Nothing to see here except for rising prices

Break out the champagne, inflation is dead. Core inflation rose 0.1% in May bringing the annual rate to 1.9% sneaking within the Fed's preferred range of 1 - 2%. So why didn't the markets rally? Maybe because investors are starting to realize that Core inflation is not telling the whole story.

Headline inflation rose 0.5% in May, the highest in 13 months. For some reason consumers haven't been deriving much confidence from the core numbers as consumer spending for May rose a paltry 0.1%, the third straight month of lukewarm spending. After-tax real incomes fell 0.1%, the second straight decline.

None of that matters though because core inflation is under control but I still don't hear the corks popping... not yet at least.

All Ords run comes to an end

Well all good things must come to an end. As predicted the All Ords retreated in June. Nowhere near as much as I would have liked but hey at least I got the call right. Given the fallout of the housing market in the US, an exhausted consumer, high headline inflation, weakening corporate profits and deteriorating credit markets (did I leave anything out?) I think the US market is going to do it tough in July and the All Ords will not be immune from its effects.

Dissecting Fed comments

The above piece appeared in the Wall Street Journal comparing yesterday's Fed statement from that of May. Personally I think investors look for clues as to the state of the economy in their daily lives rather than trying to detect nuances in the Fed's comments. For example they might notice that mortgage rates are higher and that loans are harder to get. Or that the price of food and gasoline is increasing.

Anyhoo I found an interesting interpretation of the Fed's comments from Irwin Kellner which the WSJ either missed or that doesn't really exist. Kellner thinks that the line:

"However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated"

means that the Fed is now paying attention to the headline inflation number and not just the core. That kind of makes sense since people do have a tendency to eat and drive cars. There was an interview with Irwin Kellner on this topic yesterday but it seems to have vanished from marketwatch.com. I'll link it in if it reappears.

More subprime induced implosion

Subprime shakeout claims another fund
Caliber Global, which controlled almost $1 bln in assets, to shut down

By Alistair Barr, MarketWatch
Last Update: 2:12 PM ET Jun 28, 2007

SAN FRANCISCO (MarketWatch) -- Caliber Global Investment Ltd., a London-listed fund that controlled almost $1 billion of mortgage assets, said on Thursday that it's shutting down after turmoil in the subprime market cut demand for its shares.

Caliber, (UK:CLBR) run by Cambridge Place Investment Management, plans to sell all of its assets over the next 12 months and return as much money as possible to shareholders, the fund said in a statement. The plan needs to be approved by investors at an extraordinary meeting in August, Caliber added.

Caliber is the latest casualty of rising delinquencies in the subprime mortgage market, which caters to poorer borrowers with blemished credit records. Bear Stearns Cos. (BSC) is trying to salvage two of its hedge funds that focus on the space, while another run by UBS AG. (UBS) shut down earlier this year.

Subprime mortgage problems have also disrupted some initial public offerings. Everquest Financial, which had ties with Bear's troubled hedge funds, pulled its IPO registration earlier this week.

Carlyle Group, one of the largest private-equity firms in the world, cut an IPO of a mortgage bond fund by 25% and dropped the price, Bloomberg News reported on Thursday.

Caliber had already been hit hard by the subprime mortgage downturn. The fund had gross assets under management of $908 million at the end of March. It was almost six times leveraged and recently had a market capitalization of about $115 million.

More than half its assets were residential mortgage-backed securities and over 60% of its portfolio was from the U.S. Three quarters of the assets were investment grade and the rest were either junk-rated or unrated.

The net asset value of the fund has dropped by more than a quarter to a range of $6.50 to $6.60 at the end of May, Caliber said on Thursday.

"Following discussions with major shareholders, the board has concluded that the company should pursue an orderly return of all of its capital to investors over the next twelve months in order to maximize value for shareholders," Caliber said in a statement.

"The Board and its advisers recognize that there is insufficient demand currently for investment through listed investment companies exposed to this asset class," the fund added. Caliber shares jumped 25% to $4.70 on Thursday. The stock is still down more than 40% so far this year.

Queen's Walk Investment Ltd., (UK:QWIL) a similar London-listed fund run by Cheyne Capital, one of the largest hedge funds in Europe, has also been hit by the subprime shakeout.

Queen's Walk mainly buys the equity tranches of asset-backed securities. At the end of 2006, the fund had 86% of its assets in residential MBS. U.S. assets accounted for 12% of the portfolio.

This week, Queen's Walk reported a loss for its fiscal year, which ended on March 31. The fund's net asset value fell 27% during the first three months of 2007, the fund added.

Queen's Walk shares are down 40% so far this year. A hedge fund run by Cheyne, called the Cheyne ABS Opportunities Fund LP, is a major shareholder of Queen's Walk.

US consumers cautious

U.S. consumers are showing more caution about the economy and the job market with the consumer confidence index falling to 103.9 in June from 108.5 in May, marking the lowest level since August 2006. Economists had expected a pullback to around the 105 mark.

The U.S. consumer has been resilient up till now but signs are starting to show that they may be taking a breather. Clearly rising borrowing costs and high gasoline and food prices are having an effect on confidence. We've already seen some of this softness in consumer spending showing up in early 2Q07 earnings of some major electronics retailers. Expect further softness in retail numbers as we move further into 2Q07 earnings season.

