we can do is listen to the Fed as they debate the issue and keep in mind that their dual mandate of maximum employment and inflation will be their guide.

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

Steve Scaramastro, SVP

800-311-0707

Market Update 4_12_11: From headlights to nukes...it's a global economy

2011-04-12T10:49:00.000-05:00

Last night I had to replace a headlight socket in the wife’s car. This should be an easy 5 minute job…you cut some wires…you splice some wires…a little electrical tape and you’re done. Well about 30 minutes into my 5 minute job I start to laugh at the absurdity of the whole thing. A Taiwanese company made a replacement part for a German car, that was subsequently sold to a guy in Tennessee…and everyone involved expected this to work. It didn’t really go as anyone planned. After burning 30 minutes, laughing at the intricacies of international commerce that are in play, making some redneck modifications to the parts, and contributing a few dollars to the “swearing jar” I get the job done and shut the hood. This morning I come in to work and I find that the intricacies of international commerce and a globally linked economy are not done with me. The 10-year Treasury is up three-quarters of a point this morning on news that Japan has increased the severity level of their nuclear crisis from a 5 to a 7.

A “5” is apparently the way to admit you have a problem but that you have control over it (ie It’s just a drink or four). A “7” is the end of the line…the worst rating there is (ie you admit you have a problem…but you’re admitting it to the judge at your DUI hearing). Well Japan is in front of the DUI judge today…and the world doesn’t like it…so they are once again fleeing to the safety of US Treasuries. The 10-year was trading as high as 3.59% yesterday…today it has lost 11 bps in yield to trade at 3.48%.

There isn’t a lot of economic data to discuss today…the market is almost entirely driven by concerns over Japans nuclear crisis. What this means for the world’s third largest economy (and it’s follow on effect for the global economy) remains to be seen, but it certainly doesn’t imply anything positive for growth. It should also serve as more cover for the Fed to complete their planned QE2 purchases.

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

Steve Scaramastro, SVP

800-311-0707

What's in a number?

2011-03-10T10:32:00.000-06:00

Close vs. exactly

Last night the family was sitting around watching American Idol. It’s a simple concept…people sing…other people vote…somebody wins. It’s good clean family entertainment. My son is just getting a feel for this whole interactive voting deal and he’s interested in casting a vote. So he calls the number on the screen expecting to be prompted to vote on his favorite singer.

I was busy rigging up some fishing reels while he was making his call to vote so I wasn’t paying 100% attention…but I hear enough in the background that I know something went wrong.

I hear him tell his momma “Uh…I think something’s not right.” About the time I turn around he’s handing the phone to his momma…and from the look on momma’s face when she gets on the phone I have no doubt that something is wrong. While I’ve never seen that particular look on her face I have seen looks from the same “family of looks” that she uses when something ain’t right.

It turns out he missed the actual phone number by one digit…and rather than getting prompted to vote for his favorite singer he got a recording of a woman who was prompting him to call a much more controversial number where he could “party” with her and she’d presumably charge him by the minute. Thankfully 11 year old boys aren’t terribly interested in phone-call-partying with adult women or I might have had some unexpected charges on the bill this month.

It was a typical move by a sleazy marketing company…get a number that is a common mis-dial of a very popular number so you increase your hit count. I can’t fault them for the tactic but it highlights the importance of getting the number exactly right…versus getting close.

This morning Jobless Claims got “close” to the survey numbers but didn’t get it exactly. Continuing Claims were expected to post a 3.75 million level…the actual number was 3.771 million. Initial Jobless Claims also missed the mark by posting a 397,000 figure vs. an expectation of 376,000. Missing the number on the high side didn’t sit well with the market today.

Treasuries are trading higher in price on this morning’s data and are heading toward the low end of the recent range. The 10-year Treasury is currently yielding 3.42%. The domestic stock indices are down as well. The Dow is off over 220 points and just fell through the 12,000 level. Interestingly enough…oil is off $2.50 to trade at $101.90. That is down from its recent high of $105.44.

The irony in all of this is that the day that PIMCO’s Bill Gross says Treasury yields may be too low to sustain interest in them…and he sells all he owns…Treasuries begin a two day rally that pushes yields even lower. There is clearly still plenty of appetite for US Treasuries on the planet. For what it’s worth PIMCO still owns Treasuries…they are just very short. They essentially went to cash and if you’re in cash that means money markets, and money market funds are stuffed to the gills with short Treasuries.

