Results for the quarter exclude the preferred dividend of $1.3 million paid to the U.S. Treasury on the senior preferred stock. With some early signs of stabilization in the housing market, Freddie Mac expects low mortgage rates, relatively high affordability and the homebuyer tax credit to help fuel the recovery in the upcoming quarters. Though provision for credit losses showed some improvement over the prior quarter, it remained at an elevated level as the credit market continued to deteriorate.

For full year 2009, net loss narrowed to $25.7 billion or $7.89 per share, compared to a loss of $50.8 billion or $34.60 in the previous year.

Freddie Mac mainly focuses on initiatives that support the Making Home Affordable Program (MHA Program) announced by the Obama Administration in Feb 2009. As a leading player, Freddie Mac continued to support the housing market during the fourth quarter of 2009.

In 2009, Freddie Mac helped more than 272,000 borrowers stay in their homes or sell their properties through its long-standing traditional foreclosure avoidance programs and Home Affordable Modification program (HAMP). Additionally, 129,380 loans remained in HAMP trial periods as of Dec 31, 2009, according to information provided by the MHA program administrator.

Net loss (excluding preference dividend) for Freddie Mac for the reported quarter was $7.8 billion, compared to a net loss of $6.7 billion in the prior quarter. During the reported quarter, provision for credit losses was $7.0 billion, compared to $8.0 billion in the prior quarter. Though provision for credit losses decreased compared to the prior quarter, it remained at an elevated level due to continued credit deterioration and challenging economic conditions.

Fully taxable-equivalent net interest income was $4.6 billion for the reported quarter, almost flat compared to the prior quarter. Net interest yield on a fully taxable-equivalent basis for the fourth quarter of 2009 was 2.15%, up 10 basis points (bps) sequentially. The increase in net interest yield in the fourth quarter was primarily driven by lower funding costs due to lower interest rates on Freddie Mac’s short- and long-term debt.

Management and guarantee income for Freddie Mac for the quarter was $743 million, compared to $800 million in the prior quarter. The sequential increase reflects reduced amortization income related to certain pre-2003 deferred fees due to an increase in forecasted interest rates, which resulted in a decrease in projected prepayments.

Other non-interest income for the quarter came in at $883 million, compared to a loss of $1.4 billion in the prior quarter. Other non-interest income for the quarter included net mark-to-market gains of $2.1 billion, compared to net mark-to-market gains of $42 million in the prior quarter.

Credit quality significantly worsened during the quarter.  Total single-family delinquency rate, excluding Structured Transactions increased 54 bps sequentially to 3.87%. At the same time, Single-family net charge-offs increased to $2.4 billion from $2.2 billion in the prior-quarter. Total non-performing assets increased to $105.6 billion as on Dec 31, 2009 from $92.2 billion at Sep 30, 2009.

Net worth as on Dec 31, 2009 was a positive $4.4 billion, compared to a positive $9.4 billion as on Sep 30, 2009. The decline in positive net worth for the fourth quarter of 2009 resulted from the fourth quarter 2009 net loss of $6.5 billion and the dividend payment of $1.3 billion to the Treasury on the senior preferred stock. Freddie Mac had a net worth deficit of $30.6 billion as on Dec 31, 2008.

Freddie Mac was among the hardest hit financial firms by the housing slump, credit crisis and ongoing recession. We do foresee the current expansion of the Home Affordable Refinance Program (HARP) to bring down losses from foreclosures in the upcoming quarters. We think the deterioration in the overall market condition will continue to negatively impact Freddie Mac’s financial results. As a result, the company may need additional funds from the Treasury.

However, we expect the government conservatorship to continue for a long time and thus see no value in the company for common shareholders.

Zacks Investment Research

($FRE) Freddie Mac’s Net Loss Widens

In all, more than 11.3 million, or 24 percent, of all residential properties with mortgages, were underwater at the end of the fourth quarter of 2009, up from 10.7 million or 23 percent at the end of the third quarter of 2009.

An additional 2.3 million mortgages were approaching negative equity at the end of last year, meaning they had less than five percent equity. Thus even though the Case Schiller indexes have been showing a slight rise in housing prices during the fourth quarter, an additional 600,000 homeowners slipped below the waves during the quarter.

Here are the highlights of the report:

“Negative equity continues to be concentrated in five states: Nevada , which had the highest percentage negative equity with 70 percent of all of its mortgaged properties underwater, followed by Arizona (51 percent), Florida (48 percent), Michigan (39 percent) and California (35 percent).

“Among the top five states, the average negative equity share was 42 percent, compared to 15 percent for the remaining 45 states. In numerical terms, California (2.4 million) and Florida (2.2 million) had the largest number of negative equity mortgages accounting for 4.6 million, or 41 percent, of all negative equity loans.

“The net increase in the number of negative equity borrowers in Q4 2009 was 620,000, with the largest percentage increases occurring in Nevada, Georgia and Arizona. Among the states with the highest negative equity shares, California had the smallest increase in the negative equity share, which only rose 0.4 percent to 35.1 percent.

“In numerical terms, Florida had the largest increase in the number of negative equity borrowers rising by more than 141,000, followed by Georgia (65,000) and Illinois (55,000).

“The rise in negative equity is closely tied to increases in pre?foreclosure activity and is a major factor in changing homeowners’ default behavior. Once negative equity exceeds 25 percent, or the mortgage balance is $70,000 higher than the current property values, owners begin to default with the same propensity as investors.

“The aggregate dollar value of negative equity was $801 billion, up $55 billion from $746 billion in Q3 2009. The average negative equity for an underwater borrower in Q4 was ?$70,700, up from ?$69,700 in Q3 2009. The segment of borrowers that are 25 percent or more in negative equity account for over $660 billion in aggregate negative equity.

“Of the over 47 million homeowners with a mortgage, the average loan to value ratio (LTV) is 70 percent. More than 23 million, or 49 percent of all homeowners with a mortgage, have at least 25 percent equity in their home and over 12 million have at least 50 percent equity in their home.”

While not everyone who is underwater on their mortgage is going to default, the expected rate of foreclosure among people with positive equity (above water) in their homes should be zero.  After all, it’s better to sell the house and have some cash in your pocket (but not have the house) than to just let the bank take it and have no cash.

If someone lives in the house and has kids in school, they are not going to pull them out of the school for just a few thousand bucks.  A house is more than just an investment, it is a home.

However, those non-economic considerations are not unlimited. If they did not exist, then the economically rational thing to do would be to default almost as soon as the value of the house fell below the value of the mortgage. Investor-owned properties tend to behave that way because investors don’t have the psychological attachments to the property.

The real danger point (from the point of view of the mortgage holders) tends to be when people are underwater by more than 25%. At that point, the value of the little marks on the wall at each kid’s birthday or Christmas simply gets overwhelmed by the fact that continuing to pay on a $300,000 mortgage on a house that is only worth $200,000 is just a waste of money.

The following graph comes from the report (via Calculated Risk). To the left of the line, people are above water, and to the right of the line they are above water.

Generally the people to the left of the line will cure their delinquencies before the home is actually taken over by the sheriff, by selling if need be. Notice that investors are more “ruthless” about defaulting than are owners who live in the houses at all depths of water, but at around the 25% underwater point (Loan to Value of 120-125%) there is a real inflection point in the behavior of owner occupiers.

Since the deep underwater houses are very concentrated geographically , look for foreclosure activity (or short sales) to soar in the hardest hit states. Nevada just simply looks like a basket case, with more than half of the homes with mortgages having mortgages that are at least 25% higher than the current value of the house.

Note that the first four states on the graph were the poster children for the housing bubble. Michigan is a different story; there the state is losing population and as a result has too few people for the existing stock of houses, rather than having too many houses built for the population during the bubble.

However it is worth noting that there are many areas of the country where housing prices are still comfortably higher than most people’s mortgages. The final graph (from http://www.calculatedriskblog.com/) shows the number of houses with mortgages that are either underwater (blue), or just have their nose above the waves (less than 5% positive equity, in red). It is also a good answer to a trivia question, what does New York have in common with Oklahoma?

Note that there are several states for which the data was not available. The houses that are underwater are the houses that are in the shadow inventory of houses that are likely to come on the market. That means that housing prices will be under more pressure in places like Nevada and Arizona than they will be in New York or Montana. This is despite the fact — indeed, in part because of the fact — that housing prices have already fallen far more in Las Vegas than in Tulsa.

There is a self-reinforcing downward spiral to housing prices. When the extraordinary government support to the housing market ends this spring — the first-time buyer tax credit and the Fed buying up $1.25 Trillion of mortgage backed securities, mostly those backed by Fannie Mae (FNM) and Freddie Mac (FRE) are the two most important — we will probably see another down-leg in housing prices, and the worst of it is likely to be in those areas that are already hard hit.

There is a relationship between the unemployment rate and the percentage of underwater homes, but it is far from exact. Montana and North Dakota have some of the lowest unemployment rates, while the rates in Nevada, Florida and Michigan are well above the national average.

However, there are several high unemployment states such are South Carolina and Rhode Island that are squarely in the middle of the pack, while Idaho and Utah have below average unemployment rates yet have relatively high numbers of underwater mortgages. When someone is underwater on their home, and also becomes unemployed, the risk of foreclosure really shoots up.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

Zacks Investment Research

(FNM) Number of Homeowners Underwater Continues to Rise

Since there is a fair amount of seasonality in housing prices, the seasonally adjusted numbers are the ones to look at. On a year-over-year basis, the C-10 is down 2.4% and the C-20 is down 3.1%. From the peak, the C-10 is down 30.3% and the C-20 is off by 29.4%.

The consensus expectation was that the C-20 would show a year-over-year decline of 3.1% in December, so the results were in line with expectations. The year-over-year decline in November was 5.3%.

The first chart (from http://www.calculatedriskblog.com/) shows the history of the year-over-year changes for both composites. The indexes first turned negative on a year-over-year basis at the beginning of 2007. While we are well off the bottom, even in the best-case scenario we are not likely to turn positive for at least a few more months. And as I explain below, I really doubt the best-case scenario will come to pass.

While home prices have shown some stability, particularly in the second half of 2009, much of that has been due to extraordinary amounts of government support. The two most important parts of that support, the “first time” buyer tax credit and the Fed’s buying up of $1.25 Trillion worth of mortgage-backed securities (and thus holding down mortgage rates), are scheduled to come to an end in the spring.

It is very much of an open question as to what will happen when those training wheels come off. My bet is that we see a second leg down in housing prices.

There is still a big inventory overhang in the market. That is particularly true if one considers the shadow inventory of houses that are either seriously delinquent on the mortgage or are actually in the foreclosure process. Very few of the mortgage modification (the HAMP program) have been made permanent.

Furthermore, history suggests that as many as half of those will re-default anyway. That is especially true when the modification simply stretches out the repayment period, or slightly reduces the interest rate. If a house is underwater on the mortgage, those steps really don’t solve the problem. The only real cure is a reduction in principal. That could happen via the bank giving it to the existing mortgage holder (very rare) or by the homeowner selling the house for less than the amount of the mortgage (what is known as a “short sale”).

Short sales are becoming increasingly common, and are likely to be even more common this year. Those short sales will be simply more supply on the market.

Housing prices are enormously important. For starters, housing is very leveraged, much more so than equity investments are. Thus relatively small changes in prices have a big impact on people’s net worth. Housing wealth is also much more widespread than equity wealth.

For the vast majority of Americans, the equity in their house is (or was) the main source of wealth for people. Yes, a large percentage of people have some money in the stock market, either directly or indirectly (i.e. mutual funds), but for most, the portfolios are relatively small.

The overall amount of wealth in housing is roughly on the same scale as that of equities; however, I don’t think there is anyone who has even $100 million in personal housing wealth. There are many people (most of the Forbes 400 list) who own several billion of equity wealth.

Also, if the value of a house falls below the amount of the mortgage (goes underwater) it makes a lot of economic sense to simply stop paying the mortgage and eventually walk away from the house. Not everyone will do so and it is probably not worth doing if the amount you are underwater is just a few thousand. If it is substantial, however, then it really does not make a lot of sense to continue paying your mortgage.

That means more losses up and down the mortgage complex, ranging from the GSEs like Fannie Mae (FNM) and Freddie Mac (FRE) to the mortgage insurers like MGIC (MTG) to the big banks that issued the mortgages and continue to service them like Bank of America (BAC).

The second chart (also from http://www.calculatedriskblog.com/) shows the data for each of the 20 cities. It is based on the cumulative decline so far in each city. The blue bar shows how far prices had fallen by the end of 2007, the yellow by the end of 2008, and the red through the end of 2009. Thus if the red bar is shorter than the yellow bar, it means that prices during 2009 rebounded.

There is no clear-cut pattern between the cities that held up well in the beginning and how they performed in 2009. Some cities like San Diego and San Francisco, which were among the hardest hit in 2007, have actually started to recover, while some that held up well in 2007 like Portland and Seattle had big price declines in 2009. Other early losers like Las Vegas and Phoenix, are still basket-cases.  Dallas, on the other hand, held up well in 2007, and already began rebounding in 2009.

Overall, this was a modestly positive report, but I fear it is just the eye of the hurricane. When the government support comes off in the spring, we are likely to feel the other side of the storm. Still, a short reprieve is better than no let up at all.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

Zacks Investment Research

($FNM) Housing Prices Show Small Rise

In general, in his remarks about monetary policy, Bernanke addressed the “how” of draining the huge amount of liquidity added to the system over the last 18 months or so, but he did not address the “when.” The “when” really is the most important question.

To my mind, the “when” should be a long time from now. The key problem facing this economy is not inflation, it is very low rates of resource utilization. To tighten monetary policy when the unemployment rate is at 9.7% and U.S. factories are only operating at 68.8% of capacity would be dangerous and reckless. After all, the capacity utilization rate for manufacturing is normally around 80%, and prior to the Great Recession the lowest it ever dropped to was 68.2% (November 1982).

Raising the Fed Funds rate is not the only way to tighten up monetary policy. Indeed, the Fed found that cutting the rate to zero did not provide enough monetary easing in the face of the financial meltdown a year ago.

You can’t put out a forest fire with a water pistol. There was a massive forest fire in the financial panic. It caused the private sector to want to deleverage all at once. The Federal Reserve became the balance sheet of last resort (along with the Treasury).

The monetary policy part of his testimony is presented below, along with a few comments/translations from “Central Bankerese” from me.

“In addition to supporting the functioning of financial markets, the Federal Reserve also applied an extraordinary degree of monetary policy stimulus to help counter the adverse effects of the financial crisis on the economy. In September 2007, the Federal Reserve began reducing its target for the federal funds rate from an initial level of 5-1/4 percent. By late 2008, this target reached a range of 0 to 1/4 percent, essentially the lowest feasible level.

“With its conventional policy arsenal exhausted and the economy remaining under severe stress, the Federal Reserve decided to provide additional stimulus through large-scale purchases of federal agency debt and mortgage-backed securities (MBS) that are fully guaranteed by federal agencies. In March 2009, the Federal Reserve expanded its purchases of agency securities and began to purchase longer-term Treasury securities as well.

“All told, the Federal Reserve purchased $300 billion of Treasury securities and currently anticipates concluding purchases of $1.25 trillion of agency MBS and about $175 billion of agency debt securities at the end of March. The Federal Reserve’s purchases have had the effect of leaving the banking system in a highly liquid condition, with U.S. banks now holding more than $1.1 trillion of reserves with Federal Reserve Banks. A range of evidence suggests that these purchases and the associated creation of bank reserves have helped improve conditions in private credit markets and put downward pressure on longer-term private borrowing rates and spreads.”

The purchase of the Agency MBS has also been a huge prop to the housing market and the mortgage chain of companies, ranging from the agencies themselves — Fannie Mae (FNM) and Freddie Mac (FRE) — to the big originators and servicers of the residential mortgages like Bank of America (BAC).

“The FOMC anticipates that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. In due course, however, as the expansion matures the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflationary pressures. The Federal Reserve has a number of tools that will enable it to firm the stance of policy at the appropriate time.”

See earlier comment about the capacity utilization levels and unemployment. Bernanke’s “in due course” does not give any real clue as to the timing of a monetary tightening. Eventually it has to happen, and the Fed Funds rate will not stay near zero forever, but forever is a long, long time.

“Most importantly, in October 2008 the Congress gave the Federal Reserve statutory authority to pay interest on banks’ holdings of reserve balances. By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks. Actual and prospective increases in short-term interest rates will be reflected in turn in longer-term interest rates and in financial conditions more generally.”

Bank reserves only stimulate the economy, or if the economy is already overstimulated, cause inflation if they are lent out. If they sit at the Federal Reserve, they are sterile. Essentially now the Fed has the ability to bribe the banks to let the money just sit and do nothing for the real economy.

That is decidedly not the problem today. The banks have plenty of reserves, but they are just sitting on them. Perhaps Bernanke should consider imposing a negative interest rate on reserves now, and then move to a positive rate when conditions heat up.

“The Federal Reserve has also been developing a number of additional tools it will be able to use to reduce the large quantity of reserves held by the banking system. Reducing the quantity of reserves will lower the net supply of funds to the money markets, which will improve the Federal Reserve’s control of financial conditions by leading to a tighter relationship between the interest rate on reserves and other short-term interest rates.

“One such tool is reverse repurchase agreements (reverse repos), a method that the Federal Reserve has used historically as a means of absorbing reserves from the banking system. In a reverse repo, the Federal Reserve sells a security to a counterparty with an agreement to repurchase the security at some date in the future. The counterparty’s payment to the Federal Reserve has the effect of draining an equal quantity of reserves from the banking system.

“Recently, by developing the capacity to conduct such transactions in the triparty repo market, the Federal Reserve has enhanced its ability to use reverse repos to absorb very large quantities of reserves. The capability to carry out these transactions with primary dealers, using our holdings of Treasury and agency debt securities, has already been tested and is currently available.