SEC puts sub-prime loans under the microscope

It seems the SEC is having a closer look at the packaging and sales of securitzed mortgage products such as CDO's which contain sub-prime mortgages.

However regardless of what they find the problem stems from a complete lack of regulation across all financial markets. Today the only limitation on the types of financial products available is the imagination of the wannabe alchemists who invent them. Somebody might get a rap across the knuckles but you can bet they'll be at it again as soon as they can think of another way to spin straw into gold.

It's like leaving an alcoholic alone in your house with a fridge full of beer. You come home from work and chastise him for drinking all the ale, fill the fridge up again and leave him alone the next day. What do you think is going to happen? Anyway here is the full article from marketwatch.com


SEC opens probes into subprime loans
By Rex Nutting & Greg Morcroft, MarketWatch
Last Update: 6:45 PM ET Jun 26, 2007

WASHINGTON (MarketWatch) -- The Securities and Exchange Commission is actively looking into possible securities fraud in the packaging and sales of securitized subprime mortgages, Chairman Christopher Cox told lawmakers Tuesday.

Cox said the SEC had opened 12 investigations into "issues" similar to the meltdown of two Bear Stearns Cos. Inc. hedge funds that were invested in collateralized debt obligations that included subprime loans.Cox said the SEC's enforcement division has formed a working group and is "actively on the lookout for possible securities fraud."

Last week, Cox revealed in an interview that the SEC was looking into the problems at the two Bear hedge funds. Bear said last week that it would provide up to $3.2 billion in financing for one of the funds after the investment bank discovered that the underlying value of the assets was much less than it had believed.

There is little "systemic risk" to the financial system from the two Bear funds, Cox said.
Collateralized debt obligations are extremely illiquid and have no true market price. The sellers value the securities based on models that use ratings from the credit agencies to judge the risk that they will go sour. Buyers have little idea what the underlying assets are, or what they should be valued at.

In a wide-ranging oversight hearing before the House Financial Services Committee, Cox and the other four SEC commissioners defended the agency on a host of issues ranging from reform of the Sarbanes-Oxley corporate governance law to the approval of a public offering by Blackstone Group.

Despite strong criticism from several Republicans on the committee that Sarbanes-Oxley is a hindrance to U.S. capital formation, all five commissioners said they didn't believe Congress should amend the law. The SEC is wrapping up a rule that would exempt most small businesses from the most cumbersome requirements of the law.

Cox said the SEC staff had examined and rejected arguments that Blackstone was an investment company under the law and should be regulated as a mutual fund. Blackstone shares dipped below the initial offering price on Tuesday.

In remarks prepared ahead of the hearing, the commission defended its policing of corporate America under Cox's watch, saying it has fined nine companies in the first half of 2007, approaching its record high of 11 in a full year.

Since the five-member commission unanimously agreed last year on policies for fining companies, the agency has levied eight fines of $25 million or more, including a $400 million fine on Fannie Mae, the SEC also noted in testimony prepared for delivery to the House Financial Services Committee.

"No other two-year period in commission history is higher," according to the prepared remarks.

The House panel called all five SEC commissioners to appear at an oversight hearing Tuesday, an unusual move. The commission provided a single written statement to the House committee on Tuesday that highlighted the agency's enforcement efforts and rulemaking projects, and stressed consensus. During Cox's tenure, 98% of SEC decisions have been unanimous, a spirit the SEC said "we intend to continue" in tackling future challenges.


For an interesting look at who may be left holding the bag when the music stops check out the article below from THE BIG PICTURE

Who owns troublesome CDO's/CMO's?

US House prices fall at fastest rate in 16 years.

According to Standard & Poor's Case-Shiller home price index released yesterday home prices in 10 major U.S. cities dropped at the fastest pace in 16 years during the 12 months ending in April, Home prices in the 10 cities fell 2.7% on a year-over-year basis, the largest decline since September 1991. The broader 20 cities index dropped a record 2.1% on a year over year.

The Case-Shiller index is considered a superior gauge of home prices compared to the median sales-price data released by the Commerce Department or the National Association of Realtors, because it tracks multiple sales on the same property and is therefore not influenced by a different mix of homes sold in a period. It also excludes refinancings and includes homes with mortgages larger than then the $417,000 limit of the other measures.


New Home sales fall 1.6% in May


Sales of new homes fell 1.6% in May from a downwardly revised 930,000 in April. That means last months strong 16.1% increase turned out to be a little less strong 12.5% increase. New home sales are down 15.8% in the past year. Inventories of unsold homes fell 1.1% to 536,000, representing a 7.1-month supply at the May sales pace.

As can be seen in the graph above, 2Q07 sales are an improvement on 1Q however we will need to see a few more months evidence of higher numbers before we can put the improvement down to more than just seasonal effects.

Aussie Home Sales slump 4.4%

New home sales fall in May
Sydney Morning Herald - June 26th, 2007

New home sales fell in May as the cost of building continued to turn buyers away amid low home affordability, national figures show.

Housing Industry Association (HIA) figures released today show new home and unit sales amongst Australia's largest builders and developers dropped 4.4 per cent to 8,387 dwellings.