Tomorrow we get some additional economic data in the form of Retail Sales, Michigan Confidence, and Business Inventories.

TGIF?

Tomorrow is Friday (and the official Day of Rage in Saudi Arabia). As I’m studying this market and trying to keep up with all of the moving parts I always like to step back and look at the big picture. Sometimes a more big-picture look can help things jump out at you. As I was looking at this big picture a subtle trend became evident. This trend has been developing over the last several weeks. The unrest in Libya began about three weeks ago. Each week since then we’ve had a trading pattern where the 10-year Treasury sees its lowest daily yield on Friday each week. Below are the high and low weekly yields on the 10-year Treasury.

Wednesday 23 Feb. saw a 3.49% yield…by Friday 25 Feb. it was at a 3.42%

Thursday 03 Mar. saw a 3.585 yield…by the close on Friday 04 Mar. it was at a 3.49%

Tuesday 08 Mar. saw a 3.56% yield…today is Thursday and we’re down to a 3.43%

Tomorrow is Friday and this trend looks likely to continue as the unrest in the Middle East continues to be a flashpoint. What does this mean? It means that if you expect this trend to hold and you’re in the market to buy then you may want to wait until next week…and if you’re selling then Friday is your friend as long as the unrest continues.

Day of Rage

I’m not terribly angry about anything so I’m not participating in tomorrow’s Day of Rage. Not wanting to be left out of the festivities though I’ve scheduled my own event. I call it a Day of Fishing. I will be out tomorrow, floating around on a lake where I can ponder all things fishing and many things economic…but because I am a high-tech-redneck I will still be available if you need anything.

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

Regards,

Steve Scaramastro, SVP

800-311-0707

FW: Market Update 2 11 11 _ Treasury, the GSE's and Bob Marley

2011-02-11T14:01:00.001-06:00

Bob Marley on the GSE’s…Everything’s gonna be alright

The Treasury Department released their paper today that outlined potential plans to deal with Fannie and Freddie. I’ll tell you up front that this is going to be a lengthy process with a lot of headline news and no shortage of ignorant/inflammatory statements from politicians on how they are going to handle this. This process will undoubtedly generate a huge amount of interest from boards of directors and shareholders.

I picture a scene where your two smallest shareholders are having lunch and watching TV at a local restaurant. The news-caster says “Fannie and Freddie are going to be dismantled…” As one shareholder chokes on his lunch the other one explains to the waitress that they need their check pronto because the bank is going under. Meanwhile back at the ranch, you, the bank President/CFO/Treasurer are in your office peacefully readying board presentations, reports for the auditors, the call report, loan committee paperwork, and stuff for the examiners. Your phone rings and an all too familiar number pops up on the caller ID. Despite the urge to let it go to voicemail you stop what you are doing and answer it. It’s “two-share Vern” the second smallest holder of your common stock.

Vern stutters and sputters and asks “Is the bank still open?”

You: “Yeah Vern…it’s normal business hours today…have you been drinking?”

Vern: “No but Bob just choked on a sandwich and I heard that our bonds aren’t going to pay us back.”

You: “Where did you hear that?”

Vern: “On the TV.”

You: “The same TV that told you Aliens built the pyramids?”

Vern: “No, that was at the house, this one was down at the restaurant.”

You: “Chill Vern…the bonds are good…there is no logical basis for the bonds to default and besides that, the Treasury has been backing them for a while now, and as recently as this morning, no less than the Treasury Secretary himself said that they will stand behind the GSE’s to ensure they can fulfill all of their obligations.”

Vern: “OK…but do you know how to do the Heimlich maneuver? If you don’t then just make one less copy of the financials for the next meeting because Bob might not make it.”

Nothing new under the sun

Rather than reinvent the wheel on this topic I thought it would be more efficient to give you the very short story up front, and then include a write-up I did last year on this same topic. I’ve written on the topic several times over the last three years and each time it’s been with the same view…your GSE debt is safe.