“To further increase its capacity to drain reserves through reverse repos, the Federal Reserve is also in the process of expanding the set of counterparties with which it can transact and developing the infrastructure necessary to use its MBS holdings as collateral in these transactions.”

This is mostly an expansion of a long-used process that the Fed has always used to manage monetary policy.

“As a second means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers. The Federal Reserve would likely auction large blocks of such deposits, thus converting a portion of depository institutions’ reserve balances into deposits that could not be used to meet their very short-term liquidity needs and could not be counted as reserves.

“A proposal describing a term deposit facility was recently published in the Federal Register, and we are currently analyzing the public comments that have been received. After a revised proposal is reviewed by the Board, we expect to be able to conduct test transactions this spring and to have the facility available if necessary shortly thereafter. Reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so.”

Of course, to do so, the Fed will have to offer more attractive interest rates on the longer-term “CDs” than on the shorter-term reserves.

“The Federal Reserve also has the option of redeeming or selling securities as a means of applying monetary restraint. A reduction in securities holdings would have the effect of further reducing the quantity of reserves in the banking system as well as reducing the overall size of the Federal Reserve’s balance sheet.”

In other words it could reverse what it has been doing, and sell off the MBS hoard it has established.  That, however, would likely hammer the housing market and drive mortgage rates much higher.

“The sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments. One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation.

“As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves. If economic and financial developments were to require a more rapid exit from the current highly accommodative policy, however, the Federal Reserve could increase the interest rate paid on reserves at about the same time it commences significant draining operations.

“I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery. However, to help reduce the size of our balance sheet and the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or are prepaid.

“The Federal Reserve is currently rolling over all maturing Treasury securities, but in the future it may choose not to do so in all cases. In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities.

“Although passively redeeming agency debt and MBS as they mature or are prepaid will move us in that direction, the Federal Reserve may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted. Any such sales would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions.”

Letting the MBS run off alone would be a nice gradual way to deflate the size of the Fed balance sheet, but it would take many years to bring the size of the balance sheet back to pre-crisis levels if this approach were to be taken.

“As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets. Accordingly, the Federal Reserve is considering the utility, during the transition to a more normal policy configuration, of communicating the stance of policy in terms of another operating target, such as an alternative short-term interest rate.

“In particular, it is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates. No decision has been made on this issue; we will be guided in part by the evolution of the federal funds market as policy accommodation is withdrawn.

“The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present and with the federal funds rate as the operating target for policy.”

The interest rate paid on reserves could become the “new Fed Funds rate” which everyone obsesses over.

It is clear that the Fed can bring its balance sheet back down to size and tighten up monetary policy; it has more than enough tools to do so. The more important question is when will it be wise to do so.  That has to be dependent on the economic data.

Right now the data is practically screaming “NOT NOW, FOR GOD’S SAKE.” The day to tighten will eventually come, but it should not be for a long time, probably not until we are all writing 2011 on our checks.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

Zacks Investment Research

(FNM) Fed Chairman Ben Bernanke on Exit Strategy

The serious delinquency rate rose in every month of 2009 (and every month in 2008, for that matter). A year ago the rate stood at 1.72%, at its low point in the first half of 2007, it was well below 50 basis points, so we have seen a nine-fold increase off the bottom and more than a doubling in the serious delinquency rate over the last year.

Any Silver Lining?

If there is any good news in this report, it is that there does seem to be a slight slowing in the rate of growth of the delinquency rate, with the 15 bp rise in December being less than the 18 bp rise in November, which was in turn less than the 21 bp rise in October. The key point, however, is that it is still rising.

If someone is 30 days behind on their mortgage, the odds are that they will correct the problem, but if they are more than 90 days behind, the odds are that they will never come up with the money to catch up. This is a very big pool of foreclosures just waiting to happen. Fannie Mae (FNM) has not released their delinquency rate data yet, but odds are that it will look very similar to the Freddie data.

However, given the number of people who are seriously underwater on their homes, perhaps the better question is why isn’t the delinquency rate higher than it is? If you have a loan out secured by an asset, and the value of the asset is well below the amount of the loan, it is economically irrational to pay off the loan, especially if there is no recourse.

The big boys certainly understand this. BlackRock (BLK) is not going to bring down the whole firm just because they made a bad investment in Stuyvesant Town in New York. No, they write off the small amount of equity they have in the deal and default on their mortgage. If homeowners were rational, they would do the same thing.

True, there are non-economic considerations in deciding if you should continue to pay your mortgage. After all, a house is a home, not just an asset. Still, the question remains, why are so many homeowners pushing themselves into poverty by paying their mortgages when the house just is not worth that much?

Taking in the Longer View

As far as the macro economy is concerned, we should be glad that they still are. The current level of serious delinquencies means that there will be another big wave of foreclosures coming. That distressed inventory will weigh on the housing market, and could abort the recent (slight) recovery in housing prices.

That, in turn, would force still more homeowners underwater, making it economically irrational for them to pay their mortgages. Lather, rinse, repeat. Such a process was at the heart of the financial crisis last year.

If these problems start up again, we will be in a very tough spot. The GSEs will not be the only firms to suffer. The major banks like Bank of America (BAC) and Wells Fargo (WFC) will also take a hit and the losses will depress bank capital, and hence even further undermining their ability and willingness to lend.  That could lead to another round of secondary offerings, further diluting existing shareholders.

Being underwater is not the only factor in people being seriously delinquent on their mortgages. Even if they have equity in their homes, if someone is out of work, they might not have the cash flow needed to service the mortgage. However in that case, they still have the option of selling the home and preserving their equity. More jobs would certainly help the situation.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market-beating Zacks Strategic Investor service.

Zacks Investment Research

($FRE) Mortgage Delinquencies Still Rising

The decline and the revision to the prior week were not enough to keep the four-week moving average from rising. It increased by 9,500 to 456,250. Given the weekly noise in the numbers, the four-week moving average is generally considered a more reliable indicator.

This is the second week in a row that the four-week average has risen. As the graph (from http://www.calculatedriskblog.com/) below shows, the four-week average has been in a steep descent since it peaked in mid-April, and until this point has not shown any signs of forming a high plateau the way it did following the prior two economic downturns. Let us hope that the upticks over the last two weeks does not indicate that such a plateau is forming.

We probably need the four-week moving average to get down to close to 400,00 to indicate that the economy is on balance adding jobs. Relative to peak levels of over 650,000, or even the year-ago level of 547,000, we are getting pretty close to that point, but are not there yet, and progress seems to have stalled. The numbers are always a bit flaky around the holidays, and the four-week average still incorporates them, so perhaps we should not get too worried…yet.

Continuing Jobless Claims Improve

The news was better on the continuing jobless claims front. Regular continuing jobless claims, which are paid for by State unemployment insurance funds and run out after 26 weeks, fell by 57,000 to 4,602 million. However, with almost 40% of all the unemployed now out of work for more than 26 weeks, regular claims do not come close to telling the whole story. Looking at them in isolation is a serious mistake.

After regular benefits expire, people move over to extended benefits, which are mostly funded by the ARRA, also known as the Recovery Act or Stimulus Package. Those now number 5.612 million (combining the two largest programs), or more than a million more than regular continuing jobless claims. There was good news there as well, as extended claims dropped by 305,000 this week (actually two weeks ago, and regular claims are one week ago, but released today). Without those extended benefits, those people and their families would be left with no income at all.

After 26 weeks of reduced income (relative to what they were earning when employed) on regular benefits they have probably already drawn down much of their savings and run up their credit card balances. They would be far more likely to default on their mortgages if their income fell to zero.

More Strain on Housing Market?

This would make the housing situation much worse. That would not be good for firms throughout the mortgage complex from Fannie Mae (FNM) to the mortgage insurers like MGIC (MTG) to the major mortgage issuing and servicing banks like Wells Fargo (WFC) and Bank of America (BAC).

With the extended benefits, the unemployed can still afford to shop for basics, although they may end up being steady customers at the Salvation Army rather than at JC Penney’s (JCP). Still better that they are shopping in the Salvation Army thrift stores than sleeping in Salvation Army homeless shelters, which is where they would be without the extended benefits. Better not only in a humanitarian sense, but better for the overall economy as well. The dollars they spend go back into the economy, and in the process help keep other people employed.

Progress Being Made…Slowly

The progress on both regular and extended claims is good news, but let’s keep the longer-term picture in mind. Regular jobless claims are just slightly below the year-ago level of 4.673 million, but extended jobless claims are aver three times the year-ago level of 1.788 million. Those higher extended jobless claims are responsible for one of the biggest single increases of any line item in the Federal Budget if we compare the first three months of fiscal 2010 to the first three months of fiscal 2009, rising by $19.0 billion to $35.7 billion.

It would be better not to have to spend so much money on extended jobless benefits given the massive deficits and towering federal debt. However, given the level of unemployment, especially long-term unemployment, it really is money that needs to be spent.

Unemployment is a double-whammy on the budget, since not only does it cause expenditures to rise, but if people are not working, they are not paying income taxes. In the first quarter of this fiscal year, individual income tax collections are down by $47.6 billion. That impact (not just from the unemployed but also due to people earning less but still working, and from various tax cuts) from falling tax revenues is responsible for 2.5x as much of the increase in the deficit as the direct expenditures on extended claims are.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market-beating Zacks Strategic Investor service.

Zacks Investment Research

(FNM) Initial Jobless Claims Greater Than Expected

The payment represents an increase of $14.4 billion from the Treasury’s contribution in 2008 and is the largest since the U.S. central bank was launched in 1914. The increase was largely due to higher earnings on securities that the Fed had purchased as part of its intensive intervention in the financial system last year. Previously, the largest payment to the Treasury was $34.6 billion in 2007.

According to the Fed, much of its income came from the open-market purchase of U.S. Treasury debt, debt of mortgage finance giants Fannie Mae (FNM) and Freddie Mac (FRE), and mortgage bonds and other securities. Mortgage-backed securities pay a higher rate than Treasury securities. In total, it earned $46.1 billion on U.S. Treasuries and debt from government-sponsored enterprises.

The Fed earned another $5.5 billion from limited liability companies that were created during the height of the financial crisis to make loans and take over assets from financial salvages of big institutions like American International Group Inc. (AIG). Additionally, the Fed earned $2.9 billion on loans extended to banks and other financial institutions, $2.6 billion from currency swaps and $1.5 billion mostly from fees.

Though this record profit could alleviate some pressure on the U.S. budget deficit, the Fed still has significant exposure to risky assets. Also, the Fed could lose money on some of those investments if the values of the securities fall.

Zacks Investment Research

($FNM) Federal Reserve Paid $46.1Billion to Treasury in 2009

What it does is cause there to be a lot of vacant apartments. In addition, a large number of formerly foreclosed-upon houses have been bought up by cash investors who plan on renting out those houses rather than living in them themselves.

The net result is that there is a glut of rental living space on the market. According to real estate research firm Reis, the apartment vacancy rate rose by 0.1 point in the fourth quarter to 8.0%, and is up from 6.7% a year ago. It is also the highest level of vacant apartments in the 30 years that Reis has been tracking the data.

An empty apartment is simply a deadweight loss for a landlord. In an effort to fill apartments up, they have been dropping rents, and especially effective rents (i.e. including things like a month of free rent when you re-sign your lease, replacing the carpet, etc.). According to Reis, rents declined by 0.7% in the fourth quarter and by 2.3% for all of 2009. Their data however, only covers the 79 largest rental markets.

Looking at the Numbers by Location

Jacksonville, FL had the highest apartment vacancy rate at 14.4%. The biggest increase over the course of 2009 was in Tucson, AZ, where the rate jumped by 3.1% to 10.5%. So far, the declining rents have not really been picked up by the government in its CPI calculations. Those numbers have been just effectively flat over the last year, not declining.

This could be due to the BLS numbers covering the entire country, not just the 79 largest markets. However, 79 markets covers most of the areas where there are significant numbers of people living in apartments. So it seems like the BLS numbers are simply behind the curve, or there is something very wrong with the methodology that Reis, or the BLS, is using. However, the comments coming from the large publically traded REITs that specialize in apartments, such as Apartment Investors (AIV) and Equity Residential (EQR), would tend to support what Reis is saying.

The Importance of Rent (& Suspect Methodology)

Rents are extremely important. Direct rent paid to landlords has a 5.7% weighting in the CPI. More significantly is that Owners Equivalent Rent (OER), which is how the government tracks housing for inflation tracking, makes up almost 24% of the CPI. Thus together they make up more than 30%. Since rents are neither food nor energy, they make up an even bigger (almost a 40% share of the core CPI).

The BLS methodology for tracking OER is very suspect. It simply conducts a telephone survey of homeowners and asks them what they think it would cost them to rent an equivalent home across the street. I suspect that for the vast majority of responders, the answer would be just a wild guess. After all, many subdivisions don’t have a lot of people renting in them, and most long-term homeowners don’t make a habit of calling rental agents to find out what it would cost to rent in their area. The data for apartment rentals are a bit more solid, as the big landlords would be in a pretty good position to know. Thus you should be very suspicious if OER is diverging significantly from “rent” rent.

Facts on the Ground & Government Involvement

Not only have government policies been encouraging people to move out of apartments (or rented houses) and buy their own place, but there are still a significant number of new rental units coming on line. A big apartment complex is not built overnight, so many of the projects that were approved and funded right before the credit crisis are now coming on line. In addition, many projects that were originally planned to become condos have instead been turned into rental units. And as I mentioned before, large numbers of houses that had been foreclosed upon are being turned into rental units.

Renting a house or an apartment is a pretty good substitute for owning a house or a condo. A house is an asset, and the value of an asset is determined by the stream of cash flows the asset will bring in the future, discounted back to the present. What are the cash flows that your little bungalow gives you? Why, the rent you avoided paying (minus, of course, the cash outflows you have like taxes and maintenance).

While government actions can prop up house prices for a little while by handing out $8,000 checks to people who buy a home (which tends to get split with the person selling the home) and by holding down mortgage rates through massive buying of mortgage-backed paper, it is not going to be a permanent fix. This is especially true if those actions simply result in lower rents, which effectively undermine the cash flows that the asset value is dependent on.

The logic of attempting to bolster home prices is reasonable. After all, the single biggest factor in people continuing to pay their mortgages is if they have equity in the house. If the mortgage balance is $150,000 and the house is worth $200,000, you would have to be pretty stupid to stop paying. Even if you got laid off and didn’t have the cash to pay, it would still make sense to just sell the house rather than let the bank take it from you.

However, if the mortgage balance is $200,000 and the house is only worth $150,000, why would you continue to pay, even if you were still employed and had the cash to do so? Yes, there are plenty of non-economic factors that come into play, such as a feeling that you made an agreement and have a moral obligation to live up to it (trust me, the bank does not feel the same way, nor do big commercial real estate players).

However, a mortgage is a secured loan, and you don’t have to pay legally, at least if you have not refinanced. But if you don’t, the bank takes the house. It could be that if you had to sell your house you could not buy another house in the same town and school district, and would have to put up with pleas of “you are ruining my life” from your 14-year-old daughter if she had to change schools as a result. Those little marks on the wall showing how the kids have grown each Christmas or birthday also have value to many people. However, there is a limit to the value of those non-economic considerations. This is especially true if you are both underwater AND unemployed.

What’s Problematic in the Long Run

Stabilizing housing prices is a good thing, but I think the effort will ultimately be futile in the long run, especially if the efforts to do so simply result in more vacant rental properties. Ultimately what needs to happen is that the rate of household formation has to increase. Part of that is simply due to population growth, but population growth is not the whole story on household formation by a long shot.

People have to feel they can afford to have a place of their own. That means jobs. A good-paying, steady job is what will get the 26-year-old college graduate to finally move out of Mom and Dad’s basement. A good job is what will get the family that is living with friends or siblings after they got foreclosed on back into their own place.

Housing is also something we consume: the ultimate durable good, if you will. Just like people who are making minimum wage usually have to ride the bus, or drive around in an old clunker instead of a new BMW, so too they can’t afford to buy a big house, or even rent their own place. They have to double (triple, quadruple?) up.

In the housing bubble, the relationship between housing prices and both rents and incomes got way out of whack, as is shown in the two graphs below (from http://www.calculatedriskblog.com/search/label/House%20Prices) and are now back to reasonable levels. They are not, however, particularly low, even with the housing bust, and have both started to increase again in recent months.

That rebound is due to all the extraordinary government support for the market, and that support cannot last forever. I strongly suspect we will have another leg down in housing prices later this year. Not as severe as what we saw in 2008 and early 2009, but a decline nonetheless.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market-beating Zacks Strategic Investor service.

Zacks Investment Research

(FNM) Housing and Rental Data

Invesco Mortgage will grant the underwriters a 30-day option to purchase up to 1.05 million additional shares to cover over-allotments.

The company intends to use the proceeds from the offering for additional acquisitions of residential and commercial mortgage-backed securities and mortgage loans and other general corporate purposes.

Invesco Mortgage is externally managed and advised by Invesco Advisers Inc., a division of Invesco Ltd. (IVZ).

Credit Suisse Securities USA, LLC, a division of Credit Suisse Group (CS) and Morgan Stanley & Co. Incorporated, a division of Morgan Stanley (MS), are acting as joint book-running managers for the offering.

Invesco Ltd.’s third quarter earnings came in at 24 cents per share, a penny ahead of the Zacks Consensus Estimate. However, this compares unfavorably with 33 cents in the prior-year quarter. The appreciation of the global equity markets and comparatively favorable foreign exchange rates have led to an increase in the company’s assets under management (AUM), which are up both sequentially as well as year-over-year.