HIA chief economist Harley Dale said new housing activity was not improving alongside strengthening housing activity.

While sales were moderately higher over the three months to May, the level was still 10 per cent lower than the three months to May 2006.

"The cost of building a new house in Australia is extremely competitive on the world stage," Mr Dale said.

"However, taxes and charges on new house and land packages together with the cost of red-tape and the planning maze adds unnecessarily to the cost of a new house."

The survey found that low housing affordability continued to stifle the chance of a housing recovery.

Private new detached house sales fell by 6.9 per cent in May, while the sale of multi-units increased by 14 per cent.

US housing turning the corner....Bwaahaha

US Existing Home sales were virtually flat in May dropping -o.3% to a seasonally adjusted rate of 5.99 million. Economists had expected a softer 5.9 million, sales are down 10.3% from a year earlier. Inventories of homes on the market rose by 5% to a record 4.43 million, representing an 8.9-month supply at the May sales pace. This represents the biggest inventory overhang since June 1992, at the tail end of the last housing bust.

More data on housing arrives today, this time on New Home sales which surprised on the upside in April soaring by 16.2%. New Home sales have held up better than existing home sales in recent months so it will be interesting to see if the trend continues.

Another interesting point is that mortgage rates have surged higher since May, hitting 6.69% in the most recent week, compared with an average of 6.26% in May. The rising cost of housing finance is not going to help matters.

Further confirmation of the depressed state of US housing took the form of 2Q07 results from Lennar Corp (LEN) showing a -$244m loss in stark contrast to the previous years $324m profit.CEO Stuart Miller had this to say about the state of the housing market:

The housing market "has continued to deteriorate throughout the second quarter,"..."As we look to our third quarter and the remainder of 2007, we continue to see weak, and perhaps deteriorating, market conditions,"

Miller also added that management expects a loss for the 3Q07.

Brookstreet Sec. the latest sub-prime casualty

With all the fuss surrounding the Bear Stearns hedge fund debacle the implosion of an Orange County broker-dealer Brookstreet Securities slipped by unnoticed by many. Maybe because of it's paltry size in comparison to Bear Stearns. However size aside it's similarities to the Bear Stearns case is striking. The only real difference is that Brookstreet doesn't have deep enough pockets or the connections on Wall Street to keep them from keeling over. Read on for the juicy details from the ocregister:

Irvine broker Brookstreet faces liquidation
Attorneys say clients lost money on risky investments tied to complex mortgage securities.

By JOHN GITTELSOHN and RONALD CAMPBELL

THE ORANGE COUNTY REGISTER

In another fallout from Orange County's subprime mortgage industry collapse, Brookstreet Securities Corp., an Irvine broker dealer, shut its doors and laid off 100 local employees because it could not meet margin calls on complex securities backed by faltering mortgages, company spokeswoman Julie Mains said.

Mains said Brookstreet went from $16 million in capital Friday to being $3 million under water Wednesday because its clearing firm, National Financial Services, demanded payment for securities bought on margin.

The securities, known as collateralized mortgage obligations, lost value as Wall Street confidence in mortgage-backed securities collapsed. The most prominent collapse was this week's demise of two Bear Stearns & Co. hedge funds worth $20 billion that invested in collateralized mortgage obligations, which are mortgage-backed securities with varying maturity dates, risk and yields.

Mains said the value of Brookstreet's securities plunged to 18 cents on the dollar, forcing the company to dip into its capital to meet margin calls, which is when investors must increase deposits to meet minimum account requirements.

"It wasn't a problem with securities," she said. "It was a problem with the margins."

Adam Banker, a spokesman for National Financial's parent, Fidelity Investments Co., denied his company's margin calls forced Brookstreet's collapse.

The National Association of Securities Dealers ordered Brookstreet to liquidate its remaining accounts Wednesday, Mains said. Some customers lost the entire value of their investments while others "did indeed go negative," Mains said. She said clients should try to find another broker-dealer to take over their accounts.

Mains said clients should have known they were making risky investments, but consumer attorneys said CMOs should only be sold to pros.

Stuart Meissner, a New York attorney and former securities regulator, said he received calls from people whose Brookstreet accounts went from $250,000 to negative value. "They were supposedly guaranteed 10 percent returns," Meissner said.

Sam Edwards, a Houston attorney who has sued Brookstreet for investment malpractice, said he received calls from clients across the country complaining about losses in collateralized mortgage obligations bought on margin.

"These are very complicated, very high-risk securities and not appropriate for retail customers," Edwards said.

Brookstreet managed $571.6 million in 3,644 accounts, according to a Securities and Exchange Commission report. The report said 75 percent were individual investors who did not qualify as "high net worth," which means they had investable assets of less than $750,000.

Brookstreet has 15 days to recapitalize or, more likely, surrender its broker-dealer license, Mains said.

The dribble trotted about the sub-prime fallout being contained is getting more and more difficult to defend as an article appearing on this weekend's THE BIG PICTURE blog succinctly points out:

Contain This!

More on Bear Stearns

More of "Why the Bear Stearns Hedge Fund Story is So Important"

From Bloomberg:

Merrill Lynch & Co.'s threat to sell $800 million of mortgage securities seized from Bear Stearns Cos. hedge funds is sending shudders across Wall Street.

