Wednesday, 31 October 2007

ADP report shows reasonable employment growth


Nonfarm private employment grew 106,000 from September to October of 2007 on a seasonally adjusted basis, according to the ADP National Employment Report. The estimated change in employment from August to September was revised up 3,000 to 61,000. October’s increase of 106,000 marked an acceleration of private nonfarm employment after three months (July through September) during which the average monthly change was just 43,000.

In October, employment in the service-providing sector of the economy grew a healthy 134,000. Employment in the goods-producing sector declined 28,000, the eleventh consecutive monthly decline. Employment in the manufacturing sector fell 14,000.

The report was much stronger than expected. Economists had been expecting on average 58,000 jobs created in October. The ADP numbers bode well for Friday's Non Farm Payrolls report. Based on the ADP numbers, which as show above is closely correlated with NFP's, implies NFP growth of about 135,000 for the month of October. Economists are expecting growth of around 90,000.

The ADP report shows continued weakness in manufacturing and goods producing sectors however that has more than been offset by growth in service sector jobs. One month does not make a trend but I have to admit to being surprised at the resilience of the US job market.

A couple of months ago the employment market appeared to be taking a dive. Whilst it has definitely slowed, the ADP report suggests US employment growth is holding up for the time being. The NFP report will be watched closely on Friday to see if it confirms the ADP data.

Another LBO deal bites the dust

From the Wall Street Journal:

Cerberus Drops Bid for ACS Amid Credit Crunch

Cerberus Capital Management officially withdrew its $6.2 billion offer for Affiliated Computer Services Inc. yesterday, amid shareholder irritation over how the company's directors handled the $62-per-share approach, according to people familiar with the matter.

The ACS situation underscores the often-fraught position of corporate boards, who must push to get the highest price for company shares, all the while ensuring that they don't lose the interest of prospective buyers. With the recent downturn in the credit markets, sellers have lost some of their leverage, leaving some deals in the lurch.

In a letter to a special board committee of ACS, Cerberus officials said, "We regret that we must withdraw our offer to acquire the company due to the continuation of poor conditions in the debt markets."

We've been hearing in the last month or so that conditions in the credit markets are improving. Clearly they can't be that good as LBO firms are still having trouble raising debt for buyouts.

XAO extends gains in October

Last month I speculated that the All Ords would finish down for the month of October and surprise, surprise I was wrong. The All Ordinaries (XAO) finished up 3% for the month and has risen 9.6% since the end of July. From one year ago the XAO has risen 26.6%.

As we turn to November we are reminded that the so-called santa rally kicks in taking us through to the end of March in what is typically the best period for stocks. Looking at the last 10 years worth of data on the XAO, the month of November saw gains 9 times out of 10. The only time in the last 10 years the XAO finished lower in the month of November was in 2003 when the XAO fell 2.6%.

So it would seem to be a brave call to bet against a 9 out of 10 record but I'm going to do it anyway. The Australian economy continues to expand at a good pace despite a worsening drought and a lackluster housing market. As usual the direction of the XAO will be heavily influenced by the movements in the US market.

As I am writing this we are about 7 hours away from a Federal reserve decision on interest rates. The consensus is for a 0.25% rate cut.

If indeed the Fed cuts 25 basis points then the market should rally in the short term. However I think the rally will be much more short lived than the rally after the previous 50 basis point rate cut. If the Fed decides to go another 50 basis points then all bets are off for a pullback in November.

In the US, consumer confidence took a bigger than expected fall in October, housing is horrible and getting worse, banks and securities firms are taking big hits, SIV's are in trouble, the ABX indices look sick and corporate earnings have flat-lined.

US employment numbers will be crucial in the next few months as will retail spending, both have slowed but are not yet at recessionary levels. Although it puts me squarely in the minority camp, I see no evidence to suggest the US economy will avoid a recession in 2008. Of course, if that scenario plays out, the risks for equity markets remain firmly to the downside.

Aust Demand for Credit Remains Strong

Demand for credit remains solid
Demand for credit continued at a solid pace in September, despite an interest rate rise in August, and adding to the case for a further hike next week.

Total credit grew 1.2 per cent in September for an annual pace of 15.9 per cent, down only slightly from 16.0 per cent in the 12 months to August, Reserve Bank of Australia data (RBA) released on Wednesday shows.

This is still higher than the 15.3 per cent annual pace recorded in July and prior to the last rate rise.

Economists had forecast a 1.0 per cent increase in September.

The RBA is widely tipped by economists and financial markets to raise its cash rate to 6.75 per cent from 6.5 per cent next week on the back of data showing an acceleration in underlying inflation.

It would be the sixth increase since the 2004 election adding to the burden of highly-indebted households and impacting on the Howard government's re-election chances.

It will also delay a recovery in home building and keep pressure on housing affordability.

Other data released today by the Australian Bureau of Statistics shows building approvals jumping 6.8 per cent to 13,710 units in September and now standing 4.2 per cent higher than 12 months ago.

Economists had expected a 0.7 per cent increase.

The increase was largely due to the more volatile `other dwellings component' - such as apartments and townhouses - surging 13.8 per cent.

House approvals rose 2.5 per cent for the month tracking 2.6 per cent lower than a year earlier.

The RBA data showed housing credit rose 0.8 per cent in September for annual pace of 11.7 per cent, while business credit grew by a further 2.0 per cent for a large 23.3 per cent increase over the year.

Demand for personal credit was the only soft spot in the report, falling 0.2 per cent for an annual rate of 11.4 per cent.

Aust New Home Sales rise in Sep fall for the Qtr

From the Housing Industry of Australia (HIA):

New Home Sales weaken in September Quarter

New home sales rose in September, but not enough to prevent a fall over the quarter.
HIA’s New Home Sales figures released today show a 9.9 per cent monthly rise in the sale of new homes and units among Australia’s largest builders and developers, but sales fell over the quarter.

Despite the recovery from the slump in August, new home sales for the September quarter were down by 3 per cent.

Detached home sales increased by 14.5 per cent for the month but weak outcomes in both July and August meant that the bounce was insufficent to prevent a 2 per cent fall over the quarter. Sales of apartments slumped by 21.5 per cent in September and were down by 10 per cent over the quarter.

HIA Chief Economist, Mr Harley Dale, said that the September bounce did little to alter the flat profile for new home sales over 2007.

"Through the inevitable ups and downs you see from one month to the next, there has been no recovery emerge for detached house sales over 2007 to date and the situation for the multi-unit market is worse now than it was in 2006," Mr Dale said.

"Rising interest rates are certainly a negative for the industry. However, the high cost of serviceable land and the excessive level of taxes, fees and charges on new housing are preventing a much-needed recovery in new home building irrespective of where we are in the interest rate cycle," Mr Dale said.

"The result will put further upward pressure on existing housing stock, which is bad news for aspiring first home buyers and is also bad news for those already facing rent stress," said Mr Dale.

HIA’s New Home Sales Survey is compiled from a sample of the largest 100 residential builders in Australia and is the most leading indicator on new housing activity.

More on Case-Shiller Home prices

The 20 City index is showing it's biggest year on year decline since the index started in 2000.

The 10 city index is showing it's biggest year on year decline since 1991. The largest year on year occurred in April 1991 when the index declined 6.3% year over year. After which it made an abrupt U-turn and then flat-lined for a couple of years.