Treasury Secretary Geithner must have been reading my stuff because today he said:

“As the market improves and Fannie Mae and Freddie Mac are wound down, it should be clear that the government is committed to ensuring that Fannie Mae and Freddie Mac have sufficient capital to perform under any guarantees issued now or in the future and the ability to meet any of their debt obligations.”

Below is a Market Update piece from March of 2010. This was in response to some very inflammatory rhetoric from Congressman Barney Frank regarding the GSE’s. My hope is that as you get questions from the board and other interested parties you will be able to simply hit the forward button on this e-mail and provide the inquisitors with all the info they need on this topic.

There will be a lot more reporting on this issue as it unfolds. The important thing to note on the front end is that your GSE debt is in great shape, and will be paid back in full. At some point in the future there may be a new entity fulfilling the roles previously occupied by the GSE’s…but that won’t impact the source of repayment of your bonds. The US Treasury has gone out of its way at every turn in this process to let bond holders know that the GSE’s will have the capital they need to fulfill their obligations…that much is known.

If you have any questions on this issue just let me know.

Steve Scaramastro, SVP

800-311-0707

Why Barney Frank is wrong…and I am right

Mr. Frank either doesn’t understand the nature of the global financial system, or he’s willing to look like a complete buffoon to get some attention.

Before anyone gets too worked up about Barney’s statements let me point out a few facts, and then we’ll look at why we will never see anything like what he just mentioned.

In the beginning

Secondary effect

To help you visualize the impact of a downgrade I’d like you to think back to all of the Gulf War footage we got to see on TV. Footage where an F15 Strike Eagle drops a laser guided 500 lb bomb right on top of a tank…you get the initial explosion which is pretty impressive, but then you get what is called a “secondary”. The “secondary” is where the fun really starts…it’s where all of the fuel and ammo that was onboard that tank blows up as a result of the first explosion. The secondary is what spreads the damage far beyond what would have been done by the initial impact.

And do you think anyone would be willing to buy a US “Housing Finance” bond EVER in the future after this fiasco?

Prove it

In summary

SO…the GSE’s fail to pay or force a haircut, they kill most of the banks in the country in the process (through OTTI capital write-downs on their GSE debt), they anger foreign central banks to the point that they sell their holdings partly out of self defense and partly as a punitive measure, the secondary effect that we love so much roils through to the rest of the investing world in the form massive liquidations in response to the downgrade to “D” and giant swathes of the American public see their retirement portfolios wiped out.

Wrap it up already

I hope everyone has a great weekend. If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

Market Update 2 9 11 _ Higher and steeper...where are we now?

2011-02-09T09:47:00.000-06:00

The Pullback

From December 13^th to January 28^th the 10-year Treasury averaged around a 3.40%. Then at the end of January it began a nice run to the upside and is now trading at 3.70%. In two weeks we’ve had a 30 basis point improvement in yield on the 10 year Treasury. On 1/28/11 the yield difference between the 2 year and the 10 year Treasury was 278 bps…today it is 287 bps. So the yield curve today is both higher and steeper than it was two weeks ago.

Why?

There has been a range of economic data coming in a little better than the survey estimates over the last few weeks. There isn’t a runaway trend of positive news by any stretch of the imagination, but when you’re down in the dumps any good news is reason to celebrate. For example:

Personal Consumption was up 4.4% vs. the estimate of 4.0%

Michigan Confidence was 74.2 vs. the estimate of 73.3

Personal Spending up 0.7% vs. the estimate of 0.5%

Chicago Purchasing Managers report posted 68.8 vs. the estimate of 64.5

ISM Manufacturing posted 60.8 vs. the estimate of 58

Domestic Vehicle Sales of 9.59 million vs. 9.42 million…although GM and Chrysler are still using taxpayer money to subsidize their operations so I’m not sure this is a great number. On a side note it really agitated me to watch tax-payer funded Super Bowl commercials that cost millions of dollars per minute…even worse they were pitching tiny hybrid vehicles that nobody wants to drive. The one saving grace was the 426 Horsepower Camaro…but even that is using taxpayer money so it tarnished the whole thing a bit.

Inflation still under control as measured by the PCE deflator (the Feds preferred gauge)

Unemployment Rate dropped from 9.50% to 9.00% (it’s debatable if this is really good news as much of the change may not have come from people going back to work)

Wow…that’s a lot of good news…everything is better right? Not really.