Though we expect an improvement in operating leverage from Invesco Limited’s expense reduction initiatives and improved global flows due to its broad diversification, we believe such improvements would be somewhat limited in the near term, given the ongoing volatility in the equity markets worldwide. Earnings are also susceptible to foreign exchange fluctuations.

Zacks Investment Research

(IVR) Invesco Mortgage Capital Will Offer 7 Million Shares

The pay czar, who decides compensation-packages for the highest-paid employees at all the firms that received bailout money and have not repaid yet, considers the situation of Fannie Mae and Freddie Mac unique as the future of these companies is uncertain.

After slashing 50% pay of the top 25 earners in October at seven firms that have received substantial support from the Troubled Asset Relief Program (TARP), earlier this month, the pay czar announced a new set of pay restrictions on top executives at four of those firms. The primary intention of the pay czar is to enable the bailed out firms to repay government money by controlling excessive pay. However, despite receiving substantial government support, Fannie and Freddie’s regulator, the Federal Housing Finance Agency (FHFA), did not impose any pay restrictions on top executives of these firms.

The pay czar views the decision of FHFA not to impose pay restrictions on the top executives of Fannie Mae and Freddie Mac as fair because: 1) there is no stock, so all of the compensation needs to be in cash and 2) the future of Fannie Mae and Freddie Mac politically remains very uncertain, and as a result it’s very difficult to convince employees to work for Fannie Mae and Freddie Mac.

The U.S. Treasury announced last week that it would offer significant new financial support to Fannie Mae and Freddie Mac notwithstanding their performance in the next three years. The move by the Obama Administration follows the recent repayment of bailout money by the nation’s biggest financial institutions.

To keep Fannie Mae and Freddie Mac afloat, the Treasury has removed the restrictions that capped the capital availability of the mortgage giants at $200 billion each. Already, taxpayers have provided $111 billion to the companies. According to the Treasury, losses of Fannie Mae and Freddie Mac are not expected to exceed the government’s estimate of $170 billion over 10 years.

Also, last week, Fannie Mae and Freddie Mac disclosed that their chief executives received $6 million as annual compensation as the mortgage giants try to attract and retain talent to support the U.S. mortgage market.

Fannie Mae and Freddie Mac have been among the firms hardest hit by the housing slump, credit crisis and ongoing recession. We anticipate losses to increase in the coming quarters and the conservatorship to continue for a long time, and thus see no value for the common shareholders.

However, we do foresee Fannie Mae’s and Freddie Mac’s increased participation in the Making Home Affordable Program, potentially lowering losses from foreclosures in the upcoming quarters.

Zacks Investment Research

(FNM) Pay Czar Says Fannie Mae and Freddie Mac Are Being Discriminated Against

To keep Fannie Mae and Freddie Mac afloat, the Treasury has removed the $200 billion caps on the capital availability of both companies. Already, taxpayers have provided $111 billion to them. According to the Treasury, losses for Fannie Mae and Freddie Mac are not expected to exceed the government’s estimate of $170 billion over 10 years.

Uncapped access to bailout funds through 2012 is necessary to protect the strength and stability of the U.S. mortgage market, the Treasury said. Together, Fannie Mae and Freddie Mac own or guarantee almost 31 million home loans worth about $5.5 trillion — about half of all mortgages.

Amid increasing concerns that Fannie and Freddie did not have enough capital to withstand losses on their portfolio, the government ultimately announced the takeover of these companies to prevent a collapse last year. However, as expected, the biggest losers were the shareholders of these companies.

Finally, Fannie Mae and Freddie Mac were placed under the conservatorship of Federal Housing Finance Agency (FHFA). Under the conservatorship, Fannie and Freddie no longer manage a strategy to maximize common shareholder returns and the Conservator has eliminated common and preferred stock dividends (other than dividends on the senior preferred stock). However, since then they have provided most of the liquidity in the mortgage market, allowing homeowners to refinance and buy new homes.

With the move to support Fannie Mae and Freddie Mac in the long-term, the government has ultimately transformed them into its arms, making them take active part in its mortgage modification programs.

The companies disclosed on Thursday that their chief executives received $6 million as annual compensation as the mortgage giants try to attract and retain talent to support the U.S. mortgage market. The packages were approved by the Treasury and FHFA.

Fannie Mae and Freddie Mac have been among the firms hardest hit by the housing slump, credit crisis and ongoing recession. We anticipate losses to increase in the coming quarters and the conservatorship to continue for a long time, and thus see no value for the common shareholders.

However, we do foresee Fannie Mae and Freddie Mac’s increased participation in the Making Home Affordable Program, potentially lowering losses from foreclosures in the upcoming quarters.

Zacks Investment Research

(FNM) Mortgage Giants Fannie Mae & Freddie Mac Find Support

Fannie Mae (FNM), which facilitates the lending of almost one in four U.S. residential mortgages, says the recent 11% jump in home sales is proof-positive that the three-year housing slump may end in 2010.

The reality is that we have a ton of excess inventory to burn off before any meaningful recovery can commence.

But here’s a good start…

Rather than further embrace the loser’s game of foreclosure, banks are increasingly entering into short sales, where they accept a sale for less than the balance owed on a property…

“It’s finally dawning on the banks that they’re better off with a short sale,” said Richard Green, director of the Lusk Center for Real Estate at the University of Southern California. (Foreclosed homes can sit vacant for months. And they’re easy targets for vandals.)

Short sales tripled to 40,000 in the first six months of 2009. Yet, for each short sale there were still 25 foreclosures.

What’s holding the number of such sales down, however (and you’ll love this), is that bank employees have no short-sale training. I mean, who ever heard of a bank losing money on a mortgage?

Wells Fargo, Bank of America and JP Morgan Chase are all adapting to the new reality by hiring more staff with proper short-sales training. The fact that banks are willing to accept these sales should limit the housing market’s downside in the year ahead.

Alexander Green knows the housing market better than anybody. And he’s got a way to parlay the present situation into your dream home.

Ahead of the tape,

Robert Williams

View original at: Investment U

(FNM) Rethinking Foreclosure: Is There a More Sensible Way?

The period of suspension will be from Dec 19, 2009 to Jan 3, 2010. Freddie did not estimate how many homeowners would get this grace period.

Concurrently, another mortgage finance company Fannie Mae (FNM) is also suspending foreclosures and evictions for about two weeks.

Earlier on the same day, Citigroup Inc. (C) also announced a 30-day suspension of foreclosures and evictions, affecting about 4,000 borrowers.

Freddie Mac’s third quarter net loss came in at $1.94 per share, compared to a net loss of 11 cents in the prior quarter and $19.44 in the prior-year quarter.

Though the results improved significantly over the prior-year quarter, the company expects its provision for credit losses to remain high during the fourth quarter of 2009.

Freddie Mac has been among the firms hardest hit by the housing slump, credit crisis and ongoing recession. We anticipate losses to increase in the coming quarters and the conservatorship to continue for a long time, and thus see no value for the common shareholders.

However, we do foresee its increased participation in the Making Home Affordable Program potentially bringing down losses from foreclosures in the upcoming quarters. The company is also trying to improve the profitability of its guarantee business by tightening its credit standard.

Zacks Investment Research

(FRE) Freddie Mac Suspends Evictions

Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating. The housing sector has shown some signs of improvement over recent months. Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit.

Businesses are still cutting back on fixed investment, though at a slower pace, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales. Financial market conditions have become more supportive of economic growth.

Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up. Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period. Activity in the housing sector has increased over recent months. Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.

Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.

Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

They noted that the job market is finally showing some positive signs, something that on the margin makes this statement a bit more hawkish than the last one. They added in the term “moderate rate” with regards to household spending, which to my ear sounds softer than just expanding.

They noted a better tone to financial market conditions. Overall, I would say the Fed sounds a bit more upbeat about the economy now than they did in the November meeting.

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

No change at all — the Fed still realizes that the biggest problem the economy faces is slow growth and the associated high unemployment rate and low rates of capacity utilization.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends and stable inflation expectations are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter of 2010.

The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. The amount of agency debt purchases, while somewhat less than the previously announced maximum of $200 billion, is consistent with the recent path of purchases and reflects the limited availability of agency debt.

In order to promote a smooth transition in markets, the Committee will gradually slow the pace of its purchases of both agency debt and agency mortgage-backed securities and anticipates that these transactions will be executed by the end of the first quarter of 2010.

The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

The quantitative easing program — buying up the Fannie Mae (FNM) and Freddie Mac (FRE) mortgage-backed securities and debt — is now about 85% complete, and it does not sound like they are planning on extending it. Recently the pace has been about $17 billion a week, and if they were to finish the program at the end of March as they indicate, that means that on average they would be spending about $12 billion a week.

The Fed buying has probably lowered mortgage rates by about 0.50% from where rates would otherwise be (based on historical spreads of mortgage rates over the 10-year T-note). How much of a hit the housing market will take if mortgages were to rise by that amount after they finish up is still and open question.

They kept the key phrase of “exceptionally low levels of the federal funds rate for an extended period.” They did, however, drop the language of using a wide range of tools. In other words, they are not going to try to pull another rabbit out of their hat to try to increase liquidity further in the face of the zero boundary on the fed funds rate. The Fed thinks we have successfully escaped from the liquidity trap.

In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve’s special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve’s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility.

The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1. The Federal Reserve expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010.

The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral. The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.

Note that this whole section is new. Essentially, the Fed is looking for a return to normality, and letting the alphabet soup of special lending facilities die a quite death. They did their job and prevented a total implosion of the financial system (the partial implosion was nasty enough) and the Fed thinks that it can now rely on its conventional, long-standing tools to keep the financial plumbing of the economy unclogged. While this is not close to a raising of the fed funds rate, it will effectively be a bit of a monetary tightening.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

While the Fed made it clear that they are NOT going to raise the fed funds rate anytime soon, they are going to take some steps to bring things back to normal. Effectively, by not embarking on another spree of quantitative easing, the Fed will be a bit tighter than it has been. It clearly sees some significant improvement in the economy, and feels that it can now drop the innovative emergency measures they put in place during the collapse last year.

I would interpret the phrase “extended period” to mean a minimum of six months, and more likely a year. Historically, the Fed has always waited until well after the Unemployment rate had peaked to start to raise the fed funds rate. Last time for a year past the peak, and the time before that for 18 months. Both those recessions were extremely mild relative to the one we are just climbing out of now.

I agree that inflation, particularly core inflation, is going to stay low for the foreseeable future. The low fed funds rate will put upward pressure on the prices of commodities (and thus we might see a pick-up in headline inflation) and downward pressure on the dollar. While both of those effects imply higher inflation, there is more than enough slack in the system and other deflationary forces elsewhere in the economy to offset those pressures.

The very low fed funds rate also means that the yield curve will remain extremely steep. This will help allow the banks to earn their way out of their balance-sheet mess. The money from the big net interest margins will help pay for the big loan losses that many of them will still have to take, most notably on commercial real estate, but also still on residential mortgages if we see another wave of foreclosures in 2010 (as I think is likely).

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market-beating Zacks Strategic Investor service.

Zacks Investment Research

(FNM) No Rate Change at the Federal Reserve

The recession is over! In the third quarter GDP grew by 2.8% (3.5%), slightly below (comfortably ahead) of expectations for 2.9% (3.0%) growth. This is a huge improvement over the 0.7% decline in the second quarter and the 6.4% plunge in the first quarter.

The internals of the report were strong as well, although it appears that much of the growth came from things like the Cash for Clunkers program and the extraordinary levels of support that are currently being given to the housing sector.

I will first go over the percentage growth rates for the main components of GDP, and then how much each part contributed to, or subtracted from, the 2.8% (3.5%) growth rate. This is probably the more important part since the size of the different parts of GDP are very different, and a small percentage change in a big component can have more impact than a large change in a small component. Just as a reminder: GDP is equal to the sum of Consumer spending, Investment spending, Government spending and net exports, or Y = C + I + G + (X – M) and I will be using that framework for the discussion.

Growth Rates

The overall 2.8% (3.5%) growth of GDP was almost matched by its biggest component, Personal Consumption expenditures, or PCE, which grew 2.9% (3.4%), a big improvement over the 0.9% decline in the second quarter and the 0.6% increase in the first three months of the year.

It is important to note that during the recession, consumer spending declined far less than did overall GDP, especially in the first quarter, so the consumer was becoming a much bigger part of the overall economy. This is not healthy over the long run, but at this point I think people are happy to get some growth where ever we can find it

Consumers spend on both goods and services, and goods are broken down into durable and non durable goods. The big mover in the third quarter were goods, which increased by 7.2% (8.1%) following a decline of 3.1% in the 2Q and an increase of 2.5% in the 1Q. Spending on durable goods was the real driver, growing at an annualized rate of 20.1% (22.3%) in the 3Q, following a 5.6% decline in the 2Q and a 3.9% increase in the 1Q.

Spending on non-durable goods tends to be much more stable than spending on durable goods. Non-durable goods spending rose by 1.7% (2.0%) reversing a 1.9% decline in the 2Q, which was in turn a reversal of a 1.9% increase in the 1Q. Spending on services tends to be even more stable than spending on non-durable goods. Service spending grew at an annualized rate of 1.0% (1.2%) in the 2Q up from a 0.2% increase in the 2Q and a 0.3% decline in the 1Q

Historically, spending on durable goods has been one of the key drivers to getting us out of a recession, and not spending on durable goods one of the key reasons for falling into recessions. It is the volatility in the sector that makes it important more than its absolute size.

Now, you might wonder, what caused the recession to be so nasty last winter when Consumer spending wasn’t really all that bad? The answer is that Investment really fell of a cliff. The good news is that it is starting to come back.

Overall Gross Private Domestic investment grew at an 8.4% (11.5%) annualized rate in the 3Q, but it still has a lot of lost ground to make up from the earlier part of the year. In the second quarter overall investment spending fell at a 23.7% annualized rate

Now here is the kicker — that was actually a dramatic improvement over the 1Q when investment spending absolutely collapsed, falling 50.5%. Clearly the biggest collapse in investment spending since the Great Depression (and it came on the heels of a 24.2% decline in the 4Q of 2008). To anyone who understood what was going on, those were really terrifying times, and the turnaround from them is absolutely spectacular

There are two basic types of investment: fixed and inventory, and right now we are concerned with fixed investment (I will cover inventory later in the contributions to GDP part).

Fixed investment is broken into two parts, Non-Residential or business investment and Residential investment, which is mostly homebuilding.

Overall Fixed investment rose by 0.3% (2.3%) following declines of 12.5% in the 2Q and 39.0% in the 1Q. Business investment, however, continued to decline, but at a much slower rate, falling 4.1% (2.5%) after 9.6% and 39.2% declines in the 2Q and 1Q, respectively. With massive amounts of unused capacity it is not surprising that businesses are cutting back on their capital spending still.

Business investment comes in two flavors, spending on structures like building new factories, malls and office buildings and spending on equipment and software to go into them. Spending on structures continues to be very weak, falling at a 15.1% (9.0%) annualized rate in the 3Q, but that marks an improvement over the 17.3% decline in the 2Q and the 43.6% collapse in the 1Q. With massive amounts of space sitting idle in offices and empty strip malls littering the landscape, look for new investment in commercial real estate to continue to decline in coming quarters.

Moody’s has estimated that the value of commercial real estate has plunged by 41% since the peak a little over a year ago, and that is hardly an inducement to build more. If a business needs the space, it’s far cheaper to just buy some existing space.

Spending on Equipment and Software (E&S) on the other hand is starting to come back, if only feebly, rising 2.3% (1.1%) after a 4.9% decline in the 2Q and a 36.4% plunge in the 1Q. Look for some stability in this line going forward as the new Microsoft operating system will probably generate a new PC cycle, but with capacity utilization still around 70% I would not expect a boom in orders for new factory equipment.

The real star of fixed investment though came on the residential side, which rose 19.5% (23.4%). This is the first increase in almost four years, and follows declines of 23.3% in the 2Q and 38.2% in the 1Q. The long string of declines had brought residential investment to a record low share of GDP. The extraordinary support of the housing sector by the government, including the first time buyer tax credit, the Fed buying up $1.25 Trillion of Fannie (FNM) and Freddie (FRE) backed paper to artificially suppress mortgage rates and the FHA acting like the old New Century Financial or Washington Mutual on their worst days have played a big role in the turnaround. I seriously question the sustainability of it after the support is removed, and I don’t think the support can continue indefinitely.

Government spending grew by 3.1% (2.3%) in the 3Q, a big slowdown from the 6.7% increase in the 2Q, but more than the 2.6% decline in the 1Q. It was all at the Federal level where spending rose at an annual rate of  8.3% (7.9%) down from a 11.4% increase in the 2Q, but up from the 4.3% decline in the 1Q.

Remember this measure of government spending does not include spending on transfer payments like Social Security and Medicare, which are largely captured in the consumption numbers. Defense spending was the big driver — we are still a nation fighting two wars. It grew at an annual rate of 8.3% (8.4%) down from a 14.0% rate of increase in the 2Q but up from a 5.1% decline in the 1Q.

Non-defense spending rose at a 6.9% (6.8%) annual rate following a 6.1% increase in the 2Q and a 2.5% decline in the 1Q. State and local spending on the other hand is constrained by balanced budget laws and falling tax revenues. It declined 0.1% (1.1%) in the 3Q following a 3.9% increase in the 2Q and a 1.5% decline in the 1Q. They were able to increase spending in the 2Q due to support for the Federal government as part of the stimulus package. Now that support looks like it is being overwhelmed by the plunge in property, income and sales taxes.