A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark. The securities are known as collateralized debt obligations, which exceed $1 trillion and comprise the fastest-growing part of the bond market.

Because there is little trading in the securities, prices may not reflect the highest rate of mortgage delinquencies in 13 years. An auction that confirms concerns that CDOs are overvalued may spark a chain reaction of writedowns that causes billions of dollars in losses for everyone from hedge funds to pension funds to foreign banks. Bear Stearns, the second-biggest mortgage bond underwriter, also is the biggest broker to hedge funds.

`More than a Bear Stearns issue, it's an industry issue,'' said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. Hintz was chief financial officer of Lehman Brothers Holdings Inc., the largest mortgage underwriter, for three years before becoming an analyst in 2001. ``How many other hedge funds are holding similar, illiquid, esoteric securities? What are their true prices? What will happen if more blow up?''



This reminds me of the Japanese bank problem that started in the late 1980s/early 1990s. Banks had a ton of assets that were not continually repriced as the market decreased. Instead, the banks had assets on their books that reflected a higher price. As the value of those assets decreased, the value of banks collateral decreased as well. Eventually, the problem was dealt with, but it took 10+ years of major problems in the Japanese economy for the problem to get corrected.

This problem is directly related to the problems in the housing market:

CDOs were created in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc., the home of one-time junk-bond king Michael Milken. Sales reached $503 billion in 2006, a five-fold increase in three years. More than half of those issued last year contained mortgages made to people with poor credit, little loan history, or high debt, according to Moody's Investors Service.

.....

Not since 1994 have mortgages with past due payments been so high, according to first-quarter data compiled by the Federal Deposit Insurance Corp., the agency that insures deposits at 8,650 U.S. banks. Lehman analysts estimated in April that the collateral backing CDOs had fallen by $25 billion.



One of the reasons for the big increase in the mortgage market over the last 10 years (and pretty much the last 25) is the creation and development of the Mortgage-back securities market. This market has created a ton of liquidity which allows an increase in mortgage underwriting.

CDOs are theoretically an insurance policy against a blow-up in the mortgage industry. However, these investments have never been tested by a real problem in the market. That does not mean they won't work as advertised. It simply means that the market has never tested them.

People are understandably worried about how these hedging tools will perform if the market goes belly-up.

Merrill's decision yesterday to accept bids on $800 million of bonds it took as collateral for its loans further stifled trading in CDO securities, said David Castillo, who trades asset- backed, commercial-mortgage and CDO bonds in San Francisco at Further Lane Securities.

``Nobody wants to look at the truth right now because the truth is pretty ugly,'' Castillo said. ``Where people are willing to bid and where people have them marked are two different places.''

The real question is "why is Merrill doing this?" They most likely have a dog in this hunt somewhere and know the real stakes involved -- a massive repricing across the hedge fund universe that would have a negative impact on a ton of investors. My initial thought is Merrill is using this as a negotiating tactic so they can talk to Bear from a position of strength and exact some major concessions. However, I am sure there are other possibilities.

Humpty Dumpty had a great fall

When I use a word, It means just what I choose it to mean - Humpty Dumpty

Never have Lewis Carroll's words rung truer than in the current Bear Stearns Hedge Fund debacle. It's now been reported that two hedge funds managed by Bear Stearns are in serious trouble. The names of these two funds? Wait for it 'The High Grade Structured Credit Strategies Enhanced Leverage Fund' and 'High Grade Structured Credit Strategies Fund.' There is absolutely nothing 'High Grade' about these funds riddled as they are with high risk sub-prime mortgages.

So when Bear Stearns uses the word High Grade that's what they choose it to mean. However unlike Humpty Dumpty Bear Stearns doesn't have the luxury of living in a fantasy world, although the world of debt securitization and structured finance comes close to it. If BSC were to name their fund exactly what it is they'd have to rename it something like the 'High Risk Mortgages That Noone Else Would Touch Leverage Fund.'

The ratings agencies are in on the scam as well since they don't rate the funds according to what they are made up of. Some of the funds carry AAA ratings. The rating agencies along with the investors and banks have been seduced by the new-found sophistication of CDO's. The logic goes that because the risk is so diversified noone will get whacked too badly if things go south.

However the speed with which Merril Lynch reacted to the news by seizing $800 million of the funds assets and then auctioning some of them off to cover their exposure could only be described as panic. JP Morgan Chase, Bank of America and Goldman Sachs all closed out their positions in the fund as well. The CDO market is relatively illiquid so panic selling could see prices fall significantly.

Since we know foreclosures on sub-prime mortgages are going to to get worse before they get better we should expect some more fallout from the CDO market. An interesting point about Bank earnings is that despite moving into a worsening credit cycle they have yet to start increasing their loan loss provisions. It will be interesting to see to what extent the major banks are hit and how well they are able to absorb the losses.

My friend over at Shenandoah Capital has an interesting view on why the Bear Stearns hedge fund debacle matters.

US earnings - electronics retailers feeling the pinch

On Tuesday Best Buy Co. (BBY) the biggest retailer of electrical goods in the US reported an 18% decline in 1Q07 profit. The company cited heavy sales of low-margin items such as notebook computers and gaming hardware as impacting on profits. They expect the trend to continue and lowered their full years earnings forecast accordingly. The company called the reigning in of consumer spending on electronics as "the first industry-wide interruption in six years".