GDP on an annualized basis posted 3.2% in Jan vs. a 3.4% estimate

Dallas Fed Manufacturing report posted 10.9 vs. an estimate for a higher level of 15

Construction spending was down month-over-month

Initial Jobless Claims still above 400,000 a month

Continuing Claims still running near 4 million

Payrolls data missed the mark by a huge margin in January

And it’s starting to sound like a cliché but it has to be said…the housing market is still a mess.

So where does this leave us?

This is a bit of a staging area for yields. Investors have been living with a lot of fear over the last few years. Now that some of the fear is subsiding they are making some adjustments. If you are a money manager banking on a recovery then you move early. You sell Treasuries while you still have gains and you buy other risky assets while their prices are still fairly depressed. Treasury prices drop (pushing yields higher) and the price of other risky assets (such as stocks) rise.

This adjustment process is more art than science. If you move early and you are right then you post big fat positive returns, your shareholders love you, you get your picture on the cover of Bloomberg magazine, and you keep your job.

If you wait until you’re certain that the recovery will be robust and everything is going to be great again…then you’ve waited too long and you’ll get low prices on the sale of your Treasuries, stock prices will be higher than you wanted to pay, you will post returns far below your peers, you will be fired, and your name will be mud on internet investing forums around the world. The early bird got the worm and you go hungry. We’re seeing some of this now…the early birds are positioning. Is it too early? As with most things in economics it’s difficult to say for sure.

Clearly the fear of a double-dip recession has faded from the market. The economy has some traction and has been able to generate a few positive bits of data to show that things are getting a little better.

However…there are still tremendous obstacles to be overcome. Most people are still forecasting Unemployment to remain elevated for years, the Fed is still tracking core inflation that is running at levels below their target levels, and they are committed to holding rates low under those circumstances.

Where does this leave us?

Currently it leaves us with a very steep yield curve and indications from the Fed that it will remain that way for an extended period (the survey data say Fed Funds will be unchanged through 1Q of 2012). We have been given a very nice pop in yields over the last two weeks and this is widely viewed as a buying opportunity. I don’t know of anyone that is calling for a continuous improvement in yields from this level…I’m not saying we couldn’t pop higher…but I know of nobody that is calling for it and we are already at record levels of steepness. In fact this morning (with no data) we’re seeing some resistance. The 10 year yield is dropping back below 3.70% and we’re hearing things like “oversold” in conversations about the Treasury market.

It’s human nature to see a 30 bps run-up in yields and think “I’ll wait because it’s going to keep going up.” Generally this leads to the next bit of human nature…the part where we say “Ah! I should have bought while the yields were higher!”

One way to avoid this is to take at least some money and put it to work at these levels. You don’t have to load the boat to take advantage of the pullback. We do portfolio analytics for thousands of fixed income portfolios and those that perform best over time tend to be those that invest consistently rather than trying to time the markets.

If you have liquidity lying around doing nothing you should be quite happy to see this pullback…the market has given us a great opportunity to pick up some yield that wasn’t there two weeks ago.

And remember…if you call in and say “Ah I should have bought when rates were higher” it’s only human nature for me to say “Ah…I told you so”. I wouldn’t really say that though…because you’d fire me.

Yields on virtually everything are higher over the last two weeks. The 3 to 5 year spot on the curve has seen a lot of activity due to the steepness…a small increase in duration garners a nice pickup in yield on this curve. If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

FOMC...By unanimous decision

2011-01-26T14:26:00.000-06:00

My kids were excited that it was Fed Day

I mentioned in passing to the wife last night that today was Fed Day. Little did I expect this statement to catch the ears of my kids who are in 5^th and 3^rd grade. They immediately perked up and asked “tomorrow is Fed Day?” I was shocked. Most adults don’t know what Fed Day is, yet public schools are apparently teaching elementary school kids about monetary policy now-a-days. Maybe there is hope for the future.

So I acknowledged that yes…tomorrow is Fed Day. They then asked me if they got the day off from school. I was far too eager to give them credit for learning about monetary policy…they simply heard something that sounded like an official holiday and they didn’t want a day off to get past them. They were the only people I ran into that were excited about Fed Day…and ultimately it even let them down.