International trade has started to rebound, and we saw an increase in both imports and exports. Increasing exports are good for GDP and increases in Imports are bad for GDP, and unfortunately imports rose more than did exports. We were able to improve our overseas sales by 17.0% (14.7%) in the 3Q — a nice turnaround from the 4.1% decline in the 2Q and the 29.9% plunge in the 1Q. Unfortunately we also increase what we bought from overseas by 20.8% (16.4%), a big turnaround from the 14.7% decline in the 2Q and the 36.4% plunge in the first three months of the year. Keep in mind that we import a lot more than we export, so not only was the percentage increase bigger for imports, it was coming off a higher base.

Contributions to Growth

Not all components of GDP are created equal.  Some are very big, and others relatively small. Some tend to be very stable over time, and some tend to swing violently from quarter to quarter. The bigger and more volatile they are, the more they will impact the overall growth rate of GDP. Thus looking at just the percentage changes in the componenets does not tell the full story. Of the 2.8% (3.5%) total growth, how many points were added or subtracted by each part of the economy?

The biggest part of the economy is the Consumer or PCE, over all it contributed 2.07 (2.36) of the 2.80 (3.50) points of total growth. In the second quarter it caused 0.62 of the 0.70 total decline in the 2Q. In the first quarter it actually offset 0.44 points of the 6.40 total decline. In other words, excluding the consumer the economy would have contracted 6.84% rather than 6.40%.

Within consumer spending, spending on goods added 1.60 (1.79) points after subtracting 0.71 points in the 2Q and adding 0.56 points in the 1Q. Spending on durables was the main driver, adding 1.34 (1.47) points after subtracting 0.41 points in the 2Q and adding 0.28 in the 1Q.  Non durable goods added 0.26 (0.31) points after subtracting 0.29 in the 2Q and adding 0.29 in the 1Q.

While spending on services is much more stable than spending on goods, it is also a much larger portion of the consumer wallet. Service spending added 0.47 (0.57) points to the overall GDP growth in the 2Q, up from adding 0.09 points in the 2Q and subtracting 0.13 in the 1Q. It is the volatility that gives durable goods there importance to the economy not the overall size. In the third quarter total spending on durable goods was at a $1.055 Trillion annual rate, just 15.4% of the $6.852 Trillion spent on services, but durables goods had an impact on economic growth that was 158% bigger.

Investment spending was a big swing factor in the 3Q.  It added 0.91 (1.22) points to overall growth. That is a HUGE improvement over the 3.10 point subtraction in the 2Q and the 8.98 point implosion in the 1Q.  Unfortunately. 0.87 (0.94) points of that contribution came from inventories. Inventory investment is the “worst” type of GDP growth since large increases in one quarter are usually reversed in the next quarter, or in this case, large declines being reversed upwards.

In the 2Q inventory investment subtracted 1.42 points from overall growth and in the 1Q they subtracted 2.36 points.  Even in the 4Q they subtracted 0.64 points from growth.  Three straight quarters of sharply lower inventories is highly unusual and we were due for a bounce.  Perhaps we have one more quarter of a solid contribution from inventory investment, but I would not expect it to last much beyond that.

Overall fixed investment added just 0.04 (0.28) points to growth, but that sure was a nice improvement over the 1.68 point subtraction and the 6.62 point disaster that was the 1Q.

However, it was not coming from the business side.  Business investment subtracted 0.40 (0.24) growth points in the 3Q, so it is still very soft, but at least it is not imploding like it was earlier in the year.  In the 2Q it subtracted 1.01 points and in the 1Q it took away 5.29 growth points.  Within business investment it was spending on structures that caused the problem with a deduction of 0.55 (0.32) growth points while spending on E&S offset 0.15 (0.08) points of that.  In the 2Q both sides of business investment were drags on the economy with investment in Commercial real estate subtracting 0.69 growth points and spending on equipment deducting 0.32 points.  The 2Q was in turn a major improvement over the 1Q disaster where spending on structures subtracted 2.28 growth points and equipment spending subtracted 3.01 points.

Housing finally helped the economy in the 3Q, adding 0.45 (0.53) points to growth, after a string of 15 straight quarters where it was a drag on the economy.  In the 2Q it was a 0.67 point drag and in the 1Q it was a 1.33 point drag.  The long decline has, however, made housing a much smaller share of the overall economy.  In the 3Q residential investment totaled only $360.9 billion, or 2.52% of the overall economy.  At the peak of the housing bubble it represented 6.34% of the overall economy.  Thus the 19.5 (23.3%) increase in residential investment had far less of an overall impact than it did in the past.

While residential investment is still near a record low share of the overall economy, I have serious questions about the sustainability of the increase.  The extension and expansion of the tax credit as is now moving through the Congress might keep things going for the next few quarters, but after that things are likely to fall apart again. Most of the tax credit is going to those who buy existing homes, rather than new homes, and thus it is a very inefficient way of increasing residential investment.  It is however, an open question if we really want to be directing resources into housing given the glut of housing units in the country. Just like we saw with the Cash for Clunkers program, it is probably just encouraging those folks who might have bought later to buy now. Cash for clunkers was a much smaller program, totaling only $3.0 billion, yet is had a huge impact on the economy, most of the improvement in consumer durable goods came from autos.

The tax credit is also tricking people into thinking that the house is more affordable that it really is, just the way that teaser rate ARM’s did, and we saw just how well that worked out.  The FHA is handing out mortgages with only 3.5% down and people can use the tax credit for that ridiculously small down payment.  This has future disaster of biblical proportions written all over it.  The next bailouts will not be of the banks like Bank of America (BAC) and Citigroup (C) but of the FDIC and the FHA.

Direct government spending had a small but positive impact on overall growth in the 3Q, adding 0.63 (0.48) points a fairly significant slowdown from the 1.33 contribution in the 2Q, but better than the 0.52 point drag in the 1Q.  All the help came from Washington , not city hall or the statehouse.

The Federal government added 0.65 (0.62) growth points, down from 0.85 points in the 2Q but up from a 0.33 point drag in the 1Q.  The Pentagon was the main factor in all three quarters, with defense spending adding 0.48 (0.45) points in the 3Q following a 0.70 addition in the 2Q and a 0.27 point drag in the 1Q.  Non-defense spending was sort of a non issue, adding just 0.17 (0.17) points in the 3Q, not much difference from the 0.15 point contribution in the 2Q, and up a little bit from the slight 0.06 point drag in the 1Q.

State and Local governments are not allowed to run operating deficits, and so when faced with declining tax revenues they have to cut back, unless Uncle Sam helps them out.  Well Washington is helping, but its not enough and S&L spending was a 0.02 (0.14) point drag in the 3Q.  The Federal help was enough in the 2Q and so the contribution to growth in the 2Q was a positive 0.48 points.  In the 1Q, before the stimulus package could get much traction S&L spending was a 0.19 point drag.

Net exports had been just about the only bright spot in the first half of the year, even though it came the wrong way, from both imports and exports plunging, only with imports falling more than exports did.  That reversed in the 3Q as both showed a nice expansion, but our appetite for foreign goods outstripping the desire for U.S. goods and services abroad.  The increase in exports added 1.71 (1.49) points to growth, but the increase in imports was a 2.53 (2.01) point drag, for a net negative contribution from net exports of 0.82 (0.52) points. In the 2Q falling exports subtracted 0.45 points but plunging imports added 2.09 points, for a net imports net help to the economy of 1.64 points.

In the first quarter, as world trade came to a near standstill, net exports were just about the only positive you could find for the economy. Yes, plunging exports subtracted an awful 3.95 points of growth, but the fact that we were buying practically nothing from overseas added 6.58 growth points for a net aid to the economy of 2.85 points. In other words, if the U.S. were a closed economy in the first quarter, growth would have fallen not at a 6.4% rate, but at a 9.25% rate.

Overall

Relative to the first cut at the data, the downward revisions were broad based, with smaller contributions from all major areas of the economy, with the exception of the government.  Of particular concern is that fixed investments contribution to growth virtually disappeared.

Investment’s share of GDP is near all time low’s and that is not a good thing for the future of the country. Inventory investment really does not count in this regard.   The trade deficit (net exports) continues to be a major problem.  While consumption spending growth was revised lower, it still grew faster than overall GDP, indicating that it continues to grow as a share of the economy.

This country needs to move its economy towards one that is focused on investment and exports, not one dominated by consumption, and consumption of imported goods in particular.   Still, even though it was not as good a report as the original, it sure is an improvement over the second quarter, and especially over the fourth quarter.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market-beating Zacks Strategic Investor service.

Zacks Investment Research

(FNM) Third Quarter GDP Growth Revised to 2.8%

Existing single family home sales rose by 9.7% to a 5.33 million pace, while condo sales soared by 13.7% to a seasonally adjusted annual rate of 770,000. Sales have been greatly aided by the “first time” homebuyer tax credit, which while eventually extended and expanded, for most of the month looked like was about to expire. Thus, in October people were scrambling to try to get in under the wire.

This is the fifth straight month that existing home sales have exceeded year-ago levels. Even more impressive is the fact that actual, non-seasonally adjusted sales actually were higher in October than they were in September. This is highly unusual, since existing home sales are highly seasonal and sales normally drop sharply in October, as can be seen in the graph below (from http://www.calculatedriskblog.com/.) We are almost back up to the October 2007 level of sales on an actual, unadjusted basis (which is reasonable to look at when comparing the same month of the year).

There was even more good news in that inventories also declined by 3.7% from September, and are down 14.9% from a year ago. Combined with the rising sales pace, that brought the months supply down to 7.0 from 8.0 last month. We are almost at “normal levels” of inventory relative to sales, but not quite. Still where we are today is much healthier than the double-digit months tha prevailed for most of 2008, and this is the second sharp drop in a row. The graph below also comes from http://www.calculatedriskblog.com/.

Lower mortgages rates — greatly suppressed by the Fed’s policy of buying up $1.25 Trillion of mortgages backed by Fannie Mae (FNM) and Freddie Mac (FRE) but that buying spree is expected to end at the end of the first quarter — have also helped the existing homes sales market. In October, 30-year fixed rate mortgages fell to an average of 4.95%, down 2.17% from 5.06% in September and down 20.16% from the year-ago level of 6.20%.

A third and very important reason for the rebound in existing home sales is that prices have come down. Overall, median existing home prices are now $173,100, a 7.1% decline from a year ago. Existing single-family home prices have held up a little bit better, down 6.8% from a year ago, while prices for Condos are down 10.4% from last year.

Regionally, existing home sales were up by double digits for the month in every region but the West. The Midwest led the way with sales up 14.4% to an annual rate of 1.43 million. From last year, sales in the region are up 28.8%.

In the very important South region, sales rose by 12.7% and are up 25.7% from a year ago. Sales in the South were at an annual rate of 2.30 million, or 37.7% of the total. While that is well below the over 50% rate that the region accounts for when it comes to new home sales, it still makes it the largest region of the country by a wide margin.

The Northeast is the smallest region, with sales at an annual rate of 1.06 million, but that rate was up 11.6% from September and is up 27.7% from a year ago. The rebound was much more muted out West, where sales were up just 1.6% for the month and just 12.0% year over year. The West has also suffered by far the largest decline in median prices, down 14.7% from a year ago — more than double the next largest decline (the South — 14.7%).

In the Northeast, which is the most expensive market (median price of $235,400) prices are down just 2.6% year over year. In the Midwest, the most inexpensive market (median price $146,600) prices are actually up 1.1% from a year ago.

While the news on existing home sales is good, and the existing home market is FAR larger than the new home market, it is also far less significant to the economy than is the new home market. New homes directly stimulate residential investment, which is an important (and volatile) component of GDP. Lots of labor and materials go into building a new home.

Existing home sales have only an indirect effect on the economy. They stimulate sales of things like paint from Sherwin Williams (SHW) and furniture from La-Z-Boy (LZB) as people redecorate, but such spending is much smaller than building a whole new house. In other words, this is good news, just don’t get too carried away about its significance.

Zacks Investment Research

(FNM) Existing Home Sales Soar Again

Results for the quarter exclude the preferred dividend of $1.3 million paid to the U.S. Department of the Treasury on the senior preferred stock. Though the results improved significantly over the prior-year quarter, the company expects its provision for credit losses to remain high during the fourth quarter of 2009.

The company is mainly focused on initiatives that support the Making Home Affordable Program (MHA Program) announced by the Obama Administration in February 2009. As a leading player, Freddie Mac continued to support the housing market during the third quarter of 2009, enabling more than 78,000 struggling borrowers to accept offers to modify their loans under the Home Affordable Modification program and approximately 69,000 borrowers to lower their payments under the Freddie Mac Relief Refinance Mortgage.

Net loss (excluding preference dividend) for Freddie Mac for the quarter was $6.3 billion, compared to a net loss of $25.3 billion in the prior-year quarter. During the reported quarter, provision for credit losses increased 32.9% year-over-year to $7.6 billion due to continued credit deterioration in the company’s single-family credit guarantee portfolio.

Net loss was partly offset by net interest income for the quarter, which increased 4.7% sequentially to $4.5 billion. The increase was primarily driven by lower short-term and long-term funding costs.

Management and guarantee income for Freddie Mac for the quarter increased 12.7% sequentially to $800 million. The sequential increase reflects higher amortization income related to certain pre-2003 deferred fees due to the decrease in forecasted interest rates, which resulted in an increase in projected prepayments.

Other non-interest loss for the quarter came in at $1.9 billion, compared to net interest income of $2.5 billion in the prior quarter. Other non-interest loss for the quarter included net mark-to-market gains of $42 million, compared to net mark-to-market gains of $5.2 billion in the prior quarter.

Credit quality significantly worsened during the quarter. Total single-family delinquency rate, excluding Structured Transactions increased 55 bps sequentially to 3.33%. At the same time, Single-family net charge-offs increased to $2.2 billion from $1.9 billion in the prior-quarter. Single-family non-performing assets increased to $91.6 billion at Sep 30, 2009 from $76.9 billion at Jun 30, 2009.

Net worth at Sep 30, 2009 was positive at $10.4 billion. This reflects an $8.5 billion gain in accumulated other compressive income (AOCI), primarily driven by improved values on the company’s available-for-sale securities.

Freddie Mac has been among the hardest hit financial firms by the housing slump, credit crisis and ongoing recession. We do foresee the current expansion of the Home Affordable Refinance Program (HARP) to bring down losses from foreclosures in the upcoming quarters. The deterioration in the overall market condition continues to negatively impact Freddie Mac’s financial results. As a result, the company expects to request additional funds from the Treasury.

However, we expect the government conservatorship to continue for a long time and thus see no value in the company for common shareholders.

Zacks Investment Research

(FRE) Freddie Mac Gets Boost From Government Program

As the graph below shows, the market is expecting the Fed to remain on hold, with Fed Funds between 0 and 25 basis points for an extended period. The graph shows the expected outcomes for the January meeting (before today’s announcement) from the Cleveland Fed. The market set the odds of anything other than standing pat at either today’s meeting or the December meeting effectively at zero.

Reading off the chart, it looks like about a 95% probability of no action in January as well. I doubt we will see the Fed raise rates before the third quarter of 2010.

The Fed is playing out exactly the script that Ben Bernanke suggested in his academic work prior to joining the Fed: keep rates near zero, promise to keep them there for an extended period of time to help bring intermediate term rates low, and if needed use quantitative easing to increase the money supply in the event of a liquidity trap.

The Fed will first stop the quantitative easing (the buying of long-term treasuries and mortgage paper) before it considers raising rates. It is done with its program of buying $300 billion of long-term T-notes, and will finish up its $1.25 billion MBS buying program by the end of the first quarter. It slightly reduced its plan to buy agency debt from $200 billion to $175 billion.

“Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up. Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period.

“Activity in the housing sector has increased over recent months. Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.

“Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.”

“Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn. Conditions in financial markets have improved further, and activity in the housing sector has increased.

“Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.

“Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.”

The Fed sees more improvement in the economy. Most notably, it points out that household spending is increasing, rather than stabilizing as it saw in the last meeting — although due to the all the factors it pointed to last time, it is going to be a rather sluggish pick up.

Conditions in the Financial markets, by which they mean things like the rates that banks charge each other in the overnight funding market (the TED spread) had already returned to pre-crisis levels by the time of the last meeting, so there was not a lot of room for further improvement. Business investment is still sluggish, which is not a surprise given that capacity utilization is still around 70%, well below the lowest point reached in any recession since they started tracking capacity utilization in 1967, but up a bit from its low of near 67% in June.

The Fed thinks its policies are working, but that growth is going to be slow for the foreseeable future. I have to agree with them on that. Historically, capacity utilization of 80% is normal, and of 75% represents a deep recession. Capacity utilization of 85% or more represents a boom and signs that the economy is overheating, and needs to be reigned back in by higher interest rates. We are a long way from there.

“With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”

“With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”

Not a syllable changed from last time. Inflation is not a problem, and it will not be for some time to come. The reason is that with high unemployment, there is no way for the wage side of a wage price spiral to gain any traction. With almost 30% of the country’s factories, mines and power plants sitting idle, businesses do not want to risk losing market share by raising prices aggressively.

“In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions — including low rates of resource utilization, subdued inflation trends and stable inflation expectations — are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

“To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. The amount of agency debt purchases, while somewhat less than the previously announced maximum of $200 billion, is consistent with the recent path of purchases and reflects the limited availability of agency debt.

“In order to promote a smooth transition in markets, the Committee will gradually slow the pace of its purchases of both agency debt and agency mortgage-backed securities, and anticipates that these transactions will be executed by the end of the first quarter of 2010. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.”

“In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability.  The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

“To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt. The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.

“As previously announced, the Federal Reserve’s purchases of $300 billion of Treasury securities will be completed by the end of October 2009. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet, and will make adjustments to its credit and liquidity programs as warranted.”

The same basic idea in both statements, although the Fed did elaborate more on why they will keep rates low for an extended period. In other words: “Mr. Market, we mean it when we say we are not going to raise rates any time soon.”