However if you thought that was on the gloomy side the rest of the electronics retailers are having a much worse time of it.

Circuit City Stores (CC) reported a loss for 1Q07 as expected by analysts whilst they undergo an attempted turnaround of the business. A look at the financials tells a story of rising expenses and declining margins. In addition management gave little to cheer about saying they expect further volatility in earnings going forward and withdrew their full year earnings outlook.

Add to that the announcement by Tweeter Home entertainment group (TWT) last week that it had filed for bankruptcy and you'd have to say electronics retailers are having a tough time of it. It begs the question in what other segments of the retail landscape are consumers reigning in their spending and are the robust consumer spending figures of recent months telling the full story?

On the positive side Morgan Stanley (MS) posted a 40% rise in profit for 2Q07 easily beating analysts expectations.

Fed Ex (FDX) posted a 7% lift in earnings but after stripping out one-off items was slightly below market expectations.

Also in the news Home Depot has decided to buy back a massive $22.5bn of it's own stock after announcing the sale of it's supply business for $10.3bn.

US housing still doing it tough

As can be seen from the graph below the National Association of Home Builders (NAHB)/Wells Fargo Housing Market Index (HMI), released on Monday shows the HMI at it's lowest level since the 1991 recession, currently sitting at 28.



If you are wondering like I was what the HMI index measures here is the lowdown courtesy of the NAHB.

Derived from a monthly survey that NAHB has been conducting for more than 20 years, the NAHB/Wells Fargo HMI gauges builder perceptions of current single-family home sales and sales expectations for the next six months as either “good,” “fair” or “poor.” The survey also asks builders to rate traffic of prospective buyers as either “high to very high,” “average” or “low to very low.” Scores for each component are then used to calculate a seasonally adjusted index where any number over 50 indicates that more builders view sales conditions as good than poor.

This is what a few of the NAHB spokesman had to say about the latest index reading. Firstly the NAHB President Brian Catalde, a home builder from El Segundo, California:

“Builders continue to report serious impacts of tighter lending standards on current home sales as well as cancellations, and they continue to trim prices and offer a variety of nonprice incentives to work down sizeable inventory positions,”

And this from the NAHB's chief economist.

“It’s clear that the crisis in the subprime sector has prompted tighter lending standards in much of the mortgage market, and interest rates on prime-quality home mortgages have moved up considerably during the past month along with long-term Treasury rates,”

“Home sales most likely will erode somewhat further in the months ahead and improvements in housing starts probably will not be recorded until early next year. As a result, we expect housing to exert a drag on economic growth during the balance of 2007.”

Doesn't really jibe with the official tune that claims the housing market has turned the corner does it? And while we're on the subject of housing....


Housing starts down, permits up
If you remember last month it was the opposite of the above, permits we're down and starts were up. It's not surprising that permits rebounded from their 10 year lows and biggest percentage fall in 17 years in April to be up 3% in May. Nor it surprising that starts fell 2.1% in May. In fact it's never really surprising what starts do since the standard error is so large - for May it was 8.1%. The standard error for permits is much lower at 1.4% and since permits lead starts you could say that this is mildly positive news or you could say like Mission Residential's chief economist Richard Moody that:

"The data seem eerily calm," .... "Simply put, there is too much inventory lingering in the market, and the most recent data suggesting rapid growth in the number of foreclosures mean the inventory overhang will become more severe, particularly with higher mortgage rates taking a bigger bite out of demand."

Or you could say something totally meaningless and non-committal like Ken Mayland, chief economist for ClearView Economics

"We are making progress toward the point where housing can be said to be 'stabilizing,' "

If one of my students (whose first language is not English mind you) wrote something like that I'd ask them to re-write it. Sorry Ken but your view is anything but clear.

2Q07 earnings start with a whimper

With all the euphoria surrounding benign inflation figures (benign if you subscribe to the official numbers that exclude the necessities of life like food) some poor earnings figures slipped by without much notice.

Freddie Mac (FRE) recorded a $211m loss for 1Q07 citing losses on it's derivatives portfolio and widening credit spreads. That's right 1Q not 2nd, Freddie Mac was 80 days late in reporting and has been behind in it's quarterly reports since 2002 when they suddenly discovered that they had misstated earnings by a mere $5 billion or so.

For those that don't know Freddie Mac is a government sponsored enterprise that buys mortgages from banks, bundles them up and then sells them off, better know as securitization. Freddie Mac does not buy sub-prime loans however Freddie's Chairman and CEO Richard Syron noted that:

"the full impact of the housing downturn has not been felt."

Goldman Sachs (GS) topped analysts expectations with a whopping 1% increase in 2Q07 earnings. CFO David Viniar said in a conference call that the subprime sector's woes are not over and to expect "more pain" before the problem is purged.

Bear Stearns (BSC) posted a 33% profit decline for 2Q07 noting:

"Mortgage-related revenues reflected both industry-wide declines in residential mortgage origination and securitization volumes and challenging market conditions in the sub-prime and Alt-A mortgage sectors."