It will be interesting to see if a similar pattern occurs this time around. Somehow I doubt it. The evidence suggests this contraction will be at least longer if not deeper as the bulk of mortgage resets are yet to occur and a massive amount of inventory needs to be shifted.

Click on the image above to listen to the man himself, Bob Shiller, with his take on the latest home price figures in this interview on Bloomberg yesterday.

Tuesday, 30 October 2007

Case-Shiller Index falls for 8th consecutive month

From Bloomberg:

S&P/Case-Shiller Home Prices Fell 4.4% in August

Home prices in 20 U.S. metropolitan areas slumped in August by the most in at least six years, a private survey showed today.

Values dropped 4.4 percent in the 12 months that ended August, an eighth consecutive decline, according to the S&P/Case-Shiller home-price index, which has data back to 2001.

The figures reinforce the view among Federal Reserve officials and Treasury Secretary Henry Paulson that the housing slump has further to go. Near-record inventory levels suggest sellers will continue to lower prices, posing a threat to consumer spending because homeowners will have less equity to borrow against.

"This is really the No. 1 risk: a sustained, sharp decrease in home prices really squeezing consumers," said Meny Grauman, an economist at Scotia Capital Inc. in Toronto.

Economists forecast the gauge would decrease 4.2 percent, according to the median of 11 estimates in a Bloomberg News survey.

The group's 10-city composite index, which has a longer history, dropped 5 percent in the 12 months ended in August, the most since June 1991.

Compared with July, home prices in the 20-city index fell 0.7 percent after a 0.4 percent decline the month before. The figures aren't seasonally adjusted, so economists prefer to focus on the year-over-year change.

No Positive News

"The fall in home prices is showing no real signs of a slowdown or turnaround," said Robert Shiller, chief economist at MacroMarkets LLC and a professor at Yale University, in a statement. "There is really no positive news in today's report."

Shiller and Karl Case, an economics professor at Wellesley College, created the home-price index based on research from the 1980s.

The index is a composite of transactions in 20 metropolitan regions. Fifteen cities showed a year-over-year decline in prices, led by a 10 percent drop in Tampa, Florida, and a 9 percent decline in Detroit. The area showing the biggest gain was Seattle with a 5.7 percent increase.

Most economists expect housing to extend its slump and continue to be a drag on economic growth as loan foreclosures rise and tougher lending standards make borrowing more difficult.

UBS writedown bigger than expected

From Bloomberg:

UBS Reports SF830 Million Loss on Debt Writedowns

UBS AG, Europe's largest bank by assets, reported its first quarterly loss in almost five years after declines in the U.S. subprime mortgage market led to $4.4 billion in losses and writedowns on fixed-income securities.

The third-quarter net loss was 830 million Swiss francs ($712 million), or 49 centimes a share, compared with net income of 2.2 billion francs, or 1.07 francs, a year earlier, Zurich- based UBS said in a statement today. The loss exceeded the 683 million-franc estimate of nine analysts surveyed by Bloomberg.

The slumping U.S. housing market, which cost the world's biggest securities firms and banks more than $30 billion in bad loans and trading losses in the quarter, may lead to further writedowns, UBS reiterated today....

UBS said that while the fourth quarter "started with good results from all business," the bank can't assume it "will continue as positively as it began, or that the current difficulties will be resolved in the short term."

Debt market writedowns, which cost Chief Financial Officer Clive Standish and investment-banking head Huw Jenkins their jobs this month, will probably lead to another unprofitable quarter at the securities unit in the current three-month period, Rohner said today. The division earned 1.36 billion francs in the final three months of 2006.

The comments in bold are further evidence that this is not a one quarter event for UBS. Expect more such announcements as we get further into the 4th quarter.

Repeat after me: This Is Not A One Quarter Event

Despite record write-downs from large banks and brokerage firms in the third quarter the market cheerily expects earnings to rise by about 10% in the fourth quarter. That figure assumes that business for the banking and brokerage industry will be largely back to normal. However if you care to look there is enough evidence to seriously doubt such assumptions.

Just as a couple of examples, today UBS warned that more write-downs may be on the way due to their exposure to the U.S. housing and mortgage markets. Also there are rumors that Merrill Lynch is not done with it's writedowns and will need to take more in 4Q07. This is even more likely now that a new CEO will be coming in and will probably be bringing a large broom to sweep away the mess created by the previous inhabitant.

Then there is the much mooted 'Super SIV' bailout plan being sold by Wall Street's own government employed shill Hank Paulson which is little more than a desperate attempt to keep more forced writedowns of dubious quality assets off bank balance sheets.

Gretchen Morgenson of the New York Times summed things up well yesterday:

Guesstimates Won’t Cut It Anymore

The props holding up the values of risky mortgage securities finally started to give way last week. And that means the $30 billion in losses and write-downs taken by big brokerage firms in the third quarter are not likely to be the last....

The executives on Merrill’s dismal conference call conceded that even after they decided to value their C.D.O. holdings more conservatively — resulting in losses — much of their methodology was based on “quantitative evaluation.” (For the rest of us, that means that Merrill was in the unfortunate position of still having to guesstimate its exposure to losses.)

ANALYSTS quickly responded by forecasting an additional $4 billion in write-downs on Merrill’s portfolio. Marking positions to model — a favorite reality dodge on Wall Street — just doesn’t cut it anymore....

...Merrill’s decision to write down its holdings as it did gives a clear signal to other banks and brokerage firms that valuing similar assets at lofty levels is no longer acceptable or credible....

“We’ll definitely see a lot more write-downs,” said Josh Rosner, an expert on asset-backed securities at Graham-Fisher, an independent research firm in New York. “I think that the exposures that we are seeing and the announcement out of Merrill are the leading edge, not the end.”

Also today from Bloomberg:

Fitch May Cut Credit Ratings on $36.8 Billion of CDOs

Fitch Ratings said it may cut rankings on $36.8 billion of collateralized debt obligations linked to residential mortgage securities.

The company placed $32.6 billion of debt on review for a possible downgrade, according to a statement today. The remaining $4.2 billion had already been under review. Almost $24 billion of the debt had AAA ratings, New York-based Fitch said.

Fitch, a unit of Paris-based Fimalac, follows Moody's Investors Service, which last week cut ratings of CDOs linked to $33 billion of subprime mortgage securities. Lower ratings may force owners to either mark down the value of their holdings, or sell the securities. Moody's, Fitch and Standard & Poor's in July began lowering ratings on hundreds of mortgage-linked securities after their value tumbled as much as 80 cents on the dollar.

"The market at this point no longer believes the rating agencies when it comes to mortgage-related products," said David Castillo, who trades CDOs in San Francisco at Further Lane Securities. "It's merely forcing the hand of investors who are ratings-driven from an investment-criteria perspective."

How are the ABX indices doing? As of yesterday 17 of the 20 ABX indices fell to all time lows.

There will inevitably more writedowns to come in 4Q07 which is going to put significant pressure on double digit earnings growth expectations.

Friday, 26 October 2007

Countywide's 3Q shocker


Countrywide reports $1.2 billion loss

Beleaguered mortgage lender Countrywide Financial Corp. reported Friday its first quarterly loss in 25 years, a reflection of the turmoil in the credit markets that's roiled financial-services companies in the U.S. and elsewhere.