The Fed did back off its quantitative easing program slightly. It is done with the program of buying $300 billion of longer-term T-notes, and is continuing its program of buying $1.25 trillion of mortgaged-backed securities. It did, however, slightly reduce its planned purchases of Fannie (FNM) and Freddie (FRE) debt, from $200 billion down to $175 billion. In the overall context of the quantitative easing program, the reduction is trivial. It is, however, a sign that the program will not be expanded, nor is it likely to be renewed after the current program is completed by the end of the first quarter.

“Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.”

“Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.”

Everyone agreed at both meetings. There had been a few Fed types who had been making speeches about the need to bring things back to normal sooner rather than later, but when the rubber hit the road, they are still on board with the program.

Overall, the Fed seems to understand that the weak economy is the overriding problem. Yes, things are getting better, but given the sluggish pace of improvement, this is not the time to be taking away the punch bowl.

This would be in keeping with historical precedent as I pointed out here. Following the end of the 2001 recession, the Fed waited 32 months before it started to raise rates, and then it did so at a very gradual 25 basis points at a time. Following the 1991 recession it waited 35 months.

So assuming that the NBER eventually determines that the recession ended in July 2009, history suggests that the Fed will not begin to raise rates until the first quarter of 2012. The last two recessions were far milder than this one, which would argue that the Fed should stay on easy street for even longer this time around.

The problem is that keeping rates so low for so long the last time was a key factor in allowing the housing bubble to form. Still, the balance of risks seems to be on the side of an economic relapse, not of an overheating that causes inflation to soar.

Keeping rates low means that we will have a steep yield curve. A steep yield curve allows banks to make a lot of money, since their economic function is to borrow  short term, and lend long term. The idea is that if the curve is kept steep enough long enough, even basket-cases like Citigroup (C) and Bank of America (BAC) will be come solvent again.

The promise of keeping rates low for a long time should also put more pressure on the dollar, which would be good for improving our trade deficit — although at the risk of higher inflation, particularly headline inflation — since oil prices will go up at the dollar goes down. However, given the low inflation pressures elsewhere in the economy, it really is not that big of a risk.

Zacks Investment Research
View original at: Zacks.com News Feed

(FNM) The Fed Stays on Easy Street

Last week, my “crazy prediction” came true.

In the March issue of my newsletter, Forecasts & Strategies, I published a chart, which illustrated the maximum pessimism in the stock market.

The difference was, though, that while most other people were running away from the market, I stated that stocks were a “screaming buy.”

And in an interview with Jeremy Siegel in May, I followed that up by offering three reasons why the Dow Jones Industrial Index was headed for 10,000. Specifically, they were…

• The Fed’s “zero” interest rate policy and an expanding money supply (still in place).
• Obama’s stimulus package favored bailing out bad mortgages and assets in the economy through massive deficit spending. I said: “Essentially, the government is putting a floor under the real estate market, which will keep it from collapsing any further.”
• Historically, stocks perform extremely well following a major crash. According to Jeremy Siegel, author of Stocks for the Long Run, every time the market hits bottom after a crash, the rally can be quick and powerful. After a major bear market, stocks rebound by 24% on average during the first year of recovery. And the average annual return over the next five years is 18%.

In short, I said it wasn’t too late to get invested: “Since the Dow was around 8,300 at the first of the year, it could climb back to 10,000 by year end. And although the easy money has been made and the market will be volatile, it’s not too late to get aboard.”

But what about now?

Pinpointing the Next Milestones for the Dow

If history is any guide, given what I just mentioned about stocks rebounding by 24% on average during the first year of recovery, it means the Dow could exceed 11,000 by the end of 2009.

Moreover, it could reach 15,000 over the next four years, according to the trend.

But recall that the Dow Jones Industrial Average has gone nowhere over the past 10 years. However, it has crossed the 10,000 mark 50 times during this decade looking for direction.

The situation reminds me of the Dow during the 1969-82 bear market, when Wall Street faced a series of crises in inflation, energy and political scandals.

After 10 years of stagnation, it might be time for Wall Street to rally again – and move substantially above 10,000 for good.

But there’s an even bigger story…

Why the Dow and Gold Will Continue to Rise

While the Dow has underperformed this century, gold – the ultimate inflation/crisis hedge – has tripled. The “Midas Metal” surpassed its own barrier last month, cracking the $1,000 per ounce mark and today’s situation is not unlike that of the 1970s.

From here, I suspect that both the Dow and gold will head higher for a while. Why? Because the Fed is determined to maintain a “zero” interest rate policy until the U.S. economy is clearly out of the woods.

That can only mean a weak dollar and higher prices for oil and gold.

However, oil and gasoline prices can only go up so much without disrupting the U.S. industrial base. At some point, all cycles come to an end, and the Fed will be forced to raise rates to a “natural” level – around 4% or so. When it happens, expect the dollar to rally and gold to come back down.

So what does that mean for the market? And what are the best investments?

Three Investments to Buy Now

I don’t think the Dow will fall with gold. It should move higher as we return to economic normalcy. Of course, that’s barring more blunders by the Obama administration – for example, raising taxes, nationalizing healthcare, running bigger deficits, expanding the war in the Middle East, etc. If such events occur, all bets are off.

Where to invest now? Dividend-paying stocks are still offering above historic yields, which means financial stocks have more room to grow. My favorites:

• Annaly Capital Management (NYSE: NLY) – a REIT that yields 15%.
• Alliance Bernstein Holding (NYSE: AB) – an international money management firm that sports a 6% yield.
• Penn West Energy Trust (NYSE: PWE) – a Canadian oil and gas trust that churns out a 10% yield.

Good trading,

Mark

View original at: Investment U

(NLY) As the Dow Cracks 10,000 – What’s Next for the Market?

The average 30-year rate increased to 5.14% from 5.12% in the previous week. The mortgage rate was significantly higher than the record low of 4.78% set at the week ending April 2.

Long-term mortgage rates remained flat this week, near historical lows, which is helping sustain a high level of affordability in the home-purchase market.

Climbing mortgage rates may threaten a gain in home sales spurred by falling home prices, a government tax credit for first-time buyers, and a Federal Reserve program designed to lower borrowing costs. New home sales jumped more than expected in July and sales of existing homes rose to their highest level in almost two years.

Last year, the Federal Reserve decided to lower mortgage rates by buying bonds backed by home loans. It increased the size of its program to $1.25 trillion in March. These bonds purchased from Fannie Mae (FNM), Freddie Mac and Ginnie Mae brought down yields on mortgage-backed securities and allowed lenders to reduce rates on new loans while still selling the securities backed by them at a profit.

The plan helped cut mortgage rates to a record low 4.78% in April. Sales Increase Rates started climbing in May along with Treasury yields due to investor concerns that higher government debt would fuel inflation. The 30-year mortgage rate climbed to 5.59% in the week ended June 11 and has since fallen back.

The mortgage rates seem to be stabilizing now and indicate optimism after a long time.

Zacks Investment Research
View original at: Zacks.com News Feed

(FRE) Freddie Mac Marks Rising Mortgage Rates

• The total mortgage portfolio decreased at an annualized rate of 3.3% in July to $2.2 billion.
• Refinance-loan purchase volume was $34.1 billion in July, down 33.0% from $50.9 billion in June.
• The aggregate unpaid principal balance of mortgage-related investments portfolio decreased to $799.1 billion at July 31, 2009 from $829.8 billion at June 30, 2009.
• The net amount of mortgage-related investments portfolio mortgage purchase (sale) agreements entered into during the month of July totaled $11.0 billion, up 11.1% from the $9.9 billion during the month of June.
• Total guaranteed PCs and Structured Securities issued decreased at an annualized rate of 2.1% in July.
• The measure of FRE’s exposure to changes in portfolio market value averaged $556 million in July.
• Delinquencies, which reflect loans whose payments are overdue and its increase adds to stress on the company’s capital, increased to 2.95% of its book of business in July from 2.78% in June and 1.01% in July 2008. However, the multifamily delinquency rate remained flat at 0.11% in July compared to June, but increased significantly from 0.03% in July 2008.

Freddie Mac reported a surprise profit in the second quarter of 2009 and indicated that it may not need additional federal aid in the near term.

In September 2008, the U.S. government took control of Freddie Mac and its larger sibling, Fannie Mae (FNM), after they reported huge losses and shrinking capital caused by plummeting U.S. house prices. The government is now relying heavily on Fannie Mae and Freddie Mac in their efforts to stimulate the U.S. housing market by buying more mortgage loans, easing refinancing and helping homeowners avoid foreclosures.

Given the uncertain near term outlook for Freddie Mac, we maintain an Underperform recommendation on the stock.

Zacks Investment Research
View original at: Zacks.com News Feed

(FRE) Freddie Mac’s Mortgage Volume Metrics for July

The Ocala, Florida-based company had captured 1.7% market share nationwide by creating $17 billion of mortgage loans from January to June, 2009. On that basis, it was the 12th largest mortgage lender in the U.S.

Taylor was also one of the largest U.S. home loan providers not owned by a large bank. As a result, there was lack of significant amount of deposits that could help cushion its capital position in the troubled market environment.

The company filed for bankruptcy due to recent actions taken against it by the Department of Housing and Urban Development, and mortgage financiers Freddie Mac (FRE) and the Government National Mortgage Association (Ginnie Mae).

Further, the negative developments at Taylor were related to various investigations surrounding the failure of Colonial Bank, which was Taylor’s primary bank for years. Colonial froze about 100 Taylor Bean bank accounts earlier this month.

On Aug 14, Colonial BancGroup was seized by the Federal Deposit Insurance Corporation (FDIC). It is the biggest bank failure so far this year, and the sixth-largest in U.S. history. Colonial’s $20 billion in deposits, 346 branches and about $22 billion of assets were sold to BB&T Corporation (BBT).

According to the bankruptcy filing, Taylor has more than $1 billion of both assets and liabilities, and between 1,000 and 5,000 creditors.

In the first half of 2009, bankruptcy protection filing increased 64% year over year to more than 30,000. Also, according to the American Bankruptcy Institute, the number of Chapter 11 business reorganizations increased 113% year over year to 7,396, and Chapter 7 business liquidations jumped 57% year over year to 20,375. Continued financial stress on both consumers and businesses due to the market turmoil was the reason for increase in bankruptcy filings this year.

Zacks Investment Research
View original at: Zacks.com News Feed

(FRE) Taylor Bean & Whitaker Mortgage Files for Bankruptcy

“Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks.

“Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit. Businesses are still cutting back on fixed investment and staffing, but are making progress in bringing inventory stocks into better alignment with sales.

“Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.”

“Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing. Conditions in financial markets have generally improved in recent months.

“Household spending has shown further signs of stabilizing but remains constrained by ongoing job losses, lower housing wealth, and tight credit. Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales.

“Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.”

The Fed is marginally more positive on the economy. “Leveling out” is better than “the pace of contraction slowing,” implying that the contraction has actually stopped. The improved conditions in financial markets have lasted and the trend is still in the right direction (notice the change from weeks to months).

Household spending (aka consumption) has stopped falling off a cliff but is still very depressed, and for good reason — lack of income as people are out of work and less accumulated wealth due to the housing market decline (the decline in the stock market has been partially recouped, but stock market wealth is far more concentrated amongst the wealthy than is housing wealth).

No change in the statement about businesses. A swing in inventories will probably be the first spark in an economic recovery, but while welcome, that would not be enough to create a sustained recovery.

No change in the rest of the statement, which pretty much says that the economy will be anemic for a very long time, but that the enormous amount of money being thrown at it from both the fiscal and monetary ends will eventually get some traction and lift us out of this morass.

“The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”

“The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”

Translation: headline inflation will be much higher than core inflation, but headline inflation does not matter to you since you don’t eat or drive. The key point is that there will not be a wage price spiral since the wage side of that will not gain any economic traction.

If you ask your boss for a raise, he will probably point you to the door. What headline inflation there is will result in a reduction in the real standards of living for the vast majority of people. No change from last time.

“In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

“As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve is in the process of buying $300 billion of Treasury securities.

“To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.

“The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.”

“In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

“As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.

“The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.”

The Fed has been very active in buying up both treasuries and GSE — Fannie Mae (FNM) and Freddie Mac (FRE) — backed mortgage paper. It is almost out of ammo from its previously announced plan. The big news is that they did not decide to expand the program.

On the mortgage-backed side, the Fed has been the dominant player in that market since the program was announced, accounting for well over 50% of the volume. Without the Fed action, mortgage rates would be substantially higher, and the housing market would be in even deeper doo-doo than it is now.

Big question: when the Fed stops, does the housing market fall apart again? It would be premature to speculate on how the Fed will dispose of this mountain of paper it is holding, but the immediate question is if there is a real market for it if the Fed is not buying hand over fist.

“Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.”

“Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.”

No official dissention among the members of the board. Every one is playing nice, at both this meeting and the last one. That is not unusual.

Zacks Investment Research
View original at: Zacks.com News Feed

($FNM) Notes on Fed Statement – economic activity is likely to remain weak for a time

Ten of the nation’s largest banks have received the Treasury approval for TARP repayment, as they are now able to tap the debt markets without FDIC’s support and also access the equity markets as the investor confidence returns in the stronger banks.

While the bigger banks have benefited a lot from the various programs launched by the Federal Reserve, the Treasury and the FDIC, and are now in a much better shape, many smaller banks are still in a very weak financial state, and the FDIC’s list of problem banks continues to grow. Further, government efforts have not succeeded in restoring the lending activity at the banks. Lower lending activity will continue to hurt the margins, though the low interest rate environment should be beneficial to the banks with a liability sensitive balance sheet.

For the last few quarters, the banks have mainly suffered due to the losses in the mortgages and Commercial Real Estate (residential construction loans). Housing prices have continued to decline, and given the sharp increase in the level of unemployment, we anticipate continued losses in these portfolios. Further, deterioration in other Commercial Real Estate loans is now rising at a rapid pace, and the downturn in this class is also likely to be very challenging.

With deterioration in the overall economic environment and rising job losses, we anticipate the losses will continue to increase in all the other asset classes as well, especially in the consumer related loans. It was recently reported that U.S. credit card delinquencies rose to a record high and are expected to rise further. We expect the asset quality deterioration to continue at least through the end of FY09.

As a result of a rise in charge-offs, the levels of reserve coverage have fallen over the past quarters and the banks will have to make higher provisions in the coming quarters, affecting the profitability. Also, the banks will also continue to take mark-downs in the investment portfolios, further hurting the bottom-line.

OPPORTUNITIES

We recently upgraded our recommendation on Ocwen Financial Corp (OCN) to a Buy, as this company may be a major beneficiary of the President’s Home Affordable Modification Plan, which provides incentives for loan modifications to the borrower, the investor and the servicer. OCN was appointed by Freddie Mac (FRE) as one of the servicers for the new pilot initiative launched to identify borrowers who are at a risk of foreclosure. Recently the Treasury extended TALF to include securities backed by servicing advances, which will provide comfort on the liquidity front.

WEAKNESSES

Banks with high exposure to housing and Commercial Real Estate loans, like Wilmington Trust Corporation (WL), KeyCorp (KEY), Zions Bancorp (ZION) will remain under pressure. We also continue our Sell recommendations on Freddie Mac and Sallie Mae (SLM), as we anticipate rising losses and increased provisions during FY09.

Zacks Investment Research
View original at: Zacks.com News Feed

(FRE) U.S. Banks – Zacks Analyst Interviews

Everyone’s scrambling… House subcommittee chairman Paul Kanjo wants to launch a government investigation. Outgoing SEC Chairman Chris Cox is “gravely concerned by the apparent multiple failures” of the SEC. He too, wants to get to the bottom of this.

And of course, House Financial Services Committee chairman Barney Frank, whose regulatory urgings did a masterful job ensuring Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) didn’t fail, wants to introduce even more legislation.

He’s trying to require hedge funds and investment managers open up their books. But it’s useless. Everyone’s trying to find a complex solution to “what went wrong?” and how some of the biggest investors lost so much – when a simple answer suffices.

Investors simply violated two of Investment U’s pillars of investing – asset allocation and position sizing.

If you don’t invest too much (position size) in any one opportunity and spread your investments around widely (asset allocate), it’s impossible to be wiped out in one fell swoop. Yes, protection is that simple.

But even the “smart money” refuses to adhere to these boring, yet effective principles. For instance, Spain’s Banco Santander (NYSE: STD), the largest euro-zone bank invested a total of $3.1 billion in the Madoff’s Ponzi scheme.

In the aftermath, the lesson’s simple. Asset allocate, don’t regulate. Because another day will bring another con man just as smooth talking and connected enough to be plausible as Bernie Madoff. And no matter how many protections we bake into the system, financial “innovation” will always outpace regulation.

In other words, for true protection look in the mirror. A little discipline (asset allocating and position sizing) can go a long way in securing your hard earned capital.

Companies mentioned in this article: FNM, FRE and STD.

View original at: Investment Advice and Investment Research with a Contrarian Point of View

(FNM) After the Madoff-Ponzi, The Lesson’s Clear

None the wiser, I also did not succeed in capturing a leprechaun and finding the gold during my visit last week to the Emerald Isle. However, the beautiful Irish scenery, hospitality and “open for business” attitude resulted in a very successful trip and will keep me going back in search of the “buried treasure”.

Nervousness about the financial system was still paramount as investors realized that none of the problems were likely to be fixed anytime soon. The upshot of the week’s trading was a further weakening in credit markets, judging by the elevated credit spreads. Global stock and bond markets ended another volatile week on a mixed note, whereas crude prices gained surprisingly little on the impending arrival of Hurricane Gustav and a festering geopolitical situation with Russia.

Next, a tag cloud of the text of all the articles I have read during the past week. This is a way of visualizing word frequencies at a glance. As expected, words such as “banks”, “prices”, “credit” and “financial” featured prominently in my reading matter.