It was easy to forget that today was Fed Day. It’s been so predictable for so long that it’s difficult to maintain any level of suspense over the next statement from the Fed. Today they voted to again keep the overnight rate “exceptionally low for an extended period of time”. This time however, it was a unanimous decision…there was no dissent. For as long as I can remember Tom Hoenig has dissented against the opinion of his fellow Fed members. His voice will no longer be heard. He has rotated off the list of voting members.

There are four new voting members and there was some speculation as to how these new voices would sound on voting day. They sounded off in unison today in support of the Feds current plan. As of today the Fed will keep rates low and they will continue with QE2. I picture a room full of Fed governors that is a little more relaxed this time around. There are four new members to chat with and nobody has to make an effort to avoid eye contact with Hoenig, or to suffer through another one of his speeches outlining his opposition to the rest of the group.

The Statement

The short story is that our “recovery” isn’t moving quickly enough. Unemployment is still too high, long term inflation is stable, core inflation is still decelerating, housing still stinks, credit is still tight, and household wealth is still depressed. Those are not ingredients in a recipe for monetary tightening.

The next FOMC meeting is on 3/15/11. As always the Fed will continue to monitor the data as they come in and will re-evaluate their plans as needed. Until then we’ll have to live with the exceptionally low rates for an extended period. If you have any questions or if there is anything I can be doing for you just let me know.

The full FOMC statement is attached.

Regards,

Steve Scaramastro, SVP

800-311-0707

Market Update _ 2010 Year in Review

2011-01-07T10:47:00.001-06:00

A question

What do the years 2009, 2010, and 2011 have in common?

They all started with Fed Funds at zero and the FOMC statement telling us that rates will remain low for a long time. If there is one thing we’ve learned about this Fed over the last few years it’s that when they say they are going to do something…they mean it.

So we begin 2011 with the Fed broadcasting that rates are expected to remain “exceptionally low” for an “extended period”.

Monetary Policy

Economic conditions will determine when they raise the rate…and to date the Fed continues to see only modest economic progress set against a backdrop of an atrocious unemployment rate and declining levels of inflation. This is not a scenario under which they will be raising rates.

We recently got the minutes from the last FOMC meeting of 2010. The statement points out that progress toward the Feds dual mandate of maximum employment and price stability has been “disappointingly slow”. This has solidified their support for the originally planned QE2 purchases. Like it or not…QE2 will continue.

The unemployment rate is running just under 10% currently. Several Fed members have stated recently that they expect this rate to remain elevated for the next few years. They also state that inflation continues to trend lower and if left alone…could continue for years and endanger the economy. While most at the Fed discount the potential for outright deflation they will not tolerate the current trend.

The summary on the Monetary Policy side is that unemployment is unacceptably high, inflation is running too low, and the rest of the numbers are modestly positive but pretty weak…the Fed will not raise rates while this situation exists. These will be important points to consider as you make your plans for 2011.

What phrase could sum up the year?

“Government Spending” might be the best summation for 2010. We saw the extension of unemployment benefits to 99 weeks, we got $900 billion worth of QE2 on the schedule, the first time homebuyers credit was extended, you name it they spent money on it. Our government spent so much money (that it didn’t actually have) that it prompted statements from ratings agencies and foreign countries that these actions could ultimately affect our credit rating…and therefore our borrowing costs. We spent so much that even the Fed warned Congress that the current trajectory on the fiscal side was unsustainable and that the Fed couldn’t fix everything by itself.

Among the multitude of problems that come with rampant government spending is the fact that it is not as efficient as private sector spending at producing results. I was reminded of this recently on…of all things…a duck hunt. There aren’t many parallels between the two because duck hunting provides a venue for entertainment and family time that government spending obviously can’t…but the one similarity made me laugh.

Our duck lodge sits in the Mississippi delta. The delta is a wide expanse of agricultural land that sits between the Mississippi river on the west and the rolling hills of central Mississippi on the east. It plays a vital role in the migratory patterns of all manner of waterfowl and it is a great place to go when you want to “get away” from life for a bit. I went to the lodge on a Tuesday night and I had the whole place to myself. I spent a few minutes in the freezing darkness, gazing up at the ink-black winter sky and taking in the billions of stars that are visible in such a remote area. Once I was satisfied that I was truly away from civilization I went inside and hit the rack early. The following morning I got to watch the sun rise on some of the best wetlands habitat that this country has to offer. There are few getaways that are better than this…its great “down time”.