The company maintained its dividend payout and said it has also negotiated $18 billion in additional liquidity that it characterized as "highly reliable." Countrywide also said it expects to turn a profit in the fourth quarter and in 2008.

The Calabasas, Calif.-based company (CFC) reported a third-quarter net loss of $1.2 billion, or $2.85 a share. In the year-ago period, Countrywide saw net income of $648 million, or $1.03 a share.

Its mortgage-banking business suffered a $1.3 billion loss in the latest quarter.
Countrywide's ability to pay its dividend to shareholders was in doubt with the company under so much strain. However, the company on Friday declared a 15-cents-a-share regular quarterly dividend.

The company said third-quarter results included a loss of 73 cents a share to reflect the impact of the below-market strike price of convertible preferred issued during the quarter.

"Countrywide's results for the third quarter of 2007 reflect the impact of unprecedented disruptions in the U.S. mortgage market and the global capital markets, as well as continued weakening in the housing market," said Chief Executive Angelo Mozilo in a statement.

Chief Operating Officer David Sambol blamed the loss on inventory write-downs driven by the credit crunch, higher credit costs as a result of the housing downturn, and restructuring charges.

"We view the third quarter of 2007 as an earnings trough, and anticipate that the company will be profitable in the fourth quarter and in 2008," Sambol said.

Countrywide said it took losses and write-downs of about $1 billion on non-agency loans and mortgage-backed securities. Moreover, The company increased its loan-loss provisions on its held-for-investment portfolio to $934 million, up from $293 million in the second quarter.

The lender also raised its estimates of future defaults and charge-offs due to a worsening housing market, higher delinquencies and tighter credit. Countrywide plans to cut between 10,000 and 12,000 workers by the end of the year as a result of plunging origination volume.

Countrywide took a $57 million restructuring charge in the third quarter. It expects to see between $70 million and $90 million of additional restructuring charges, primarily in the fourth quarter.

The company said it expects the housing market to continue to weaken in the near term, and unless interest rates head lower, it sees lower mortgage originations through 2008.

Countrywide forecast consolidated earnings in the range of 25 cents to 75 cents a share for the fourth quarter.

I've been saying this a lot lately but I'll say it again. Truly ugly stuff. Well the good news they maintained their dividend, got an additional $18 billion in funding and will return a profit in fourth quarter. Before we get carried away, as the market has, sending the stock up more than 32% today, let's take a closer look at these so-called positives.

In CFC- just another $12 billion to tide us over I reported that CFC had obtained $25.5 billion of extra funding since the end of July. Now you can make that $43.5 billion. That's a lot of funding, some of which will go towards paying their $0.15 dividend. That the company may need to source another $18 billlion in funding should send alarm bells.

Then there is the exciting news that CFC will return to profitability in 4Q07. The company gave a range of between $0.25 - $0.75 a share for the fourth quarter.

Let's take the middle of that range $0.50, and see what that gives for the full year. CFC reported earnings per share of $1.57 for the first half of the year. Now you can add a loss of -$2.12 and a final quarter of $0.50. That means that CFC will post a net loss of -$0.05 per share or approximately -$28m. So CFC is on target to at best break even this year as opposed to Net Income of $2,674m or $4.42 a share in 2006.

The company also said they will make a profit next year and buried down in the bottom of their 8-K said they would post a Return on Equity of between 10 - 15% in 2008. Taking the middle of that range would give Net Income of around $2.0 billion in FY08 still approximately 25% lower than what they earned in 2006.

Discounting at my required rate of return of 15% I get a valuation of $21.24 per share. So if you believe CFC's forecasts you can understand the rally in the stock price.

However I think it requires a leap of faith on the part of investors to believe CFC's forecasts. The company said it expects the housing market to weaken in 2008 and as such to expect lower loan origination volumes. At the same time delinquencies are rising and the company is raising it's expected estimates for future charge offs.

In 'A closer look at Countrywide (CFC)' I noted that their provisions for loan losses was going exponential. As the chart above shows the third quarter accelerated that trend.

As the company admits, the outlook for housing is going to get worse. Also remember that in 2006 45% of mortgages originated by CFC carried adjustable rates. Thus we can expect, despite CFC's plan to help renegotiate some $16 billion of loans that high credit provisioning will persist through 2008.

There is no compelling reason to buy this stock other than the belief it has been drastically oversold and the forecasts the company has given are accurate. That's a lot of believing in a company that said on August 2nd of this year:

It is important to note that the Company has experienced no disruption in financing its ongoing daily operations, including placement of commercial paper.

A company that can go from that statement to completely wiping out any profit for the year in 2 months does get my benefit of the doubt on forecasts for 12 months in advance. Not to mention the fact that the CEO has been selling his stock like crazy.

ABCP market decline slows

The Asset Backed Commercial Paper market continued to decline however at the slowest rate since the purge began in early August. ABCP fell by $4.6 billion in the week ending October 24th.

The biggest threat to continued falls in the ABCP market is the uncertainty of SIV's ability to roll over their paper as highlighted by recent events at Cheyne Capital Management Ltd, IKB Deutsche Industriebank AG and the latest casualty Axon Financial Funding Ltd.

A bottom in New Home Sales?

From the US Department of Commerce report:

Sales of new one-family houses in September 2007 were at a seasonally adjusted annual rate of 770,000, according to estimates released jointly today by the U.S. Census Bureau and the Department of Housing and Urban Development. This is 4.8 percent (±10.3%)* above the revised August rate of 735,000, but is 23.3 percent (±8.0%) below the September 2006 estimate of 1,004,000.

The median sales price of new houses sold in September 2007 was $238,000; the average sales price was $288,000. The seasonally adjusted estimate of new houses for sale at the end of September was 523,000. This represents a supply of 8.3 months at the current sales rate.

90% confidence interval includes zero. The Census Bureau does not have sufficient statistical evidence to conclude that the actual change is different from zero.

So do we have at least a tentative rebound in New Home sales? Not so fast. Firstly the revision to August was significant, previously estimated at 795,000 revised down to 735,000. Secondly as highlighted above with a 10% standard error, like the non-farm payroll data, the monthly data is quite unreliable. Note that every month in summer has been revised downward, so September sales will almost certainly be revised downward next month.

There were actually 60,000 new homes sold during September, that is the lowest September number since the 54,000 sold in 1995. Also remember the figures do not account for cancellations, which as you can see below, surged in the September quarter.

Centex (CTX) 35%
MDC Holdings (MDC) 57%
KB Homes (KBH), 50%
Lennar Homes (LEN) 32%
D.R. Horton (DHI) 48%
Beazer Homes (BZH) 68%
NVR (27%)

An apt summmary of the figures came from Richard Moody, chief economist for Mission Residential.
"Take this one with a large truck load of salt,"

CNN Money also put the latest figures into perspective with these comments from David Seiders of the NAHB.

David Seiders, chief economist for the builders' trade group, said Thursday that the latest report has some questionable readings, including a 38 percent rise in sales in the West, which he expects will be revised significantly lower in subsequent months. Without that reported increase, sales would have fallen from the already weak revised level in August.

Seiders also pointed out that the report does not capture cancellations by buyers who were unable to get financing or had to pull out of sales because they couldn't sell their homes.

"We saw an upsurge in cancellations in August and September, according to all the builders," he said. "The net sales, if we could get that number, would clearly be weaker than this. It's too early to get hopes up on this report."