I do believe we are still in a primary bear market where stock markets are, at best, faced with a prolonged convalescence period characterized by sub-optimal returns. Whether significant further declines will take place from these levels and valuations overshoot to bargain levels is anybody’s guess.

However, in the short term I give the nascent stock market rallies the benefit of the doubt provided the mid-July lows are sustained. For any rally to become more enduring will require further base building and an eventual shift in central bank policy to targeting GDP growth rather than inflation.

The rally’s lack of breadth, however, is worrying, causing Richard Russell (Dow Theory Letters) to warn: “If July 15 was a true bottom, the market should be roaring up today, and that’s not what’s been happening. Caution is warranted!”

But we should also take note of the fact that 64% of stocks in the S&P 500 are currently trading above their 50-day moving averages, as pointed out by Bespoke. “As shown in the chart below, the reading has been creeping higher and higher since mid-July, and looks to be on its way to the 80% to 85% levels seen twice over the last year. Readings above 50% are signs of a healthy market, and it hasn’t been above 50% for much of 2008.”

Seasonality indicates that “September has firmly secured the rank as the worst month of the year” (Stock Trader’s Almanac), but that a year-end rally typically starts in late September / early October.

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.

Economy
“Global business sentiment remains weak and fragile and consistent with recession in the US, Europe and Japan,” according to the Survey of Business Confidence of the World conducted by Moody’s Economy.com. The survey results suggest that the Asian economy (ex Japan) continues to post growth that is near its potential. “Across the globe, sentiment is consistent with an economy that is near recession. Pricing pressures remain very elevated, but fell notably last week.”

The minutes from the FOMC meeting of August 5, released on Tuesday, indicate that committee members were concerned about the near-term risks to growth. Most participants expected inflation to fall, although they remained wary about upside risks to inflation. Given the problems in financial markets, members did not view current monetary policy as overly stimulative.

Other economic reports released in the US during the past week included the following:

• The GDP growth rate in the second quarter was revised upward to 3.3% from 1.9%, exceeding expectations. In the first quarter, real GDP increased by 0.9%. The better-than-expected outcome did not change most economists’ view that the economy was weakening, with the beneficial effects of rebate checks and foreign demand fading fast. Corporate profits edged down for the fourth straight quarter, falling twice as fast as in the first three months of the year.

• New orders for durable goods rose by 1.3% in July, surpassing expectations for only a slight increase. Core capital goods orders also surprised on the upside, increasing by 2.6% over the month.

• Existing home sales increased by 3.1% over the month in July, according to the National Association of Realtors. This increase put the annualized pace of sales up to 5 million units. However, substantial slack persisted, with inventories hitting a record high of 11.2 months. Furthermore, the median price of an existing house declined by 7.1% in year-ago terms, slightly worse than in June.

• Personal income tumbled by 0.7% in July after rising by 0.1% in June. Excluding the tax rebate effect, disposable personal income rose by 0.5% in July, up from 0.3% in June. Spending growth slipped to 0.2% from 0.6% the previous month. Real spending fell by 0.4% as price growth remained high. The core PCE deflator rose by 0.3%, matching the fastest rate since September, while the top-line deflator rose by 0.6%. The saving rate fell back to 1.2% from 2.5% in June but remained inflated by rebates.

Source: Slate

Summarizing the US economic situation, John Mauldin (Thoughts from the Frontline) said: “Even many mainstream economists are now suggesting we will be in a recession by the fourth quarter, if we are not in one now. The recovery, when it comes, will be tepid until credit spreads signal an end to the credit crisis. It is going to be Muddle Through for 2009. This is NOT going to be good for the stock market. When will it be safe to get back into the water? Pay attention to credit spreads.”

Data releases from Europe and Japan underlined rapidly deteriorating economies flirting with recession. The Japanese government announced a $107 billion set of fiscal measures, including tax cuts and larger government-guaranteed loans, in response to the weakening economy.

Week’s economic reports

Source: Yahoo Finance, August 29, 2008.

In addition to the Fed releasing its beige book on September 3 and interest rate announcements by the Bank of England and the European Central Bank on September 4, next week’s US economic highlights, courtesy of Northern Trust, include the following:

1. ISM Manufacturing Survey (September 1): The consensus for the manufacturing ISM composite index is 49.5 vs. 50.0 in July. If the consensus forecast is accurate, it would be consistent with weakness in other parts of the economy. Consensus: 49.5 versus 50.0 in July.

2. Employment Situation (September 5): Payroll employment in August is expected to have dropped by 85,000, taking the tally of consecutive monthly declines to eight. The jobless rate is predicted to have held steady at 5.7%. Consensus: Payrolls: -75,000 versus -51,000 in July, unemployment rate: 5.8% vs. 5.7% in July.

3. Other reports: Construction spending, auto sales (September 2), factory orders (September 3), ISM non-manufacturing (September 4).

Click here for a summary of Wachovia’s weekly economic and financial commentary.

A summary of the release dates of economic reports in the UK, Eurozone, Japan and China is provided here. It is important to keep an eye on growth trends in these economies for clues on, among others, the trend of the US dollar.

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, August 31, 2008.

Equities
Global stock markets, in general, were mixed during the past week. The MSCI World Index rose by 0.6%, with the MSCI Emerging Markets Index closing unchanged.

Among mature markets, the US stock indices were mostly lower, but European stocks turned in good performances, for example Italian Comit 30 Index (+2.6%), French CAC 40 Index (+1.9%) and German XETRA Dax Index (+1.3%). Australia (+4.1%), Japan (+3.2%) and Canada (+2.4%) also shrugged off the gloomy economic outlook and moved higher.

The emerging markets category saw solid gains in Hong Kong (+4.3%) and Taiwan (+2.0%), whereas large declines were registered by Pakistan (-7.9%), Russia (-3.3%) and Turkey (-2.6%). The Russian Trading System Index ( 16.3%) and the Chinese Shanghai Composite Index (-13.6%) were the worst performers for the month of August.

With the exception of the Russell 2000 Index (+0.3%; YTD -3.5%), the US stock markets closed lower as shown by the major index movements: Dow Jones -0.7% (YTD -13.0%), S&P 500 Index +0.7% (YTD -12.6%) and Nasdaq Composite Index -2.0% (YTD 10.7%).

Particularly noteworthy, the MSCI World Index has outperformed the MSCI Emerging Markets Index over the past month (-1.6% vs -8.2%), past three months (-11.9% vs -21.0%), YTD (-15.4% vs -23.2%), and also since the stock market peaks of October 2007 (-20.7% versus -28.6%).

The Russell 2000 Index is trading above both its 50- and 200-day moving averages, whereas the Dow Jones Industrial Index, S&P 500 Index and Nasdaq Composite Index are above their 50-day averages but still below the important 200-day line – often used as an indicator of the primary trend.

Click here or on the thumbnail below for a market map, courtesy of Finviz.com, providing a quick overview of the performance of the various segments of the S&P 500 Index over the week.

The thrifts and mortgage finance group (+16%) was the best-performing group for the week, led by Freddie Mac (FRE) and Fannie Mae (FNM), up 61% and 37% respectively. This is a strong reversal from being the worst-performing group during the previous week with a decline of 23%. The stocks were driven down recently by speculation on whether a government bailout was imminent, a prospect that would probably wipe out the equity holders. Those concerns seemed to diminish last week after some analysts estimated that the firms had enough capital to last at least until next year.

The homebuilding group was the second-best performing group, gaining 9% on housing reports being interpreted as showing signs of a stabilizing market.

The trucking group (-7%) was the worst performer, led by its single member, Ryder System (R). A brokerage analyst downgraded the trucking sector, predicting that freight volumes in the peak shipping season through November might be weaker than expected because of the soft US economy.

The Internet retail group (-6%) was the second-worst performer, led by its largest member, Amazon (AMZN). A blog posting by a newspaper reporter raised the topic again of how well Amazon’s Kindle electronic book reader was actually selling.

Fixed-interest instruments
Global government bond yields were mostly lower during the past week, as investors dismissed the threat of inflation and priced in concerns about a global recession.

The ten-year US Treasury Note declined by 4 basis points to 3.83%, the UK ten-year Gilt yield by 13 basis points to 4.48%, the German ten-year Bund yield by 5 basis points to 4.17% and the Japanese ten-year bond yield by 5 basis points to 1.42%.

Currencies
The US dollar maintained its recent rally as the currency benefited from the view that foreign central banks will be quicker to cut rates than the Fed will be to tighten rates.

The past week saw the greenback rising against the euro (+0.7% – a six-month high), the British pound (+1.6%), the Swiss franc (+0.2%), the Australian dollar (+1.2%) and the Canadian dollar (+1.6%).

Sterling has come under further selling pressure as pessimism about the UK economic outlook intensified, dropping to a 12-year low on a trade-weighted basis ahead of the Bank of England’s interest rate announcement next week.

The Japanese yen was the only currency to gain against the US dollar during the past week, closing 1.1% higher on the back of better-than-expected economic data and the announcement of a $107 billion fiscal stimulus package.

Commodities
The dollar’s strength and growing concerns of slowing demand knocked dollar-denominated commodity prices as seen in the Reuters/Jeffries CRB Index, which declined by 0.8%.

West Texas Intermediate crude traded between $115.0 and $118.76 a barrel last week before closing 0.8% up at $115.46 on Friday. The gain was relatively small given the impending arrival of Hurricane Gustav and concerns about the geopolitical situation with Russia, but word from the Department of Energy that it would release strategic oil stocks to combat any disruption kept oil prices in check. (The Gulf of Mexico is responsible for 25% of US crude oil production and 15% of US natural gas production.)

The chart below shows the past week’s movements for the various commodities:

Now for a few news items and some words and charts from the investment wise that should be of help with keeping our investment portfolios on a winning path. As the Irish say: “Go n-eírí an bóthar leat. May the road rise with you.” And also wishing you a fabulous Labor Day weekend.

Hat tip: Barry Ritholtz’s Big Picture

YouTube: Take a load off Fannie
The story of Fannie Mae, as narrated by The Band.

Source: YouTube, August 24, 2008. (Hat tip: Barry Ritholtz’s The Big Picture.)

(more…)

View original at: Investment Postcards from Cape Town

(FRE) Words from the (investment) wise for the week that was (August 25 – 31, 2008)

Source: Lisa Benson, Slate

US stocks plummeted on Thursday after two days of gains as investors’ recent optimism was dented by renewed doubts about financials stocks, manifesting in the sector dropping 6.8% – its largest one-day decline in more than eight years.

In a rare Saturday session, the US Senate passed housing rescue legislation aimed at helping struggling homeowners avoid foreclosure and providing financial support to troubled mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE), reported TheStreet.com. The bill, which cleared the House on Wednesday, now goes to President Bush.

Reuters highlighted that US banks’ direct primary credit borrowing from the Federal Reserve rose to the highest level ever in the latest week, reflecting the growing need of the banking sector to rely on the central bank for cheap funding. On the day of July 23, banks’ primary credit borrowings rose to $17.68 billion, the highest borrowing since September 12, 2001 when banks borrowed $45.5 billion in a single day.

No wonder John Paulson, who recorded what was thought to be the single biggest profit in the history of the hedge fund industry last year by betting on a financial collapse, is planning a new fund to provide capital to cash-strapped banks.

President George W. Bush, as reported in the Financial Times, also had his take (albeit unofficial) on matters: “There’s no question about it. Wall Street got drunk … it got drunk and now it’s got a hangover. The question is how long will it sober up and not try to do all these fancy financial instruments.”

Given all the shenanigans, Richard Russell (Dow Theory Letters) thought there was too much complacency. “… I guess everybody thinks the Fed or the Treasury is going to bail the whole economy out. Why worry, if you’re in trouble, call Mr. Bernanke, and he’ll drop a bundle of Federal Reserve notes in your mail box. Be sure the box is big enough,” said Russell a day after turning a youthful 84.

Now for a new feature of this report: A tag cloud of the text of all the articles I have read during the past week. This is a way of visualizing word frequencies at a glance. It is quite obvious that the key areas last week were “bank”, “prices”, “inflation”, “oil” and “economy”. As the saying goes: A picture paints a thousand words …

Key to mapping out the intermediate stock market cycle is whether the July 15 levels for the S&P 500 Index (1,215) and Dow Jones Industrial Index (10,963) will hold. Specifically, the extent to which bank shares can sustain their moves above recent lows will be a vital determinant as to how well stock markets in general can rally from these levels. Short-term movements aside, do not expect a quick convalescence period.

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.

Economy
The Federal Reserve’s Beige Book, released on Wednesday, noted slower growth since the last report issued on June 11. Weakness in consumer industries, housing and finance offset strength in IT and healthcare. Retail and wholesale price pressures were mounting, although there was little concern yet about wage inflation.

More specifically, the past week’s economic reports in the US included the following notable releases:

• The Index of Leading Economic Indicators (LEI) fell by 0.1% in June, following a revised 0.2% drop in May. The quarterly average of LEI is down 2.0% from a year ago, the largest decline in the current business cycle. Historically, such large year-on-year declines of the quarterly average of the Index were associated with recessions.

• Weakness continues to characterize the housing market. Existing Home Sales declined by 2.6% month on month in June, according to the National Association of Realtors. Sales declined to 4.86 million annualized units. Inventories are rising and the months of inventory are about flat at 11. The median existing home price is declining, with a year-on-year drop of 6.2%, but not as severely as earlier this year.

• The Census Bureau reported a -0.6% month-on-month decrease in New Home Sales in June. However, the Bureau revised the monthly sales figures upward back to March, and thus June sales were stronger than expected at 530,000 annualized units. The median new home price declined slightly in June, as did months of inventory. Months on the market, however, are rising.

Furthermore, US foreclosure filings more than doubled in the second quarter compared to a year ago, representing an increase of 121% from a year earlier and 14% from the first quarter, according to RealtyTrac.

Summarizing the economic situation, David Rosenberg, North American economist of Merrill Lynch, said in a research report: “Though fiscal stimulus will provide a lingering boost to 3Q, we expect GDP to plummet 2.5% in 4Q and see a similar decline in 1Q. In all, we have shaved our 2009 GDP forecast to -0.5%, a full percentage point lower than where it was previously, while 2008 is broadly unchanged at 1.5%.”

As far as interest rate policy is concerned, Asha Bangalore (Northern Trust) remarked: “It is … important to recognize that the Fed is not in a position to raise rates until there is financial market stability, the housing market crisis improves, and firms decide to expand their payrolls. Concerns about economic growth will prevail over inflation, for now. In other words, tough talk about inflation will continue but it cannot be translated into action in the near term.”

Across the pond, the UK was faced with a relentless stream of negative economic news. The minutes of the Bank of England’s (BoE) monetary policy committee meeting in June showed that the BoE was struggling to balance the downward price pressures of slowing economic growth against the upward price pressures of strong oil and food price growth.

A slew of weak data also came from the Eurozone, with the RBS/Markit composite PMI dropping from 49.3 in June to 47.8 in July, the lowest since November 2001 and clearly indicating a contracting economy. It appears unlikely that the European Central Bank (ECB) will hike rates any further in the second half of this year.

Elsewhere, Japan’s trade surplus was nearly 90% lower than last year’s surplus, and core inflation ballooned to a fresh decade high of 1.9% year on year in June.

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, July 25, 2008.

Next week’s economic highlights, courtesy of Northern Trust, include the following:

1. Real GDP (July 31): Real GDP is predicted to have advanced at an annual rate of 1.5% in the second quarter, supported by consumer spending. The fiscal stimulus package accounted for the strength in consumer spending, a one-off event. Real GDP grew by 0.6% in the fourth of 2007 and by 1.0% in the first quarter of 2008. The forecast range for growth in GDP in the second quarter is 1.4% to 3.0%. This report will contain revisions for the period 2005:Q1 to 2008:Q1. Consensus: 2.4%.

2. Employment Situation (August 1): Payroll employment in July is predicted to have declined by 75,000 after a loss of 62,000 jobs in June. The forecast range is -150,000 to -10,000. The unemployment rate is projected to have risen to 5.6% in July from 5.5% in June. Consensus: Payrolls: -72,000 versus -62,000 in June, unemployment rate: 5.6% versus 5.5% in June.

3. ISM Manufacturing Survey (August 1): The consensus for the manufacturing ISM composite index is 49.2 versus 50.2 in June.

4. Other reports: Consumer Confidence (July 29), Construction Spending, Auto Sales (August 1).

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, July 27, 2008.

Equities

Global stock markets, in general, maintained their positive tone during the past week after the strong recovery of the previous week, with the Dow Jones World Index registering an increase of 0.9%.

The Japanese Nikkei 225 Average was the strongest performer among developed markets, rising by 4.2% – its biggest weekly gain for five months.

The real stars, however, were among the emerging markets, including Pakistan (+7.8%), Taiwan (+6.1%), South Korea (+5.8%), the Philippines (+5.2%), Indonesia (+4.8%) and India (+4.7%). On the other side of the scale, previous strong performers Russia (-8.6%) and Brazil (-4.7%) suffered as oil and commodities fell further.

The US stock markets were mixed, with smaller and technology stocks outperforming their larger counterparts, as shown by the major index movements: Dow Jones Industrial Index -1.1% (YTD -14.3%), S&P 500 Index -0.2% (YTD -14.3%), Nasdaq Composite Index +1.2% (YTD 12.9%) and Russell 2000 Index +2.5% (YTD -7.3%).

Click on the thumbnail below for a market map, courtesy of Finviz.com, providing a quick overview of the performance of the various segments of the S&P 500 Index over the week.

The managed healthcare group was the best performer for the week, rising by 13%. The Internet retail group was the second-best performer (+9%), led by Amazon.com (AMZN), its largest member, with better-than-expected earnings and guidance.