After a few hours of peaceful solitude in the duck blind (interrupted occasionally by the blast of a 12 gauge pump action shotgun) I gathered all of my gear, loaded it onto my 4-wheeler, and headed back to the lodge. At one point I stopped and looked back over my shoulder to watch some birds that were working a hole on the north end of the property. As I looked back I caught a glimpse of the gear bag on the back of my machine and the irony of the whole situation hit me. I’m riding a $4,000 ATV that is loaded with expensive decoys, ammo, a gun, waders, heavy hunting jacket, duck calls etc. I’m rolling across the wetlands with about $7,000 worth of gear…and I’ve got a grand total of 4 ducks strapped to the top of the decoy bag. I had to laugh looking at the situation. This is without a doubt the most cost inefficient thing I’ve ever done.

If this weren’t a recreational activity there is no way I could justify my participation in the event. The cost that morning was roughly $1,750 per bird. Chicken is WAY cheaper. The scene reminded me of the stories of $400 government hammers, and $2,000 government toilets, and of the inefficient nature of government spending in general.

Now obviously there are a whole host of benefits to duck hunting beyond the ducks themselves…but me paying $1,750 per duck instead of $5.00 per chicken at a grocery store reminded me a lot of the government paying someone $7,000 to buy a house today that they would have bought on their own in the next 18 months anyway…it’s a pretty inefficient way to get the job done.

At least I get some fun stories out of the duck hunting…I don’t hear any bureaucrats sitting around telling stories about how much fun they had last weekend with their family and friends luring homebuyers into real estate offices with tax credits.

The Review

The Short story

For those in a hurry just skim the bullet points below for quick refresher of last year’s events.

What happened last year? How will 2010 be remembered? Here is the short story:

- 2010 starts with Fed Funds at zero

- Who Dat? Saints win the Super Bowl

- New Home Buyers credit extended

- GSE’s clear “logjam” of late paying loans from pools…prepays have one month spike

- Goldman execs appear before congress

- Global economic problems spread

- Austerity measures spur riots in Europe

- Fed announces $600 billion QE2 program (up to $900 billion with MBS portfolio cash flows)

- Inflation trending lower causes concern at fed

- Outright deflation fears wane

- Unemployment continues to climb

- Double dip recession fears fade

- 10-year Treasury trades down to a 2.41% yield

- Curve steepens dramatically in 4^th Quarter and 10-year rises to 3.50%

- Recovery is underway but is modest and vulnerable to shocks

- Fed leaves rates at zero, and maintains that they will stay exceptionally low for extended time

- Year of the Step Up…every day the new issue screens are filled with step ups

- Unemployment benefits extended to 99 weeks

- Housing still in the dumps

- The Fed still owns the $1.5 Trillion in Agency debt they bought in 2009

- Tiger Woods wins zero tournaments

The longer story

When you look at the activity in 2010 it is dramatically different than prior years. 2008 saw a massive meltdown that threatened the existence of Wall Street, the banking system, and our economy. 2009 saw drastic steps taken to stabilize the situation. By the time 2010 rolled around there was some discussion of a double-dip scenario and of deflation but things seemed more stable. 2010 was when everyone was looking for solutions that would get people back to work.

On the investment side

When you think of investments in 2010 you have to think of Step-Ups, huge premiums on MBS, and gains in everyone’s portfolio. For most of the year the New Issue monitor on Bloomberg showed that the majority of the new issues from the GSE’s were step-ups. This was largely a reflection of investor sentiment. Many buyers wanted the yield associated with the longer paper, but wanted some protection in case rates rose…thus step-ups became a huge part of the investment landscape. At some point in time it became difficult to find a straight Agency Callable.

On the MBS front it became difficult to find a bond that didn’t trade north of $105. When the 10-year Treasury yield drops to the 2.40% range and MBS spreads are tight it leads to huge premiums. This is great for the bonds you already own at lower prices, but it created significant challenges for new purchases. Structure was the name of the game at that point. It became very important to pick structures that would provide some natural disincentive to prepay activity. Things like lower coupons and shorter amortization schedules were in high demand.