On prices Seiders had this to say:
"These price numbers are just about useless," said Seiders. "Price cuts are widening and deepening. We know that."

So no reason to get excited about a housing bottom yet. Surprisingly the voices of the bottom callers was notably absent. The reality that home sales are not going to get better anytime soon seems to be generally accepted.

Thursday, 25 October 2007

Jim Rogers liquidating US denominated assets

As always, the straight shooting Jim Rogers is interesting to listen to. Click on the image to listen to his latest interview on Bloomberg:

ANZ disappoints on higher provisions

ANZ reported cash earnings (the industry's preferred measure) of $3,924 million for the year ended Sep 30 2007, 9% higher than FY06. The number came in slightly below expectations. As flagged at the half yearly provisions for credit impairment increased 39% from the prior period.

Higher bad debt charges have kicked in and if the past is any guide this will be more than a one-off as we head into the bad end of the credit cycle. NAB and WBC are due to report earnings in the next few weeks so it will be interesting to see how they do on the bad debts front.

More Homebuilder pain

From Bloomberg:

Pulte Reports Loss on Writedowns, Tumbling Home Sales

Pulte Homes Inc., the third-largest U.S. homebuilder, reported a third-quarter loss after it reduced the value of its real estate and potential buyers of its homes had difficulty obtaining mortgages.

The net loss in the three months ended Sept. 30 was $787.9 million, or $3.12 a share, compared with net income of $190.2 million, or 74 cents, a year earlier, Bloomfield Hills, Michigan- based Pulte said today in a statement. Revenue fell 31 percent to $2.5 billion. The company wrote down the value of its assets by $1.18 billion in the quarter.

"The operating environment continues to be challenged with elevated levels of new and resale home inventory, tightening of mortgage liquidity, and weak consumer sentiment for housing,'' Richard J. Dugas Jr., the company's chief executive officer said in the statement.

Pulte was projected to have a net loss of $1.25 a share, according to the average estimate of analysts in a Bloomberg survey.

Orders for new homes fell 37 percent to 4,582, and the company had a backlog of 12,042 homes, worth $4.1 billion, it reported. A year earlier, the backlog reached 16,375 homes.

The company said it closed on sales of 7,468 homes in the quarter, a 28 percent decrease over the same period a year earlier. The average sales price per home fell 4 percent to $322,000 over the same period.

The company said it took impairments and land-related charges of $842 million and a goodwill impairment of $336 million in the quarter.

For the fourth quarter, the company said it projects income from continuing operations to range from break-even to 10 cents per share. It said it could not offer any guidance into next year.

Shocker of a result but notice they have managed to shift some inventory. Aslo yesterday:

Ryland Reports Loss on Writedowns and Slower Sales
Ryland Group Inc., a U.S. homebuilder targeting first-time buyers, reported a third-quarter loss on falling sales as mortgage terms made it harder for potential buyers to purchase homes.

The net loss in the three months ended September 30 was $54.7 million, or $1.30 a share, compared with net income of $87.9 million, or $1.97, a year earlier, the Calabasas, California-based company said today in a statement on Business Wire. Revenue fell 35 percent to $732.3 million....

Analysts expected Ryland to report a third-quarter loss of $1.29 a share, according to the average of nine estimates compiled by Bloomberg.

New orders declined 20.9 percent to 1,876 units, and the inventory of homes started and not yet sold declined 21.9 percent to 1,362 units. The company wrote off $128.1 million after adjusting the value of its inventory.

Ryland amended its unsecured revolving credit facility and reduced its aggregate debt to $750 million from $1.5 billion, the company announced Oct. 17.

Again if there is any positive news here it is that inventories are being worked off. Inventories should continue to flatten out as the summer selling season is now over.

Another plunge for Existing Home Sales


Home sales crater on credit squeeze

Sales of existing homes and condos fell to a seasonally adjusted annual rate of 5.04 million, the lowest since 1999, when the real estate group began tracking combined single-family and condo sales. The 8% drop was the largest monthly percentage decline in that period.

Nationwide, sales of existing homes were down 19.1% in September compared with September 2006. Sales fell in all four regions.

The deepening subprime crisis is threatening a recession, said Peter Morici, a business professor at the University of Maryland. Lehman Bros. now expects the Federal Reserve to cut its overnight lending rate by a full percentage to 3.75% by the middle of 2008, including a rate cut next week.

"The housing crunch is accelerating; the Fed can't stand by and watch," wrote Ian Shepherdson, chief U.S. economist for High Frequency Economics.
Sales were much weaker than the 5.22 million pace expected by economists surveyed by MarketWatch....

Inventories of unsold homes and condos rose to a 10.5-month supply, the largest in at least eight years....

The median sales price for homes and condos was $211,700, down 4.2% in the past year. Median sales prices have fallen in 13 of the past 14 months.

Well what did you expect? Regardless of what chief chucklehead of NAR, Lawrence Yun says, things are not going to turn around anytime soon in the housing market. However I will say that inventories look as though they could be peaking as all the homebuilders that have reported 3Q07 earnings so far have managed to work off some of their inventory.

MER $8.4 billion in writedowns oops!

From the WSJ:

Merrill Takes $8.4 Billion Credit Hit

Merrill said yesterday it took an $8.4 billion hit in the third quarter from revaluing bonds backed by mortgages and other write-downs. That was far higher than the $5 billion hit Merrill estimated just two and a half weeks ago -- a surprise that led the firm's stock price to fall 5.8% as its credit rating was downgraded.

Overall, Merrill recorded a $2.24 billion loss for the quarter, making it the only one of Wall Street's five biggest investment banks to end the period in the red. Ratings firm Standard & Poor's described the write-downs as "staggering" and blamed "management miscues."

Merrill Lynch's board met on Sunday and Monday to preview the results and grilled Mr. O'Neal and top executives. The meeting was "definitely tense and very testy," says a person familiar with it....

The $8.4 billion hit leaves it clear that Mr. O'Neal and his team didn't always appreciate the risks they took to achieve the greater profits. The write-down surpasses a $6 billion loss suffered in 2005 by the hedge fund Amaranth Advisers, which had stood as the largest single known Wall Street loss.

Not much more to say really other than that is one ugly result. Considering that Merrill's upped their losses by a cool $3 billion from just a couple of weeks ago, does anyone really believe this is going to be just a one quarter event?

Wednesday, 24 October 2007

S&P may chop ratings on Aust & NZ RMBS

A timely reminder that Australia is not immune from the tentacles of the global meltdown in RMBS. From Bloomberg:

S&P May Cut Australian, N.Z. Mortgage Bond Ratings

Standard & Poor's may cut the credit ratings of 207 Australian and New Zealand residential mortgage- backed securities as turmoil in the U.S. subprime market spreads to home-loan insurers.

It's the first time in five years S&P has put securities backed by Australian and New Zealand mortgages on negative "creditwatch," said Kate Thomson, an analyst at S&P in Melbourne, said today. Placing the bonds on Creditwatch negative, which means a rating cut is possible within 90 days, may drive yields on the debt higher.

S&P lowered ratings on about $50 billion of U.S. securities last week amid criticism from investors and lawmakers for downplaying the risk of subprime bonds. The ratings service said Oct. 19 it may lower the credit rating of PMI Group Inc. and its Australian unit after the second-largest U.S. mortgage insurer posted a $350 million third-quarter loss as defaults increased.