The thrifts and mortgage finance group was the worst-performing group, down by 14%. Washington Mutual (WM) was down 35% after it reported second-quarter losses in excess of expectations. Fannie Mae (FNM) and Freddie Mac (FRE), the two largest members of the group, were each down by more than 10%.

The consumer finance group was the second-worst performer, declining by 12%. The largest group member, American Express (AXP), reported second-quarter earnings below analysts’ consensus estimate.

Halfway through the second-quarter earnings reporting season in the US, the numbers have generally been better than feared. Of the 248 S&P 500 companies that have reported results, 72.2% have registered positive surprises, 4.8% have been in line, and 23.0% have missed expectations, according to Bloomberg.

Data from Thomson Reuters show that S&P 500 earnings so far are down by 17.9% versus a year ago, but 7.7% higher when excluding financials.

Fixed-interest instruments
Government bonds experienced a mixed week, with yields declining in countries/regions with poor economic data (Eurozone, UK, Japan) and rising where the economic numbers exceeded expectations (US – consumer sentiment, durable goods orders and new home sales).

For example, the two-year US Treasury Note increased by 6 basis points during the week to close at 2.72%, whereas the UK two-year Gilt yield declined by 11 basis points to 5.05% and the German two-year Schatz yield dropped by 10 basis points to 4.44%.

US mortgage rates also increased, with the 15-year fixed rate rising by 7 basis points to 6.05% and the 5-year ARM 16 basis points higher at 6.04%.

The three-month US Treasury Bill jumped by 35 basis points during the week to close at 1.69% as investors’ risk appetite recovered.

Credit markets eased somewhat as shown by the slightly narrower spreads of both the CDX (North American, investment grade) Index and the Markit iTraxx Europe Crossover Index.

Currencies

Currency traders’ benign view of the US economic situation, together with lower oil and commodities prices, caused the US Dollar Index to rise by 0.9%.

Individually, the greenback gained against the euro (-0.9%), the British pound (-0.3%), the Swiss franc (-1.3%), the Japanese yen (-0.9%) and the Australian dollar (-1.6%).

Commodities
Oil prices declined further during the week under review, with West Texas Intermediate sinking by 4.8% to $123.26 by Friday’s close. The crude price has declined by 16.3% since reaching a record high of $147.27 on July 11.

The correction in oil prices again weighed heavily on the entire commodities complex (especially precious metals), with traders reducing their commodities exposure on the back of mounting global growth concerns. The chart below shows the past week’s negative performance of the various commodities.

Now for a few news items and some words and charts from the investment wise that will hopefully assist in preserving our capital in these demanding times.

Source: Ken Catalino, Slate

Jon Stewart (The Daily Show): It’s the stupid economy
Jon Stewart rightfully gets confused with the various utterances about the economic outlook, and in so doing brings laughter to an otherwise serious matter.

Source: Jon Stewart, The Daily Show, July 16, 2008.

Bloomberg: Faber says Fannie, Freddie should split up, not get aid
“Marc Faber talks about the future of Fannie Mae and Freddie Mac, the global economy, and the outlook for stocks and commodities.”

Source: Bloomberg, July 23, 2008.

David Fuller (Fullermoney): Predicting the markets
“Predicting is among the most hazardous of professions, as you know, because we can only guess. Nevertheless we need to focus on these challenging questions, so here are my guesses:

“US 30-Year Treasury Bond futures – I think Bill Gross’ deficit forecast is probably right, and I also maintain that the US government will err on the side of inflation, as debtor nations invariably do. Therefore increased government borrowing is likely to face a buyers’ strike at some point, turning US 30-year T-Bonds into one of the better shorts of the decade. Tactically, I will look to short the rallies as they lose momentum.

“The US Dollar Index – While the US government does not want a currency freefall, it can ill afford a strong dollar because it needs an export led recovery. Moreover, while the dollar remains the world’s main reserve currency, the US is unlikely to kick its addictive habit of printing too many greenbacks. This will also lead to a buyers’ strike, eventually forcing the US Dollar Index lower, with an even bigger decline occurring against the Chinese renminbi and the currencies of other high-growth economies. Tactically, I will look to short rallies as they lose momentum.

“Gold – In a fiat currency world, with the main reserve unit enfeebled, and resources inflation continuing when global GDP growth increases, people everywhere will continue to regard gold as real money for investment purposes. This will eventually support an extension of bullion’s secular uptrend, once the current medium-term consolidation has been completed. Tactically, I will continue to buy following setbacks within the overall upward trend.

“Crude oil – Assuming and very much hoping that there will not be a military strike against Iran’s nuclear installations, I maintain that oil has peaked for the medium term, defined as anything from a few months to two years and occasionally even longer. However as with gold and many other resources, there is a scarcity factor for oil resulting from increasing costs of production and finite supplies of light crude. Also, demand will rise following any significant correction in prices, not least because cheaper oil will boost GDP growth. Therefore crude oil will eventually resume its secular uptrend following what I suspect will be a lengthy correction. Tactically, I would consider longs in petroleum futures and also oil drillers and equipment stocks on evidence of renewed support building following a significant setback.”

Source: David Fuller, Fullermoney, July 23, 2008.

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(FNM) Words from the (investment) wise for the week that was (July 21 – 27, 2008)

Furthermore, Treasury Secretary Henry Paulson’s plan to rescue the Government Sponsored Enterprises (GSEs), Fannie Mae (FNM) and Freddie Mac (FRE), left investors unconvinced.

The US government plan caused some agitation since Paulson was essentially asking for a blank check to ensure the funding backstop would be successful in helping the GSEs fulfill their role of providing financing for the US mortgage market. Debt holders were happy with the implications of the plan, but equity holders faced the possible dilution from a government purchase of the equity and/or the possibility of the equity becoming worthless.

As the credit crisis approached its first anniversary – literally a “year of living dangerously” – SEC Chairman Christopher Cox’s announcement that naked short selling of 19 financial companies, including the GSEs, would no longer be allowed, set the stage for a reversal of fortune.

The SEC’s announcement, together with a sharp drop in oil prices and a series of better-than-feared earnings announcements from US banks – including JPMorgan (JPM), Citigroup (C) and Wells Fargo (WFC) – triggered a recovery in investors’ risk appetite, resulting in a strong stock market rebound.

This type of event was precisely what Charles Kirk (The Kirk Report) was referring to when he said: “Technically, we are scraping against the bottom of the long-term trend channel in the S&P 500 but we need something to go right for a change for this constant selling pressure to end.”

Fed Chairman Ben Bernanke was in the hot seat on Tuesday, delivering his semi-annual monetary policy testimony before the Senate Banking Committee in Washington. In short, he abandoned his June assessment that the threat of an economic downturn had diminished, telling lawmakers that growth and inflation risks were increasing. There were “significant downside risks to the outlook for growth”, and “upside risks to the inflation outlook had intensified”, said Bernanke. His testimony had little impact on financial markets.

“So is the decline over?” asked Richard Russell (Dow Theory Letters). “I’ve said that I can’t see the market hitting bottom until at least the financials stop declining. Did the financials make the crucial turn to the upside yesterday? We should know shortly.”

David Fuller (Fullermoney) adds: “There is still plenty of fear and uncertainty out there. However, I think most stock markets have reached medium-term lows and should range higher in tradable rallies over at least the next month or two.”

On the other hand, Bill King (The King Report) sees more pain: “For about one year we tried to make two points: 1) If you’re not scared, you’re not doing your work; and 2) If you aren’t negative, there is no fathomable non-violent environment that would make you negative.”

In my opinion, it’s too soon to call a major market bottom, but the short-term picture has certainly improved for the better. Technical rallies aside, I still believe the convalescence period will not be an overnight affair. Why is it that Cat Stevens’ lyrics “… oh baby baby it’s a wild world …” keep mulling through my head?

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.

Economy

“Global business confidence has remained in a tight range since late May consistent with a global economy that is barely growing. Developed economies including the US, Europe and Japan are contracting moderately, while most developing economies are expanding moderately,” reported the Survey of Business Confidence of the World conducted by Moody’s Economy.com.

A barrage of economic reports was released in the US over the past week (as summarized in the table below), none of which changed the outlook for economic growth, housing and inflation in any meaningful way.

Regarding the outlook for interest rates, Asha Bangalore (Northern Trust) said: “Chairman Bernanke’s testimony suggested that the Fed is on hold, for now. The Fed is in a tight spot and the best it can do in the months ahead is to help stabilize financial market conditions, with one of the prerequisites for this being an accommodative stance … given the backdrop of a housing market recession, a credit crunch, and weak real consumer spending.”

No short-term remedy for the economic woes exists, as John Mauldin (Thoughts from the Frontline) stated: “… we are in for a period of very tepid growth that will last through at least 2009. We have to work our way through the after-effects of the twin bubbles of housing and the credit crisis bursting. There is no magic Fed wand. That simply takes time. No (rational) government or Fed policy is going to change the facts on the ground (although they can make things worse). But, in the fullness of time, we will in fact get through this.”

It was not only in the US that surging inflation was on centre stage, but elsewhere in the world Thailand, Mexico, the Philippines and Turkey increased interest rates in reaction to mounting inflationary pressures.

Mildly good news, however, was that Chinese consumer price inflation declined from 7.7% in May to 7.1% last month, whereas the economy grew by 10.1% in the second quarter, down from 10.6% in the first – the fourth successive quarter in which growth has slowed and the lowest rate since the last quarter of 2005.

The annual rate of Eurozone consumer price inflation in June was 4% while last month prices in the UK rose by 3.8% in year-ago terms. Both figures were significantly higher than the European Central Bank and Bank of England’s inflation targets.

As widely anticipated, the Bank of Japan left the overnight call rate target at 0.5% following last week’s two-day monetary policy meeting.

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, July 18, 2008.

Next week’s economic highlights, courtesy of Northern Trust, include the following:

1. Leading Indicators (July 21): Interest rate spread and supplier deliveries are the only two components likely to make a positive contribution in June. Stock prices, initial jobless claims, manufacturing work week, consumer expectations, real money supply and building permits are expected to make negative contributions. Forecasts of money supply and orders of consumer durables and non-defense capital goods are used in the initial estimate of the leading index. Consensus: -0.1%

2. Existing Sales (July 24): The market consensus is a decline in sales of existing homes during June to an annual rate of 4.94 million from 4.99 million in May. Existing home sales have dropped by 15.9% from a year ago. The largest year-to-year decline in the current business cycle is a 23.8% drop in February 2008. Consensus: 4.94 million versus 4.99 million in May.

3. New Home Sales (July 25): Sales of new homes are expected to post a drop in June to an annual rate of 505,000 from 512,000 in May.

4. Other reports: Consumer Sentiment Index (July 25).

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, July 21, 2008.

Equities

Global stock markets staged a strong recovery last week after having declined for six consecutive weeks. The Dow Jones World Index registered an increase of 0.9% for the week, after a positive about-turn on Wednesday as a result of a dramatic slide in oil prices, better-than-feared earnings numbers for a number of US banks, and the SEC’s moves to curb short selling of certain financial firms.

The Japanese Nikkei 225 Average (-1.8%) was the only developed market not participating in the rally and shared this dubious honor with emerging markets in general (-2.0%). Pakistan (-12.5%), Thailand (-9.0%), Indonesia (-7.2%), Taiwan (-5.9) and South Korea (-3.7%) all had a torrid time, with Turkey (+8.4%) being one of the few emerging markets gaining ground.

The US stock markets all improved, as shown by the major index movements: Dow Jones Industrial Index +3.6% (YTD -13.3%), S&P 500 Index +1.7% (YTD -14.1%), Nasdaq Composite Index +2.0% (YTD 13.9%) and Russell 2000 Index +2.7% (YTD -9.5%).

Four financial industry groups were among the top ten performers in the US this week: other diversified financial services (large banks), thrifts and mortgage finance, diversified banks, and investment banks and brokers were up 22%, 18%, 16% and 15% respectively. The homebuilding group (+19%) was also among the outperformers.

On the red side of the scale, the coal and consumable fuel group (-18%) was the worst performer, selling off in sympathy with declining prices of crude oil and natural gas. Similarly, other oil- and gas-related groups (integrated oil and gas, oil and gas exploration and production, and gas utilities) underperformed.

Click on the thumbnail below for a market map, courtesy of Finviz.com, providing a quick overview of the performance of the various segments of the S&P 500 Index over the week.

As far as specific companies were concerned, Wells Fargo (WFC) added to the spark that fueled the rally in financials. The company delivered better-than-expected earnings, accompanied by an announcement of a 10% increase in the annual dividend.

The coming week will be another busy week of earnings reporting and should provide some clarity on whether last week’s good numbers were an aberration or perhaps the start of a new trend.

Fixed-interest instruments
Government bonds experienced a volatile week, with yields benefiting from safe-haven buying early in the week, but then rising as investors switched from bonds to equities.

Yields kicked up as investors agonized about accelerating inflation throughout the world. The ten-year US Treasury Note increased by 13 basis points during the week to close at 4.09. Similarly, the UK ten-year Gilt yield rose by 14 basis points to 5.04% and the German ten-year Bund yield by 12 basis points to 4.58%.

US mortgage rates also increased sharply, with the 15-year fixed rate rising by 22 basis points to 5.98% and the 5-year ARM 20 basis points higher at 5.88%.

Credit markets eased somewhat as shown by the slightly narrower spreads of both the CDX (North American, investment grade) Index and the Markit iTraxx Europe crossover Index.

Currencies

The US dollar fell to a record low of $1.6038 against the euro before reversing course and improving in line with US stock markets. Expressed against a basket of currencies, the greenback ended the week 0.4% higher.

Individually, the dollar gained against the euro (-0.6%), the Swiss franc (-0.7%) and the Japanese yen (-0.7%). The last-mentioned two currencies were negatively affected by less risk-averse investors seeking higher yields elsewhere. The British pound (+0.4%) confounded pundits and was the only major currency making headway against the dollar.

Thailand and the Philippines raised interest rates in an attempt to combat inflation, resulting in the baht (+0.9%) and the peso (+2.9%) gaining against the dollar.

Commodities
In the midst of all of the action last week, oil prices corrected sharply. After touching $146.37 at its high on Monday, West Texas Intermediate ended Tuesday’s session at $138.74. The selling persisted for the remainder of the week, with prices settling at $134.60 on Wednesday, $129.29 on Thursday and $128.96 on Friday. The latter price marked an 11.2% decline from the previous week’s close.

Worries about demand destruction, an easing of geopolitical tensions and bearish oil and natural gas inventory reports all played a role in driving prices lower.

The sharp pull-back in oil prices weighed on the entire commodities complex. The chart below shows the past week’s negative performance of the various commodities.

In summary, although the near-term outlook has improved and the long-awaited technical stock market rally has probably commenced, it is premature to cast caution to the wind. Now for a few news items and some words and charts from the investment wise that will hopefully assist in navigating the topsy-turvy markets.

Source: Gary Varvel, Slate, July 16, 2008.

Goldman Sachs: Macro-economic themes for 2nd half of 2008

“We have left a volatile first half of the year behind us and now need to determine what we think will happen in the 2nd half of 2008. It is clear that a number of themes that we saw in the first half of this year did not end on the 30th June but continue to dominate the economic environment:

“Renewed pressure on the US consumer – The ongoing deterioration in the housing, labour, equity and consumer financing markets will force US consumers to tighten their purse, which they, surprisingly, have kept open over the last six months. We believe that this was because they spent their tax rebate in the past months.

“Continuing losses and capital raises by the global financial sector – Our equity analysts believe that the peak of credit losses globally will be in the first quarter of 2009. In the meantime, we will continue to see write-offs and requirements for new capital by financial institutions in Europe and the US.

“Slower growth in Europe – The high euro and higher interest rates are starting to have a negative impact of the data that is coming out of the Eurozone. The UK is showing mounting signs that a recession may hit the economy.

“Inflation pressures to recede but risks to renewed pressure – Slower global growth will in our opinion lead to lower global inflation (from 5.6% to 4.2% in 2009) with inflation in the advanced economies falling below 3% and emerging markets from ~9% to ~6%. The risks to this view are commodity prices and inflation expectations which make this forecast one which we are monitoring very closely.

“Softer growth and lower inflation in China – Inflation data from China has shown a moderation (from 9% to 7% now) and we believe it will be about 5% by year end. This will help global inflation. We forecast Chinese growth to moderate from around 12% in the last two years to 10% in 2008 and 2009.

“Central banks balancing policy between inflation and growth – Central banks are having to chose between stimulating growth or tightening monetary policy to prevent inflation from running away. We believe the ECB and Fed will keep rates on hold for the rest of the year (based on our moderating inflation view). A number of emerging market policy makers appear to be behind the curve and this could create more broad-based problems if no action is taken.”

Click here for the full report.

Source: Goldman Sachs, July 16, 2008.

MarketWatch: Text of Paulson statement on Fannie, Freddie
“Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction.

“GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets. Therefore we must take steps to address the current situation as we move to a stronger regulatory structure.

“In recent days, I have consulted with the Federal Reserve, OFHEO, the SEC, Congressional leaders of both parties and with the two companies to develop a three-part plan for immediate action. The President has asked me to work with Congress to act on this plan immediately.

“First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.

“Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed.

“Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer.

“Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator’s process for setting capital requirements and other prudential standards.

“I look forward to working closely with the Congressional leaders to enact this legislation as soon as possible, as one complete package.”

Source: MarketWatch, July 13, 2008.

Bloomberg: Rogers calls Fannie, Freddie rescue plan a “disaster”
“Jim Rogers talks with Bloomberg from Singapore about the US government’s efforts to bolster Fannie Mae and Freddie Mae, the outlook for financial stocks, the dollar and commodities, and his investment strategy.”

Click here for the full article.

Source: Bloomberg, July 14, 2008.