For much of the year the comments were along the lines of “I really don’t like the yield levels…but at least our bond accounting looks good.” Then the 4^th quarter hit. In November the Fed announced its QE2 program. The goal of the program was to keep rates low to support asset prices and enable low cost borrowing by consumers. This did not work out as the Fed planned. QE2 actually coincided with the beginning of a sustained pullback in prices that caused yields to rush higher. Now borrowing costs are higher for everyone and refi activity has slowed.

The run-up in yields has caused a significant drop in the “gains” column on the bond accounting reports.

Why did we see the run-up in rates? Many explanations have been tossed about. They include but are not limited to:

- Concern over our debt load is causing risk premiums to rise.

- It’s a reversal of the deflation/double-dip trade.

- Speculation that the new tax initiatives will spur economic growth.

- Bond vigilantes are punishing the Fed and Congress for poor decisions.

- Portfolio duration rebalancing.

- Year end liquidity concerns.

- Investors taking gains for year end.

Inflation?

Many investors harbor a large reservoir of fear over the potential for inflation that QE2 brings with it. The thought process is that pushing $900 billion into the market will provide the kindling for a massive bout of inflation.

Minneapolis Fed President (and soon to be voting member) Kocherlakota addressed this thought directly in a speech recently. His position is that there are already over a trillion dollars in excess reserves sitting on bank balance sheets currently…and those haven’t sparked any inflation at all. In fact even with that massive amount of excess reserves in the market inflation is actually trending lower. With this in mind, he says that another $600 to $900 billion won’t do anything that the first trillion didn’t do.

Another thing to keep in mind on the inflation front is that everyone at the Fed is confident that if inflation becomes an issue that they have the ability to efficiently and effectively pull back the liquidity that they’ve provided the markets, thus choking off any potential for runaway inflation.

It’s also worthy of note that it’s difficult to find anyone outside of the Fed that has the same degree of confidence in that plan.

Now vs. then

While many economic indicators have been posting modestly positive results recently it’s interesting to note where some of the other indicators are as we begin the New Year.

Fed Funds today 0 to 0.25%, 1-year ago 0 to 0.25%

10 year Treasury today 3.39%, 1-year ago 3.81%

Unemployment Rate today 9.80%, 1-year ago 9.70%

CPI Year over Year today 1.1%, 1-year ago 2.6%

Consumer Confidence today 52.5, 1-year ago 56.5 (in Feb of ’07 this was running at 111.2)

On the horizon in 2011

Monetary policy

There are at least four things we know about monetary policy in 2011.

1 -The Fed isn’t happy with the Unemployment Rate.

2 - They aren’t happy with the inflation rate.

3 - They’ve told us that rates will remain exceptionally low for an extended period of time.

4 - They started saying that in 2009 and we are still at zero.

Some Fed members (like Pianalto) have come out and stated that they expect the unemployment rate to remain elevated for years. It is difficult to find anyone that thinks it will drop below 8.50% before the year 2013. It is hard to envision the Fed raising rates before there is significant downward momentum in the unemployment rate.

Municipalities

Municipalities will be big in the headlines in 2011. This is widely considered to be “the next big bailout”. The recession has compounded an already complex set of problems that face many municipalities around the country.

Regulators have ramped up their attention on muni’s and they would love to see a thick file of backup that shows you are keeping on top of the financials of the muni issuers you own. We can provide a portfolio review of your municipal holdings that will help greatly when it comes showing the regulators you are staying current. If you would like us to run this for you just shoot me a copy of your portfolio.

If you have the ability to do so, now would be a good time to consider dumping credits that might keep you up at night if we start to see an uptick in worrisome municipal headlines.

Higher rates?

While it’s never possible to call rates we can certainly use the pieces of data we have in front of us to help guide our outlook.

We know that the Fed doesn’t want to raise the short end. They continue to tell us at every opportunity that the overnight rate will remain exceptionally low for an extended period. We also know that they are continuing (with almost unanimous support) the QE2 purchases which should serve to offset further increases in yields to some degree.

That doesn’t mean that the rest of the curve can’t go up though right? Right. When long term yields rise faster than short term yields it is called a steepening. We commonly measure the steepness of the yield curve as the yield difference between the 2-year Treasury and the 10-year Treasury. Using this method we can make some comparisons.