"Australian notes will definitely be affected in both the primary and secondary market and some new issues will price higher as a direct result," said Warren Mellor, structured credit analyst at National Australia Bank Ltd. in Melbourne.

Mortgage-backed bond sellers are already offering higher yields on securities to entice buyers back to a market that stalled in August after BNP Paribas SA, France's largest bank, followed Bear Stearns Cos. in freezing withdrawals from hedge funds, triggering a liquidity crunch in the global credit markets.

Australian lenders including Calibre Financial Ltd. and FirstMac Ltd. last week sold mortgage-backed bonds at yields more than double the rate of previous sales, according to data compiled by Bloomberg.

PMI Rating Watch

Sydney-based PMI Mortgage Insurance Ltd. has the third- highest investment grade rating of AA and is one of the two largest insurers of Australian home loans used to secure bonds. The 207 home loan-backed bonds that may be cut are also rated AA and some were created as recently as this month.

Almost all of the mortgage-backed bonds with ratings below the top AAA level monitored by National Australia Bank are at least partly backed by home loans insured by PMI Mortgage, Mellor said.

``We are seeing an entire product range being affected by PMI and the impact on our domestic market is a direct consequence of the company's business in the U.S.,'' Mellor said.

Latest CPI reading suggests RBA has more to do

From The Sydney Morning Herald:

Rate rise more likely on high inflation

Core inflation rose more than expected in the September quarter as prices rose across the board, strengthening the case for an interest rate rise in November.

Australia's trimmed mean consumer price index (CPI) rose 0.9 per cent in the September quarter, for an annual growth rate of 2.9 per cent, the Australian Bureau of Statistics (ABS) said.

The weighted median CPI rose 1.0 per cent in the September quarter, with an annual rise of 3.1 per cent.

Market economists had expected the average of the two measures to rise by 0.8 per cent in the September quarter for an annual rate of 2.8 per cent.

The headline CPI rose 0.7 per cent in the September quarter, for an annual rate of 1.9 per cent.

The median market forecast was for a rise of 0.9 per cent in the September quarter and an annual pace of 2.1 per cent.

The ABS calculates the trimmed mean and weighted median measures on behalf of the Reserve Bank of Australia (RBA), which uses them to gauge the underlying trend in inflation.

Unlike the headline CPI, the RBA's underlying measures are subject to revision due to the seasonal adjustment of some of their components.

JP Morgan economist Jarrod Kerr said the weaker than expected headline number should be largely ignored, with the key core measures surprising on the upside.

He said high core inflation points to the need for the Reserve Bank of Australia (RBA) to raise interest rates again.

"I think the need to raise interest rates again, and the case for it, is becoming compelling," Mr Kerr said, adding the RBA will need to consider it carefully heading into its next board meeting in November.

He said JP Morgan expected rates to rise by 25 basis points to 6.75 per cent in November during the federal election campaign.

"Even though the headline number is weak ... the core measure is at 2.9, and that's right at the top of the RBA's band," he said.

The RBA aims to maintain inflation within a target band of two to three per cent.

Mr Kerr expects inflation to rise further in the fourth quarter of 2007.

He said price increases were across the board.

Food prices rose 1.8 per cent from the previous quarter, while housing was up 4.2 per cent, alcohol and tobacco up 3.1 per cent and health up 4.3 per cent.

Westpac senior economist Andrew Hanlan said the inflation reading should force the Reserve Bank's hand and prompt it to raise interest rates in November, adding that further rises were also in the pipeline.

"The economy has certainly accelerated very strongly over the past 12 months and is running at an above trend rate, and that's now generating widespread core inflation pressures," he said.

"We saw that in the June quarter, we saw that in the PPI (producer price index) and it's been confirmed today."

He said back-to-back readings of underlying inflation above 0.9 per cent meant annual inflation was now running at somewhere between 3.5 per cent and four per cent.

"That's well above the RBA's target band," he said.

"As long as you take the view that the ... economy is still strong and the credit crisis isn't about to crunch the economy, then certainly there is a need for a tightening of monetary policy."

"Our view is the Reserve Bank will take an optimistic line that the credit crisis will blow over and that world growth will remain above par in 2008

"We expect an immediate reaction from the Reserve Bank and a tightening of 25 basis points in November, but (we believe) that will be insufficient and we will need to see a follow-up move ... it's just a question of when."

Failing SIV's pressure ABCP market

From Bloomberg:

SIV Defaults May Prompt Others to Close Their Door

Many structured-investment vehicles may be forced to close in the next few months as defaults by SIVs run by European hedge funds make it harder for others to avoid selling off their assets, according to CreditSights Inc.

Funds run by London-based Cheyne Capital Management Ltd. and IKB Deutsche Industriebank AG last week failed to repay maturing short-term debt. The defaults may lead to price and ratings cuts and force SIVs to sell assets, prolonging the "turmoil'' in credit markets, CreditSights analysts led by Christian Stracke in London wrote in a report yesterday.

"We continue to expect that the bulk of SIVs will manage to avoid a worst-case scenario of imminent liquidation,'' Stracke wrote in the report. "But the problems that the recent defaults have underlined will make a gradual unwind of many SIVs difficult to avoid over the next several months.''

Axon Financial Funding Ltd. Latest Casualty

Axon Financial Funding Ltd. LLC, a SIV with $9.8 billion of debt, had its credit ratings cut by Moody's today after its net asset value fell by more than half. The SIV, set up by New York- based hedge fund TPG-Axon Capital Management LP, had the rankings of its medium-term notes lowered by 12 steps to Ba3, three levels below investment grade, from Aaa, the highest-possible rating.

Cheyne Finance Plc was forced to sell some assets this year to repay maturing commercial paper and has now stopped paying its debts altogether. Rhinebridge Plc, run by a unit of Dusseldorf- based IKB, missed payments on $65 million of commercial paper last week. The market value of the Rhinebridge assets are 63 percent of their $1.1 billion face value, according to S&P.

Worst Ahead?

"We do not mean to say that price volatility in assets at a $1.0 billion SIV named Rhinebridge will be the straw that breaks the camel's back in global credit markets,'' Stracke wrote in the report. "But the experience at the defaulted SIVs should, at the very least, remind investors that the worst may not be over in terms of structured products ratings and the broader fall-out from the ABS sector.''

Stracke is fairly measured in his report. He is not predicting imminent liquidations and total catastrophe. However he points out that the worst may be yet to come in the Asset Backed Securities markets. If you need anymore convincing that this has the potential to cause major problems in creidt markets, just look at the desperation of Treasury Secretary, subprime is contained Paulson scurrying about the globe trying to drum up support for the super SIV program.

Centex feels the pinch in 3rd quarter

From Bloomberg:

Centex Reports Loss as Housing Slump Intensifies

Centex Corp., the fourth-largest U.S. homebuilder, reported its biggest quarterly loss in at least 17 years after writing down the value of property as the housing recession intensified.

The net loss in the three months ended Sept. 30 was $643.8 million, or $5.26 a share, compared with net income of $137.4 million, or $1.11, a year earlier, Dallas-based Centex said today in a statement. Fiscal second-quarter revenue fell 21 percent to $2.2 billion. Centex recorded $983 million in land writedowns and charges and said its cancellation rate was 35 percent.

"Market conditions were extremely challenging during the quarter, reflecting the serious disruptions in the credit and mortgage markets that occurred during that period,'' Chief Executive Officer Tim Eller said in the statement. "In response, we meaningfully reduced prices in order to improve affordability for our home buyers.''