Another point of interest has been the revelation that a hedge fund run by BSC, called the High-Grade Structured Credit Strategies Enhanced Leverage Fund, is scrambling to sell about $4 billion in mortgage-backed bonds to raise cash to meet investor redemptions and to prepare for possible margin calls. The fund has slumped 23% this year to April and is highly leveraged with roughly $6 billion in assets.

The good news for BSC is that they only have a small amount of their own capital in the fund. It was only a matter of time until something like this happened given the state of the US mortgage market and I suspect it won't be the last we here about.

To be fair it hasn't all been gloom on the earnings front with Lehman Brothers (LEH) posting a 27% increase in 2Q07 earnings earlier in the week. However LEH is obviously feeling the pinch of the housing downturn after deciding to rationalize their residential mortgage businesses by cutting 400 jobs.

Inflation you say, what inflation?

Wall Street rallied last Thursday and Friday in the face of producer prices rising a much higher than forecast 0.9% and consumer prices rising a brisk 0.7% in May.

Hold on, those are the headline rates you say. What's important are the core rates which only rose only marginally PPI 0.2%and CPI 0.1%. The core is what matters because that's what the Fed looks at when raising interest rates. To get the core rate the Fed excludes those pesky, volatile items like food and petrol.

OK then, but don't actual people have cars that need petrol and eat food because they well... need to survive? Yes but maybe the Fed isn't worried because Fed officials aren't actual people. They are in fact battery powered robots that don't require petrol or food. That would certainly explain their robotic like commentaries.

Take Cyborg Bernanke for example, one of his wires has gotten loose causing him to walk around repeating "There will be no spillover from the sub-prime mortgage market" "There will be no spillover from the sub-prime mortgage market"

Anyway for those interested in exploring the Inflation/No inflation issue here is a series of good articles from THE BIG PICTURE which make for interesting reading.

A Tale of 2 Inflation Rates

There's No Inflation -- Except for Necessities

Inflation PartII

Irwin's on the ball

Irwin Kellner is the chief economist over at marketwatch.com. Unlike just about every other economist in the US market Kellner has been arguing for sometime that the next move on interest rates by the Fed will be up. It took a while but the bond market is now siding with Kellner and over the last week other economists have also jumped into his camp.

Kellner's article is reproduced below. Click here if you would like to hear Kellner speak on the same topic.

The impossible dream
Commentary: Why the Fed could raise rates as early as this month By Dr. Irwin Kellner, MarketWatch
Last Update: 11:46 AM ET Jun 12, 2007

HEMPSTEAD, N.Y. (MarketWatch) -- Let me see if I have this right: Investors want the economy to be strong enough to generate decent profits growth, yet weak enough to give the Federal Reserve a reason to reduce interest rates. Talk about dreaming the impossible dream!

When the economy nearly ground to halt in the first three months of this year, investors didn't know whether to laugh or to cry. They were happy in one sense because they figured for sure that this weakness would lead to an early cut in interest rates by the Fed. On the other hand, they also were concerned about what this lack of growth would do to corporate profits.
As a result the stock market meandered on some days, while jumping up and falling down on others. It may have been a trader's delight, but it sure gave the average investor a case of the nerves.

Now, with the second quarter all but done and another Fed meeting looming, investors are once more biting their nails. Most of the data available for the quarter to date suggest that the economy is growing faster now than it did in the first quarter. The rate of inflation has picked up as well. This should assuage those whose primary focus is profits and dividends. Faster growth combined with higher prices generally boosts revenues and thus leads to better earnings.

At the same time, however, it has put the kibosh on the notion that an interest rate reduction is just around the corner. Indeed, there is every reason to think that the opposite is in store.
For one thing, the bond markets have finally awakened from their long slumber and begun to sniff inflation. They have boosted long-term rates by more than half a percentage point in the past couple of months alone. This has produced a positive yield curve for the first time in nearly a year.

Indeed, as yields inch their way higher, the curve is getting steeper day by day.
For another, the bond crowd (and others) has finally begun paying attention to what Fed officials from Chairman Bernanke on down have been saying for months: lack of growth is not the economy's problem -- inflation is.

I certainly have been listening to the Fed. Those of you who check our economic forecast and calendar pages regularly know that I have been calling for a rate hike for quite some time.
Some weeks it was pretty lonely out on this limb. Not any more. With just about everyone throwing in the towel on the chances for a rate cut, the rate hike limb is starting to fill up.

Indeed, just this week a major business magazine did a 180 and has now begun to warn its readers that higher rates are nigh. Judging by the number of signals that central bankers have sent in recent weeks, the Fed could very well decide to raise rates as early as this month. If they don't move in June, then they'll probably pull the trigger in August. After all, there's a limit as to how much more inflation the Fed can afford to tolerate before the markets begin to question its credibility. End of Story

Dr. Irwin Kellner is chief economist for MarketWatch. He also is the Weller professor of economics at Hofstra University and chief economist for North Fork Bank.

It's looking like a very interesting and potentially volatile 3 days ahead with key data due out on producer prices (Thursday) and consumer prices (Friday). This data and to lesser extent the beige book and retail figures due out today will be crucial in in forming the Fed's decison on the direction of rates in the near term.