Over the last 34 years the average spread between these two points on the curve over has been 83 basis points ( I use 34 years because that is as far back as Bloomberg will allow me to go using a weekly figure). The record spread was 287 basis points (4/16/10) and the current spread is 270 basis points. We are operating very close to record spread levels in the current market.

While it is certainly possible for the curve to steepen even more than it is today…and to break all existing records for steepness…it would seem that there are some limits to how high rates can go with the Fed anchoring the short end at zero and the market already pushing record spread levels.

Fannie and Freddie?

What of Fannie and Freddie? It seems like they barely make the news now-a-days. Once every few months they’ll show up looking for a few hundred billion to plug some losses but nobody really pays attention anymore. The idea is to ultimately remove them from “conservatorship” status and into something more permanent. None of the powers-that-be have offered any solutions to this problem and nobody seems gung-ho to tackle the problem right away.

Regardless of how they proceed with the GSE’s the most logical outcome is that any existing debt will be “grandfathered” so to speak and will be backed by the Government. What will replace the GSE’s is anybody’s guess…but the one thing we know is that the Government can’t afford an attempt to force a haircut on anyone’s GSE debt. The carnage from that tactic would make the melt-down of 2008 look like a picnic.

They are still out there

The Fed wants you to make loans, the regulators are still criticizing you for making loans, and people like this next guy are still coming in and asking for loans. I was talking with a friend of mine shortly before Christmas and he relayed this story to me. A guy comes into his bank. This guy hasn’t had a driver’s license in 20 years because he’s had so many DUI’s. He owes a neighboring state $44,000 in fines and fees, he owes his current state $1,500 fines, he owes the casino’s money, he is unemployed, and he went home the other day and his girlfriend told him she’s pregnant. So what does he do? He goes down to the bank and asks for a $7,000 loan.

I know this isn’t indicative of the “average” loan customer that comes in the door…but it points out the fact that not all borrowers have really come to grips with reality yet. Who knows…some may have never had a grip to begin with.

If you have any questions or if there is anything I can be doing for you just let me know. If you have any bond-buying friends that you think would like to receive these updates please let me know and I’ll get them on the distribution list as well.

Thanks,

Steve Scaramastro, SVP

800-311-0707

Market Update 12 14 10 _ Let's blow of the FOMC statement

2010-12-14T13:54:00.000-06:00

Let’s blow off the Fed today

The short story from the Fed is this…“nothing has changed.” Fed Funds will stay where it is and they continue to see the rate staying “exceptionally low for an extended period.” They will also continue the QE2 program as originally announced. By all rights today’s Fed statement should have sparked a rally in the Treasury market. Ironically…the market sold off a bit more.

There is nothing new in today’s statement…it basically provides a short list of modest positives and then offsets each of them with a longer list of significant negatives. See if you can find something in the following statements from today’s release that gets you fired up on the economy:

- “…recovery is continuing, though at a rate that has been insufficient to bring down unemployment”

- “household spending increasing at moderate pace, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.” This one might be my favorite part of the statement…it’s like someone saying you’re kind of nice, but ugly, boring, short tempered and vain at the same time. This is not glowing praise for the economy.

- “business spending on equipment and software rising, though less rapidly than earlier in the year.”

- “Long term inflation expectations remain stable but measures of underlying inflation have continued to trend downward.”

This is a pretty dim report on the economy that offers no light at the end of the tunnel.

The Fed has two jobs: maximize employment and keep inflation in check. They are nowhere close to achieving either of those goals currently. As they look ahead they don’t see that they will be close to those goals anytime soon.

Going forward the Fed will keep rates at zero and they will continue the QE2 purchase program.

Frustration ahead for the Fed

So far the Fed has gotten nothing they wanted from the QE2 program. We are at a point where the Fed sees the economy still in a bad spot…but they now have borrowing costs rising. This will undoubtedly be viewed by the Fed as a threat that will choke off what little headway the recovery has. To their end they’ve said they will continue the QE2 program…but given the results they’ve had so far with QE2 it wouldn’t surprise me to see them try to pull another rabbit out of their hat. I have no idea what it might be…but I know they can’t be watching borrowing costs rising without wringing their collective hands.

If you have any questions on this material just let me know.