September home sales are forecast to fall to a seven-year low as lenders tighten credit standards and defaults doubled last month from a year ago. Homebuilders are cutting prices to clear inventories and contend with a more than eight-month supply of unsold homes, the most in at least six years.

Centex was projected to have a net loss of $5.52 a share, according to the average estimate of seven analysts in a Bloomberg survey.

"It's just more bad news I guess,'' said Alex Barron, an analyst who follows homebuilders for Wayzata, Minnesota-based Agency Trading Group Inc. "Things continue to deteriorate.''

Shares of Centex fell 93 cents, or 3.6 percent, to $24.64 in New York Stock Exchange composite trading today. The shares are down 56 percent this year, compared with a 51 percent drop in a Standard & Poor's index of 15 homebuilders....

The average sale price for a home sold in the quarter was $280,816, down 8 percent from $305,201 a year ago.

If there can be any positives taken out of this report it would be that Centex's inventory of unsold homes fell 38% whilst cancellation rates fell as well - although they are still high at 35%

There is plenty more housing related data coming out in the next few days with Existing home sales for Septemeber coming out on Wednesday and New homes sales on Thursday. On top of that more homebuilder earnings from Pulte Homes Inc., the third-largest U.S. builder, and Ryland Group Inc. are expected this week.

Tuesday, 23 October 2007

Neumann's Chapter 11 sign of things to come

I've been saying for while that it is only a matter of time before a major homebuilder goes belly up. While that still hasn't happened a smaller Chicago based homebuilder has given a sign of things to come by filing for Chapter 11 on Monday.

Neumann in Chapter 11

The crash in the Chicago-area market for new homes has claimed its biggest casualty. Suburban builder Neumann Homes Inc. said Monday it will file for bankruptcy and has laid off most of its employees.

Warrenville-based Neumann blamed its predicament on a drop of more than 50 percent in annual sales within the Chicago and Denver markets. It also pointed to a decision in 2005 to invest in the Detroit market, a move it said cost the company more than $60 million.

Warrenville-based Neumann blamed its predicament on a drop of more than 50 percent in annual sales within the Chicago and Denver markets. It also pointed to a decision in 2005 to invest in the Detroit market, a move it said cost the company more than $60 million.

Neumann said it will file for a Chapter 11 bankruptcy and that its lenders have agreed to provide limited additional funding so that its assets can be evaluated and sold.

It also said the earnest money of customers whose new homes haven’t started construction is safe in escrow. Neumann said it will ask a bankruptcy judge to approve refunds from those accounts.

It also said it will work with lenders to ensure that homes will be completed if construction has started.

Kenneth Neumann, the chief executive officer, could not be reached for comment. The company faxed some details about its plans in response to inquiries from the Sun-Times.

In the fax, Neumann said it has closed its sales, production and customer service offices. It gave no figures concerning layoffs.

"The market downturn in the Chicago and Denver housing markets [is] now in excess of 50 percent, with home prices dropping from 10 percent to 25 percent in some sub-market," Kenneth Neumann commented in the fax. "Even after the significant help we have received from our lenders this year, the company can no longer weather this storm."

It's worth remembering that the downturn in US housing will get a lot worse before it gets better and below is part of the reason why. The chart below courtesy of Credit Suisse shows the mortgage resets yet to come - the peak of which will occur in 2008. How long will Homebuilders be able to weather the storm with cancellation rates like those at Beazer currently running at 68% and D.R Horton at 48%? It may take until next year but you can bet it will happen sooner or later.

Zelman paints a sobering picture of US housing

Ivy Zelman is one of the more pessimistic on the outlook for US housing but as the article says, probably one of the most realistic.

U.S. Housing Decline Threatens to Last Into 2009:

Ivy Zelman's view of the U.S. housing market is gloomy, but it's probably the most realistic.

A veteran Wall Street analyst, Zelman, chief executive of the research firm Zelman & Associates, says it's unlikely the U.S. housing market will recover before 2009, adding there's a "50 to 60 percent chance of a recession," as the housing slump curbs consumer spending.

Zelman paints a much darker picture than Federal Reserve Chairman Ben Bernanke, who said last week that housing will be a "significant drag" on the economy into next year.

When you consider the huge home inventories and tight-as-a- drum mortgage restrictions, it's easy to conclude that the housing slump could extend well past 2008. Unless financing loosens up and buyers return, her prophecy will become a reality.

`"I've never seen the market as bad as this," Zelman said. "And it could get worse. The home-price decline could range from 16 percent to 22 percent."

Monitoring inventory, builder incentives and demand, Zelman is also watching adjustable-rate mortgage resets. Homeowners with these loans will automatically face higher monthly payments that they may not be able to afford, another trigger for foreclosures or sales. Some $500 billion of these loans will re- adjust through 2008, Zelman says.

While foreclosures have declined somewhat from August to September, they still doubled from a year ago, according to RealtyTrac Inc., which monitors the housing market. Since more homes are coming on the market, Zelman says that will only add to the misery.

`Worst Inventories'

"These are the worst inventories we've seen as a nation," she says. Zelman originally presented her report Oct. 10 to the Home Improvement Research Institute, a Tampa, Florida-based trade group.

Zelman's words carry some weight because she was one of the few major Wall Street analysts to warn of a housing decline months before it began late last year.

She was alarmed that home prices far outpaced personal- income increases during the boom, which is how the economic disconnect began. A bubble created artificially high demand that had to deflate sometime. Now economists and analysts are trying to assess the collateral damage of the bust and subprime mortgage meltdown.

Meanwhile, builders are stuck with thousands of new homes they can't sell and potential buyers are canceling in droves or are unable to get a mortgage. Housing starts fell to a 14-year low in September.

Mass Psychology

"Builders are desperate now and blowing through inventory," says Zelman of homebuilders who are doing anything they can to sell homes. "Their revenues are shrinking so fast, they can't keep up."

The mass psychology that amplifies and spreads the angst of home sellers will put a brake on overall consumer spending, Zelman predicts.

"Some 74 percent of consumer expenditures are correlated to housing. I don't think the consumer will hold up. They will cut back on things like buying cars and vacations."

While Zelman forecasts that sales will drop for the next two years, she isn't as optimistic on home prices, which she says may continue falling until 2010 or 2011.

"We'd be better off if prices corrected all at once. It will get worse before it gets better."

Places where sales were strongest and speculators were most active before the bust will be bedeviled by high home inventories for more than a year.

Click on the link for the full story. Whilst consumers are slowly waking up to the fact that housing prices don't always go up. They are yet to take on board the type of thinking that sees home prices falling for the next 3 - 5 years. A scenario that Robert Schiller of Case Shiller fame keeps reminding us happened back in the period 1989 - 1993.

Monday, 22 October 2007

KKR / Goldman weasel out of Harman breakup fee

A month ago I noted that KKR and Goldman Sachs were trying to weasel their way out paying a $225 million break-up fee since the proposed $8 billion Harman deal fell through.

Officially the only way out of the deal without paying the breakup fee was if KKR and Goldman could show that Harman had undergone a severe decline in their business. Finally today it seems the parties have come to compromise.