US earnings update

1Q07 earnings for S&P 500 companies grew 8.3% bringing to an end a record streak of 14 consecutive quarters of double-digit earnings growth. Earnings slowed in line with a sluggish economy that grew 0.6% during the quarter. According to Thompson Financial's latest estimates 2Q07 earnings are expected to be around 3.8%.

Now we should remember that at one point 1Q07 earnings were expected to come in at around 3.3% so there is plenty of room for upside. One of the reasons many companies beat market estimates in 1Q07 was because of international exposure. About one-third of S&P500 companies have international operations. Strong global growth and a weak dollar have helped overseas operations post some healthy results offsetting lacklustre domestic demand. Wal-mart as mentioned a while back is a good case in point.

However the US consumer, which some economists are predicting needs to take a breather, are one of the drivers of global growth. A significant pullback by the US consumer would affect global growth rates. Also lets not forget that massive buybacks by many S&P500 companies are predicted to account for around 3.4% of earnings growth this year.

The argument that the market is not expensive on a P/E basis can change rapidly. Without a pullback in stock prices forward PE multiples expand considerably with low earnings growth. Could it be that analysts were a quarter too early in predicting gloomy earnings or are they just a bunch of conservative pessimists? It wouldn't be surprising as happened in 1Q07 for earnings to be much better than expected.

One sector that could surprise to the upside is the energy sector which is currently benefitting from higher prices. We may get a sneak preview of what's in store for 2Q07 earnings in the next few weeks as some companies come out with earnings pre-announcements. The Dow shed 410 points in 3 days last week and then regained more than a third of that loss on Friday. Expect more volatility to come as we get closer to 2Q07 earnings results.

More on US Treasuries

The picture below tells the story. US 10 year bonds have been sold off sharply pushing the yield 0.5% higher in a little under a month.


Why? Well firstly as noted previously the usually strong demand for US treasuires has weakened as emerging nations such as China, Brazil and Russia look elsewhere for higher yielding assets and diversification.

Secondly strong global growth is stoking the flames of inflation. Interest rates are on the rise everywhere, the EU hiked recently, China and the UK are in tightening mode as is Japan albeit from very low levels. New Zealand hiked last week to 8% and the odds of a rate rise in Australia before the year is out are firming.

Thirdly the deterioration in the sub-prime lending market is forcing managers of portfolios of mortgage-backed securities (MBS) to sell off Treasurys to hedge their weakening loans. This, in turn, feeds on itself. As yields go up, the managers of MBS portfolios have to adjust their hedges. That is they have to keep selling Treasurys. Remember the graph of mortgage resets I posted a week ago? Clearly the MBS portfolio managers will be feeling some selling pressure for a while yet.

Also let's remind ourselves of a little economics 101. When the 10 year bond yield trades below the fed funds rate clearly the market is anticipating interest rate cuts. In the past 18 years the 10 year bond yield has dipped under the Fed funds rate just 3 times. Within 6 months of that dip a rate cut ensued. The 10 year yield has been below the the Fed funds rate now for more than 10 months and with renewed signs that inflation is on the creep the market has changed it's view of the short term direction of interest rates.

If we see more evidence of inflation picking up you can expect bond yields to rise to around 5.4% as the market prices in a rate rise. With housing still in the doldrums, rising gas prices, a whiff of inflation and the current quarter likely to show the most sluggish earnigns growth for a few years there is little positve news on the horizon for stocks.

No fun for the Fed

Whilst the Australian economy seems to have a hit a sweet spot the US economy is plodding ahead in a series of fits and starts. The latest fit, Productivity for 1Q07 was revised down to 1.0% whilst labour costs were revised up to 1.8%. Not disastrous but both indicators are heading in the wrong direction. There is not much more disturbing to central bankers than sluggish economic growth and high inflation.

Not that the US is there yet but yesterday's data suggests it's a possibility. That would put the Fed between a rock and hard place. Obviously with the US economy struggling to find momentum the last thing the Fed wants to do is raise interest rates. Higher interest rates will only prolong the pain in the housing market dampening growth even further and running the risk of recession.


The graph above shows an interesting move in 10 year treasuries rising half a percent since March. Why? Well some of the reason probably lies in the fact that the fast-growing economies of China and India are beginning to diversify out of Treasuries. Also the current world wide liquidity binge has sent bond buyers in search of higher interest rates to compensate for the expected loss in buying power of both interest and principal. In case you weren't sure, none of this is particularly positive for equity markets.

Employment data adds to inflationary pressures

The Australian unemployment rate fell to a 33 year low of 4.2% as 39,400 new jobs were added. Economists were expecting around 10,000 new jobs to be added. It should be noted that the RBA has been fiddling with their methodology for compiling the data which could account for some of the fall in the unemployment rate. Regardless the result is a strong one considering more than 66,000 full-time jobs were added.

No doubt today's result coupled with yesterday's GDP number is fueling inflationary concerns, the currency and bond markets are now pricing one in. However the RBA will need to see some evidence that the robust figures of the last two days are feeding into prices. Some economists are predicting a rate rise as early as next month. Personally I think the RBA will need to see at least a couple of months of data to confirm that the inflationary genie is trying to escape the bottle before hiking rates.