KKR, Goldman Buy Harman Bond, Won't Pay Breakup Fee

Kohlberg Kravis Roberts & Co. and Goldman Sachs Group Inc. agreed to buy $400 million of bonds of Harman International Industries Inc. after they abandoned their $8 billion leveraged buyout last month.

The buyers will avoid a lawsuit from the maker of audio equipment, and won't have to pay $225 million in breakup fees for aborting the deal, Washington-based Harman said in a Business Wire statement today. The bonds will pay 1.25 percent annual interest and will convert into Harman shares if the price reaches $104, $16 less than Goldman and KKR's original bid.

"Although we do not agree with the reasons for cancellation of the original merger agreement, we view this $400 million investment as a vote of confidence in our business,'' Harman founder Sidney Harman said in today's statement. Harman said it will use the money to accelerate a stock buyback.

Interestingly the company publicly stated they did not agree with Goldman and KKR's reason for originally abandoning the deal. A bit of bad blood there perhaps but with the $400 million bond issue now in play it's all water under the bridge. However not as happy ending for LBO banker J. Christopher Flowers:

KKR is settling with Harman on the same day as LBO banker J. Christopher Flowers's lawyers meet in court to fight a lawsuit from SLM Corp. forcing him to make good on his $25.3 billion offer for the student-loan provider known as Sallie Mae. Flowers, who faces $900 million in break fees, had cut his bid last month, saying Sallie Mae had suffered a material adverse effect.

This won't be last lawsuit we hear of in the now almost totally defunct LBO market. Along with lawsuits against mortgage brokers and homebuilders brewing, lawyers sare set to pocket decent bonuses this year.

South West Florida houses dumped for half price

How would feel if you bought a home 6 months ago for $300,000 only to find out that if you had waited a little longer you could have picked it up for a bargain $145,000? Click on the video below to find out.

Jones back in charge, good news for ANH

It seems that rather than be humiliated in front of a quorum of shareholders, Glenn Ridge and Terry Grigg decided to step down at the last minute. Thus the General meeting was unnecessary. As was, now it turns out, all the letters to shareholders by company executives trying to justify themselves.

In addition Dean Jones and Andrew Barlow were appointed to the Board of Directors whilst Company Secretary Jan McPherson resigned leaving Mr dodgy - Robert Edge as Company Secretary.

It's a good result given that Jones is back on board and the dead weight has been cut. Jan McPherson also won't be missed. Her repeated mistakes with ASX announcements makes you wonder if she actually had a law degree. The only question mark remaining is that of Robert Edge.

Remember Edge was the subject of an ASIC investigation in which it was found that Edge had:

repeatedly contravened numerous provisions of the Corporations Act (the Act) and Corporations Regulations and that his failure to comply with statutory requirements was ‘chronic and widespread’.

Given what Jones and Chairman Peter Jermyn had to say about Edge in their recent letters to shareholders it is hard to see why they would want him around and why Edge would want to stay for that matter. If Edge stays it would seem rather unusual and raise more questions as to the integrity of management.

Sunday, 21 October 2007

More RMBS downgrades compound SIV headaches

Firstly to the downgrades:

Fitch Affirms $1.27B & Downgrades $265.5MM from 4 IndyMac Subprime Transactions

Fitch Ratings has taken the following rating actions on IndyMac Banks INABS certificates. Affirmations total $1.27 billion and downgrades total $265.5 million.

The rating actions are based on changes that Fitch has made to its subprime loss forecasting assumptions. The updated assumptions better capture the deteriorating performance of pools from 2006 and late 2005 with regard to continued poor loan performance and home price weakness. Additional details are available in the following research, also available at

Just days after S&P downgraded 1,713 RMBS issued in the first half of this year comes this:

S&P Lowers Ratings on 1,413 U.S. RMBS.

Standard & Poor's Ratings Services announced today that it has downgraded 1,413 of U.S. residential mortgage-backed securities (RMBS) backed by first-lien subprime mortgage loans that were issued from the beginning of the fourth quarter of 2005 through the fourth quarter of 2006. These downgraded securities had an original par value of $22.02 billion, which represents 4% of the $554.4 billion of U.S. RMBS backed by first-lien subprime mortgage loans rated by S&P during this period. These actions, combined with downgrades previously announced by
S&P, impact a total of 1,671 securities of U.S. RMBS backed by first-lien subprime mortgage loans issued during this period, representing $24.8 billion, or 4.5% of the $554.4 billion mentioned above. S&P also affirmed its ratings on securities representing $531.6 billion original par value of U.S. RMBS backed by first- lien subprime mortgage loans from this same

Of the 1,413 securities downgraded today, approximately 47% were rated in the 'BBB' category and below. Fifteen 'AAA' rated securities were downgraded, accounting for roughly 0.01% of all downgraded securities and 1.1% of the total dollar amount downgraded. No 'AAA' rating was lowered below 'AA'.

We took these rating actions at this time because, based on the most recent data, we expect further delinquencies and losses on the underlying mortgage loans; the consequent reduction of credit support from current and projected losses; and continued declines in home values.

As mentioned previously the ratings agencies have been behind the eight-ball from the get-go. However the fact that they have finally gotten around to re-rating this junk does little to instill confidence in already shaky credit markets. Particularly in light of the new threat to gloabl credit markets in the form of SIV's. Speaking of which:

Cheyne, IKB SIVs Default on Commercial Paper as Assets Fall

Cheyne Finance Plc and IKB Deutsche Industriebank AG's Rhinebridge Plc, two structured investment vehicles that bought securities backed by home loans, defaulted on more than $7 billion of debt as the value of their holdings fell....

Rhinebridge, set up and run by a unit of Dusseldorf-based IKB, missed payment on $65 million of commercial paper yesterday after revaluing collateralized debt obligations, Fitch Ratings and Standard & Poor's said.

Rhinebridge has $791 million of commercial paper and a portfolio with a face value of $1.1 billion, S&P said. The market value of the assets is now 63 percent of face value, having fallen $69 million since Oct. 16 alone, S&P said. Revaluations of CDOs of asset-backed securities have caused a ``dramatic'' fall in value, the rating company said....

Receivers from Deloitte & Touche LLP are trying to organize a bailout of Cheyne Finance by restructuring its debt or selling its assets. Cheyne Finance hasn't paid commercial paper that matured after the receivers' announcement on Oct. 17, S&P said.

Cheyne Finance's managers said its assets are worth 93 percent of face value, enough to pay back all of its $6.6 billion of senior debt, S&P said. CDOs of asset-backed securities make up 6 percent of Cheyne Finance's holdings....

Mainsail II Ltd., a SIV set up by London-based hedge-fund manager Solent Capital Partners LLP, said yesterday it had assets with a face value of $1.48 billion and debts of $1.65 billion.

As I intimated recently in Credit Crunch 2.0, SIV's are taking center stage in this new round of volatility. Given the urgency with which Comedian, I mean Treasury Secretary Paulson has been scurrying about trying to sell the SIV bailout plan, this round has the potential to be worse than the mid August dislocation.

The author of the blog 'naked capitalism' has written some excellent posts on the SIV bailout plan. The best among them I think was his post of October 20th which outlined among other things the inappropriateness of Paulson's jawboning on the subject of the MLEC. Below is just an excerpt, click on the link for the full post which is well worth a read.

SIV Rescue Plan: From Smoke and Mirrors to Jawboning

Paulson, the former CEO of Goldman Sachs, is even by Wall Street standards, a high-testosterone, can-do type. He came up through Investment Banking Services, which was the sales team for Goldman's service to big corporations (such as M&A, underwritings, real estate finance). Being cerebral is not a plus in IBS. They are paid to close deals, not to question whether the deals make any sense.

Now some people manage to overcome their upbringing, but Paulson does not appear to be one of them. He is unduly identifying himself and the Treasury with this plan (which as we said before and will address later, is a terrible precedent), and is refusing to see the widespread criticism as probably well founded (everyone on the Street wants the problem solved. Industry participants have if anything a bias in favor of a solution). Instead, he is marshaling resources to press onward regardless....

Another interesting and excellent article on the topic of SIV's came from John Maudlin's free weekly newsletter Thoughts from the Frontline. For those who aren't exactly sure what an SIV is John gives an easy to understand overview and his thoughts on the proposed MLEC. Again, below is just an excerpt so click on the link for the full, very informative article.

Taking Out the SIV Garbage

This Monday, Citibank, Bank of America, and JP Morgan Chase announced they intend to set up an $80-100 billion fund which would buy the "good children" of SIVs that are in trouble. As illustrated below (from the Wall Street Journal), they will offer to buy an asset (one of the good children) for $.94 cents plus a 4% note. There are about $400 billion in SIVs, so if they can actually raise the money, it would be a large chunk of the market. Remember, Citigroup has about $80 billion. As I will outline below, I do not think they plan to sell their own good assets into this fund....

I do not think it is to directly bail out Citigroup, B of A, or Morgan. They are going to take some losses to the extent that their SIVs have subprime exposure, as will every SIV and bank sponsor. If there is (speculating) 5% of subprime debt in their SIVs (and no one knows), Citi can easily absorb that. This is a bank that made almost $30 billion pre-tax last year. Annoying to shareholders, but not a capital problem.

I think the problem is elsewhere, and especially in Europe. There are a lot of Rhinebridges out there. We will see a lot more announcements of SIVs being closed in the next few months. One smaller fund in London called Cheyne has $6.6 billion in debt. Cheyne Finance's managers said its assets are worth 93% of face value, enough to pay back all of its $6.6 billion of senior debt, S&P said. CDOs of asset-backed securities make up 6 percent of Cheyne Finance's holdings. The commercial paper gets paid. The equity portion is a total loss and the mezzanine tranche gets whacked....

The Superfund does not solve the problem of what to do with the subprime debt. Those losses are going to find their way onto the balance sheets of the banks eventually.

But what it does do is buy time. Instead of having to take all that debt (both good and bad) from day one, it strings things out. If you bring those loans back into your bank, it means you have less capital to lend. If you can stretch out the process, it allows you to absorb the losses more easily.

This is the crux of it here. Any kind of super fund designed to buy assets is just a delay tactic. However, eventually these assets will have to be marked to market and banks will have to assume responsibility for them by bringing them on to their balance sheets. The banks realize they are going to have to take some hits but they want to do it an orderly fashion and hopefully avoid fire sale prices.

With the help of their shill Paulson it appears the idea has a fair chance of getting up and running by the end of the year. Of more importance to the stock market will be if investors gain confidence from it or see through it as a desperate delay tactic and press the panic button. Whilst uncertainty remains, expect volatility to reign.

Saturday, 20 October 2007

Black Monday 2.0?

By now you've probably read a dozen articles chronicling the meltdown in stock markets 20 years ago yesterday. Whilst the Dow Jones industrial (INDU) average had it's biggest fall on Friday for a while, the 2.6% drop pales in comparison to the more than 22% drop 20 years ago.

That 22% drop on October 19th 1987 occurred on a Monday, the preceding Friday, a sell-off had begun. So what does yesterday's sell-off signal for the coming Monday? Nothing, I'm just screwing with people's minds.

Apparently in the US markets on Friday investors got spooked by earnings. In particular, Caterpillar, Wachovia, 3M and Honeywell.

Caterpillar (CAT) posted 3Q07 earnings growth of 21% and stated that:

"We continue to see remarkable growth outside of the United States with particular strength in key industries like mining, oil and gas, electric power and marine engines,"
So why did the shares fall almost 5%? For one thing the company dropped their forecast earnings for 2007 to between $5.20 - $5.60 per share from $5.30 - $5.80 previously. However the comments by the company probably had more impact stating that they didn't see any improvement in 2008, warning that the economy will

"grow well below potential" at 1.5%, even lagging the current year. "Our outlook reflects U.S. housing, nonresidential contracting and quarrying declining further," "For the major U.S. machinery end markets, only coal mining shows a reasonable possibility of improvement from 2007." Furthermore, the Federal Reserve's move to cuts interest rates has not "removed all financial market stresses," Caterpillar said, adding that it expects another rate cut this year.

For some reason analysts were surprised by this. You see it doesn't jibe with their goldilocks scenario that sees moderate earnings growth for the remainder of this year and then accelerating again into 2008 on the back of a strengthening US economy and strong global growth.

Wachovia (WB) missed analysts expectations of $1.03 per share for 3Q07 coming in at $0.89 per share. In line with other banks they hiked their provisions for loan losses considerably (almost fourfold from a year earlier) to $408 million.

Despite posting slightly better than expected earnings and raising their FY07 earnings forecast 3M's (MMM) shares were hit hard because of concerns over declining margins in the flat-screen television business.

Amazingly it seems people are surprised that flat screen TV's are going to get cheaper and that as a consequence, operating margins for companies like 3M who make the optical film used in liquid-crystal displays are going to shrink. Go figure?

Then there was Honeywell (HON) which posted 14% earnings growth for the third quarter and upped their FY07 earnings forecast. However margin concerns plagued the stock ending down almost 4% on the day.

On the surface, none of these results are disastrous, even despite Wachovia's earnings decline and rising bad debts, their underlying banking business is performing solidly. However, there are a few themes emerging from these earnings reports, that I have been nattering on about for a while, that market analysts have been seemingly oblivious to.

Firstly margin erosion. Company profit margins are at historic highs and as history tells us they will eventually revert to more normalized levels. Thus earnings projections based on current profitability levels are fraught with danger.

Secondly in the financial sector, certain business segments that have enjoyed huge growth in recent years, such as the RMBS market, have not only dried up but as Citigroup's chief financial officer Gary Crittenden, said earlier in the week,

"Many parts of the fixed-income market and many types of investment vehicles such as CDOs have shrunk dramatically, and we're not optimistic that they will regain a foothold in the market."

Even the big players that made billions out of this industry are doubting that these market segments will return to anything like previous levels.

Thirdly, despite the mantra repeated by analysts that housing is only 5% of the economy, it is clear that the slump in residential investment is having an effect on the wider economy as highlighted by CAT's outlook for the domestic US economy.

Following on from that point the current robust commercial real estate market is showing signs of weakness as expressed by the likes of Honeywell and again Caterpillar.

Most of these points still seem to be lost on analysts. Forecasts show they still expect double digit earnings growth for the S&P 500 in 2008. One of the few analysts that seems to be in touch with these realities is Michael Metz, chief investment strategist at Oppenheimer holdings.

In an interview on Bloomberg, Metz cautioned that credit market problems have not been resolved, that housing remains a major problem which will spill over into commercial real estate and that corporate profit margins have peaked calling double digit earnings growth expectations for 2008 "completely unrealistic." Click on the image below to listen to the interview.