US housing has bottomed...yeah right

Housing Inventory Build Worsens
Another interesting article from the BIG PICTURE that punches holes in the theory that the US housing market has turned the corner and is not affecting other sectors of the US economy. Click on the link above to read the full article. Below is one of the lovely graphs from the article I just had to reproduce here for aesthetic reasons. Click here for the interactive version from the WSJ, hours of fun to be had playing with this... well maybe not hours but at least a few minutes.


Just to add to the issue of firms laying off workers in all kinds of other industries, how about the 8,800 Dell announced would be canned last week or Prudential's decision to shut down their equities research operations in 5 countries including the US affecting 420 jobs. Surely if anyone is doing well it's the Institutional brokers? Incidentally I had been working at Prudential just less than a year when they decided to shut down their Australian operations back in 1998. Should have seen the writing on the wall.

Don't get excited about rate rises yet

1Q07 GDP rose 1.6% leading some economists to comment that the RBA may now be regretting sitting on interest rates for 7 months. Today's figures put the annual growth rate to March 2007 at 3.8%. Consenus was looking for a quarterly rise of just 1.1%. The rise was broadly based driven by robust consumer spending and business investment. Strong levels of business investment are expected to continue, again raising the issue of capacity constraints and inflationary pressures. March quarter growth was the fastest since the December quarter of 2003, when the economy grew 2.0%. Today's data sent the AUD to it's highest level against the greenback in 17 years.

However there are reasons to believe that growth will have to pullback a little in the current quarter as one of the major contributors to growth in the March quarter was a build up in inventories which is unlikely to be repeated again in the next quarter. The build-up in inventories accounts for approximately 0.6 percentage points of the 1.6% total for the quarter.

It will be interesting to see whether any signs of inflation creep through to wages in the next couple of months.

And now for some Aussie data

Look at profits ex Telstra
Company profits grew at a healthy 2.1% in 1Q07. What's that you say? Yesterday's headlines said company profits grew by 7.6% or an annualised rate of 17.1%. Oh silly you, you forgot to take into account the Telstra effect. For the first time Telstra's profits were recorded in the calculation distorting the numbers. Yesterday also saw the release inventories data. Inventories rose 1.4% in the quarter ahead of expectations lending strength to a solid GDP number to be reported on Wednesday.

Housing on the mend?
Today we learned that building approvals rose a much higher than expected 8.1% in April representing a 4.5% increase in the year to April 2007. Economists were expecting a rise of just 2.5%. Good news but don't get too excited yet the rise was due almost entirely to a 19.0% increase, seasonally adjusted, in the "other sector" for private sector dwellings, which includes volatile apartment projects. The more stable private sector housing approvals rose by a seasonally adjusted 3.3%. Add to that the fact that most of the increase in new building approvals was in Queensland, which experienced a 31.6% seasonally-adjusted rise in total new dwellings and a 24.9% gain in private sector houses. Whilst New South Wales and Victoria saw further declines. As with the US figures we need a few more months data for confirmation of a trend change.

What does all this mean? The economy is chugging along quite nicely. Expect a solid GDP number of around 1.5% to be reported tomorrow and the RBA to do nothing on rates.

Picking through a deluge of data

US GDP growth almost at a standstill.
1Q07 GDP growth came in at an annualized 0.6%. Remember that's annualized meaning that growth in 1Q07 was 0.15%, the lowest since 4Q02. Economists have put this weakness down to housing and businesses running down their inventories. However the all important consumer continued to spend which leads to the big question going forward - can the consumer continue to spend?

Consumers not yet feeling the pinch.
It seems consumers can keep spending. Last Friday personal spending was reported at a solid 0.5% in April. Consumers are seemingly unaffected by higher gasoline prices and falling house prices. Even if consumers do take a breather in the coming months as some Economists believe, they counter that any pullback in spending will be more than made up for by re-stocking of inventories and housing. Certainly you'd have to agree that inventories will pick up after being sold down last quarter but I don't buy the "we're past the worst of the housing cycle" story. Here's an interesting article full of pretty graphs from the BIG PICTURE on why the housing slump may not yet have turned the corner as some believe. I liked one particular graph so much I have reproduced it below. As you can see mortgage resets are yet to peak.


Economists are expecting between 2-3% GDP growth for 2Q07. Just remember that those same economists were expecting 2.2% GDP growth for 1Q07 just 5 weeks ago.


Employment
Us non-farm payrolls rose by 157k in April rebounding from the 88k registered in March and above forecasts of between 130 - 140k. Sounds good doesn't it? The market thought so and rallied to a record high on Friday. Here's a reason to think that the NFP numbers are, well basically meaningless. Below is a graph I stole from my friend over at Shenandoah Capital


This is the magical birth/death adjustment that is so secret the Bureau of Labor Statistics refuses to tell anyone how they calculate it. Notice the adjustment in construction jobs in an industry where people are being laid off left right and center and in which the industry players are forecasting doom and gloom for the rest of the year. Call me Alice if these figures aren't concocted in Wonderland.


PCE deflator slows but don't get excited yet.
Prices slowed to an increase of just 0.1% in April bringing down the annual rate to 2.0% bang on the upper band of the Fed's preferred range of between 1 - 2%. Whilst the Fed will take comfort from the slowdown in prices it's too early to be calling for rate cuts. In fact I doubt we'll see one this year.