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(FNM) Words from the (investment) wise for the week that was (July 14 – 20, 2008)

Markets had investors feeling dazed and confused after another roller-coaster week amid further evidence of the deteriorating health of the US financial sector and a renewed rise in oil prices. Adding to the pain, Barron’s Randall Forsyth said: “Now that the bear market has officially arrived, it may stick around and gnash its teeth for a while – until it’s scared away those who remain.”

Government Sponsored Enterprises (GSEs) Fannie Mae (FNM) and Freddie Mac (FRE) were the main sources of volatility for the market, as speculation was rampant that they were destined for a government bail-out despite numerous assurances from government officials and their regulator that they were adequately capitalized. Between them, these enterprises own or guarantee about half of the $12,000 billion of outstanding US home loans.

Henry Paulson, Treasury secretary, downplayed a government takeover, saying: “Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission.” (And “tomorrow”, Mr Paulson?) Describing Fannie and Freddie as “very important institutions”, President George W. Bush said the nation’s top economic officials would be “working this issue very hard”.

A Reuters report on Friday cited a source as saying that Fed Chairman Ben Bernanke had told the GSEs they would be eligible to borrow from the Fed’s discount window. However, the Fed said there had been “no discussions” with Fannie and Freddie on access to the discount window.

Separately, Bernanke suggested that the “temporary” Term Auction Facility to Wall Street might be extended into 2009. Bill King (The King Report) did not find this particularly reassuring, asking: “… isn’t this evidence that there is something very wrong in the financial system and it is troubling to solons?”

This is a nasty market and, irrespective of oversold and short-covering-induced technical rallies, one’s emphasis should be on the return of capital rather than on the return on capital. There is an old and appropriate saying, “I’d rather be out of the market wishing I were in than in the market wishing I were out.”

GMO’s Jeremy Grantham echoed that the key to surviving bear markets was capital preservation. You want to “live to fight another day. You may see amazingly cheap asset opportunities in the next couple of years as distressed pricing might become more commonplace. It would be nice to have the money to take advantage.”

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.

Economy
“… developed economies including the US, Europe and Japan are contracting moderately, while most developing economies are expanding moderately. On net, the global economy is growing, albeit barely,” reported the Survey of Business Confidence of the World conducted by Moody’s Economy.com. “Pricing pressures spurted higher again last week and is approaching a new record high.”

Against the backdrop of what happened with GSEs, and the financial sector as a whole, US market participants paid less attention to fresh economic data. However, the past week’s economic reports included the following notable releases:

• Pending home sales for May slipped 4.7% from April. The main message is that the bottom of home sales is not here after sales of existing homes peaked in September 2005. The fact that there is a large inventory of unsold homes in the market place suggests that additional declines of home prices should follow.

• Initial jobless claims fell by 58,000 to 346,000 during the week ended July 5. However, the sharp drop reflects the shortened week due to the July 4 holiday and distortions arising from auto retool shutdowns in the summer. The decline in initial claims is a distortion and is not an indicator of a marked improvement in labor market conditions.

• Chain store sales rose by 4.3% in June, well ahead of expectations, thanks to the spending of tax rebates. Rising gasoline prices also played a role in the strength, lifting sales at warehouse clubs. Discounters performed particularly well as financially pressed consumers focused on necessities and lower-priced goods.

• The nominal trade deficit narrowed to $59.8 billion in May from $60.5 billion in April. In terms of the impact on GDP, the inflation-adjusted trade deficit of goods was nearly $90 billion in the April-May period compared with a $102 billion in the first two months of the first quarter, suggesting that trade will have a positive influence on the second quarter GDP.

• Prices of imported goods continued to advance in June, which is problematic for the Fed. The import price index rose by 2.6% in June, reflecting higher prices for petroleum and non-petroleum imports. The price index of petroleum imports moved up 7.4%, putting the overall quarterly gain at 24.4% and the year-on-year gain at 20.5%. Import prices excluding fuel rose by 0.8%, with the year-on-year gain at 6.6%.

David Rosenberg, Merrill Lynch’s chief North American economist, warned in a research report that the US remained firmly in an economic recession in spite of economic growth figures to the contrary. Pointing to last week’s news that employment has now declined for six months in a row, he said that “at no time in the past 50 years has this happened without the economy being in an official recession”.

Elsewhere in the world, the Bank of England’s Monetary Policy Committee left the repo rate unchanged at 5.0% in the light of conflicting risks of rising inflation and slowing economic activity. The UK’s annual rate of inflation hit 3.3% in May, whereas the Halifax House Price Index was down 9.6% since August 2007.

The economic slowdown under way in the Eurozone was highlighted by steep declines in industrial production across the 15-country region, raising the risk of technical recessions in at least some member countries.

Further afield, Japanese consumer confidence fell to an all-time low in June, reinforcing expectations that the Bank of Japan will announce an unchanged target interest rate on July 15.

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, July 11, 2008.

In addition to the release of the minutes of the FOMC’s meeting of June 24 and 25 (July 16) and Fed Chairman Bernanke’s semi-annual monetary policy testimony in Washington (July 15 and 16), next week’s economic highlights, courtesy of Northern Trust, include the following:

1. Retail Sales (July 15): Auto sales declined to an annual rate of 13.6 million units in June from 14.3 million in May. Price-related gains in food and gasoline will dominate the non-auto retail component of retail sales in June. Overall retail sales should post a 0.4% increase while non-auto retail sales should be stronger, mostly due to higher prices. Consensus: 0.5% versus 1.0% in May; non-auto retail sales: 1.0% versus 1.2% in May.

2. Producer Price Index (July 15): The Producer Price Index for Finished Goods is expected to have risen by 0.9% in June, reflecting higher food and energy prices. The core PPI is most likely to have risen by 0.2% after a similar gain in May. Consensus: +1.4%, core PPI +0.3%.

3. Consumer Price Index (July 16): A 0.4% increase in the CPI is predicted for June following a 0.6% gain in May. Once again a food and energy story is expected in June. The core CPI is expected to have moved up 0.2%, matching the gain reported in May. Consensus: +0.6%, core CPI +0.3%.

4. Industrial Production (July 16): The 0.5% drop in the manufacturing man-hours index in June points to a soft industrial production report in June. A reversal of four monthly declines in utilities production could raise the headline but the fundamentals remain weak. Consensus: 0.0%; Capacity Utilization: 79.3 versus 79.4 in May.

5. Housing Starts (July 17): Permit extensions for new single-family homes fell by 2.2% in May. The weakness in permits and inventories of unsold new homes are indicative of fewer housing starts in June (955,000 versus 975,000 in May). Consensus: 960,000.

6. Other reports: Inventories (July 15), NAHB Survey (July 16) and factory survey of the Federal Reserve Bank of Philadelphia (July 17).

Markets
The performance chart obtained from the Wall Street Journal OnlineWall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, Julie 13, 2008.

Equities

The MSCI World Stock Index experienced a full-house of down days and declined by 1.3% during the past week as concerns about further credit-related trouble, surging inflation and deteriorating corporate earnings intensified. The MSCI has declined by 20.1% since its high on October 31, 2007, thereby meeting the “official” bear market definition of a drop in excess of 20%.

Emerging markets (+1.2%) fared relatively well as a result of strong performances from the Shanghai Composite Index (+7.0%) and the Hong Kong Hang Seng Index (+3.6%). The MSCI Emerging Markets Index has given up 22.1% since its high on October 29, 2007, resulting in sideways relative performance compared with developed markets since October last year.

The US stock markets all declined on expanding volume. The major index movements were as follows: Dow Jones Industrial Index -1.7% (YTD -16.3%), S&P 500 Index -1.9% (YTD -15.6%), Nasdaq Composite Index -0.3% (YTD 15.6%) and Russell 2000 Index +1.4% (YTD -11.9%).

The best-performing industry group was the Dow Jones Platinum & Precious Metals Index (+12.6%), whereas the DJ Mortgage Finance Index (-41.2%) performed catastrophically on the back of the Fannie Mae (FNM)/Freddie Mac (FRE) saga.

Dow components Alcoa (AA) and General Electric (GE) officially kicked off the second-quarter earnings reporting season with as-expected profit reports. The reporting season will kick up several notches next week with reports from a number of major financial and technology companies.

The final word on equities comes from Bill King (The King Report): “Stocks are grossly oversold on a short-term basis. But … in a bear market with a negatively charged environment, grossly oversold means the conditions are right for a major storm. Ergo, the stock market needs some grand act of capitulation to generate a significant rally. … the earnings reporting season might be the catalyst for capitulation. So for the time being, sit tight and wait for ‘blood in the streets’ for a buy opportunity.”

Fixed-interest instruments
Government bonds around the globe ended the week little changed from the previous Friday’s levels, although US yields kicked up on Friday as investors agonized about the prospect of increased bond issuance should the US government bring the GSEs onto the federal balance sheet.

The perceived safety of three-month US Treasury Bills resulted in rates falling sharply by 24 basis points to 1.57%. On the longer end, the ten-year US Treasury Note dropped by 5 basis points during the week to close at 3.94%. Similarly, the UK ten-year Gilt yield declined by 7 basis points to 4.90% and the German ten-year Bund yield by 4 basis points to 4.46%.

Mounting economic woes in New Zealand resulted in three-year bond yields declining by 35 basis points to 6.10% and nine-year yields by 22 basis points to 6.14%. (The All Blacks’ rugby defeat against the Springboks on Saturday happened after close of trade!)

Currencies

Concerns about the US financial sector and the realization that the Fed would not be able to raise interest rates any time soon put pressure on the dollar, causing the greenback to decline by 1.3% over the week against the euro, 0.4% against the British pound, 0.7% against the Swiss franc and 0.7% against the Japanese yen.

Efforts by the South Korean central bank to support the won resulted in the currency’s biggest rise in ten years. The Bank of Korea said it would use its $258 billion of foreign exchange reserves to defend the won in an attempt to fight escalating inflation.

Commodities
Robert Barbera, the chief economist of ITG, said in an article in The New York Times: “Recession, we believe, is firmly in place in the US and is taking hold in Europe. And recession for developed world economies will burst the bubble for commodity prices.”

The performance of commodities was a mixed bag during the past week with agricultural commodities retreating from recent highs, industrial metals (with the exception of copper) moving higher, precious metals benefiting from safe-haven buying, and oil prices challenging $150 a barrel.

US dollar weakness, together with financial and geopolitical worries, resulted in gold bullion rising by 3.0% on the week, silver by 2.5% and platinum by 0.8%.

Oil prices experienced wide swings, with West Texas Intermediate crude touching $135.14 a barrel at its low on Tuesday before rallying back to a new record high of $147.27 on Friday. The price eventually settled for the week at $145.66 – little changed from its close the previous Friday. Reports discussing military posturing on the part of Iran and Israel, coupled with ongoing supply concerns, were at the heart of last week’s trading action.

Now for a few news items and some words and charts from the investment wise that will hopefully assist in keeping head above (the very murky) water. It’s best to remain cool and collected about these markets, and not take unnecessary risks.

Hat tip: Barry Ritholtz’s The Big Picture

Barron’s: The bear’s back
“Now that the bear market has officially arrived, it may stick around and gnash its teeth for a while – until it’s scared away those who remain. Barron’s Online Editor Randall Forsyth warns investors about the bear wear. Keep cash ready, he suggests.”

Click here for the text version of this report.

Source: Randall W. Forsyth, Barron’s, July 5, 2008.

Financial Times: Paulson stands by Fannie and Freddie
“The Bush administration on Friday attempted to quash suggestions that the US government might have to nationalize Freddie Mac and Fannie Mae, the giant mortgage companies that have unsettled the financial markets.

“Hank Paulson, Treasury secretary, said: ‘Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission,’ signalling that the Bush administration was not contemplating a rescue takeover of the two groups and wanted public shareholders to continue owning them.

“Describing Freddie and Fannie as ‘very important institutions’, President George W. Bush said Mr Paulson and Ben Bernanke, head of the Federal Reserve, would be ‘working this issue very hard’.

“Chris Dodd, Democratic chairman of the Senate banking committee, on Friday also said the Fed and the Treasury were considering opening the Fed’s discount window to Fannie and Freddie.

“However, the Fed said there had been ‘no discussions’ with Fannie Mae and Freddie Mac on access to the discount window.

“Fears that Fannie and Freddie could become victims of the credit crisis have gripped investors this week. The institutions are pillars of the financial system, holding or guaranteeing nearly half of the $12,000 billion in outstanding US mortgages and three-quarters of new loans.

“Shares in both companies opened sharply lower on Friday – with Freddie down as much as 50% – but rebounding following Mr Dodd’s comments. Freddie ended the day 3.1% lower at $7.75 while Fannie fell 22.4% to close at $10.25.

“As house prices have fallen and foreclosures have soared, Fannie and Freddie have suffered deep losses, which they have tackled by raising more capital.

“Many observers believe a collapse of Fannie and Freddie could bring the US mortgage market to a complete standstill.”

Source: James Politi and Saskia Scholtes, Financial Times, July 11, 2008.

Reuters: Fed offers hand to Fannie, Freddie
“According to a Reuters source, Federal Reserve Chairman Ben Bernanke had told Freddie Mac chief Richard Syron that his company and sister firm Fannie Mae – two pillars of the American housing market – could take advantage of an emergency funding source known as the ‘discount window’.

Source: Reuters, July 11, 2008.

Charlie Rose: Conversation with JPMorgan’s Jamie Dimon

Comments on video from Paul Kedrosky (Infectious Greed):

“After watching it, go read selectively from the viewer posts – including some scathing stuff from at least one ex-JPM employee – on the Charlie Rose site. For his part, and to his credit, Dimon explicitly takes on his critics, explaining why he thinks claims of ‘moral hazard’ are wrong-headed and stupid, like refusing to save a drunk who was drowning. He also has a nice line justifying the $2 original Bear share price, saying that ‘buying a house and buying a house on fire’ are different things.

“Somewhat surprisingly, Dimon gives considerable credence to rumors that the downfall of Bear Stearns was orchestrated. He says ‘Where there’s smoke, there’s fire’, calls for an SEC investigation, and says it wouldn’t surprise him if there was more to Bear’s collapse than mere leverage.”

Source: Charlie Rose, July 7, 2008.

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View original at: Investment Postcards from Cape Town

(FNM) Words from the (investment) wise for the week that was (July 7 – 13, 2008)

Source: Lisa Benson, Slate

US stocks plummeted on Thursday after two days of gains as investors’ recent optimism was dented by renewed doubts about financials stocks, manifesting in the sector dropping 6.8% – its largest one-day decline in more than eight years.

In a rare Saturday session, the US Senate passed housing rescue legislation aimed at helping struggling homeowners avoid foreclosure and providing financial support to troubled mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE), reported TheStreet.com. The bill, which cleared the House on Wednesday, now goes to President Bush.

Reuters highlighted that US banks’ direct primary credit borrowing from the Federal Reserve rose to the highest level ever in the latest week, reflecting the growing need of the banking sector to rely on the central bank for cheap funding. On the day of July 23, banks’ primary credit borrowings rose to $17.68 billion, the highest borrowing since September 12, 2001 when banks borrowed $45.5 billion in a single day.

No wonder John Paulson, who recorded what was thought to be the single biggest profit in the history of the hedge fund industry last year by betting on a financial collapse, is planning a new fund to provide capital to cash-strapped banks.

President George W. Bush, as reported in the Financial Times, also had his take (albeit unofficial) on matters: “There’s no question about it. Wall Street got drunk … it got drunk and now it’s got a hangover. The question is how long will it sober up and not try to do all these fancy financial instruments.”

Given all the shenanigans, Richard Russell (Dow Theory Letters) thought there was too much complacency. “… I guess everybody thinks the Fed or the Treasury is going to bail the whole economy out. Why worry, if you’re in trouble, call Mr. Bernanke, and he’ll drop a bundle of Federal Reserve notes in your mail box. Be sure the box is big enough,” said Russell a day after turning a youthful 84.

Now for a new feature of this report: A tag cloud of the text of all the articles I have read during the past week. This is a way of visualizing word frequencies at a glance. It is quite obvious that the key areas last week were “bank”, “prices”, “inflation”, “oil” and “economy”. As the saying goes: A picture paints a thousand words …

Key to mapping out the intermediate stock market cycle is whether the July 15 levels for the S&P 500 Index (1,215) and Dow Jones Industrial Index (10,963) will hold. Specifically, the extent to which bank shares can sustain their moves above recent lows will be a vital determinant as to how well stock markets in general can rally from these levels. Short-term movements aside, do not expect a quick convalescence period.

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.

Economy
The Federal Reserve’s Beige Book, released on Wednesday, noted slower growth since the last report issued on June 11. Weakness in consumer industries, housing and finance offset strength in IT and healthcare. Retail and wholesale price pressures were mounting, although there was little concern yet about wage inflation.

More specifically, the past week’s economic reports in the US included the following notable releases:

• The Index of Leading Economic Indicators (LEI) fell by 0.1% in June, following a revised 0.2% drop in May. The quarterly average of LEI is down 2.0% from a year ago, the largest decline in the current business cycle. Historically, such large year-on-year declines of the quarterly average of the Index were associated with recessions.

• Weakness continues to characterize the housing market. Existing Home Sales declined by 2.6% month on month in June, according to the National Association of Realtors. Sales declined to 4.86 million annualized units. Inventories are rising and the months of inventory are about flat at 11. The median existing home price is declining, with a year-on-year drop of 6.2%, but not as severely as earlier this year.

• The Census Bureau reported a -0.6% month-on-month decrease in New Home Sales in June. However, the Bureau revised the monthly sales figures upward back to March, and thus June sales were stronger than expected at 530,000 annualized units. The median new home price declined slightly in June, as did months of inventory. Months on the market, however, are rising.

Furthermore, US foreclosure filings more than doubled in the second quarter compared to a year ago, representing an increase of 121% from a year earlier and 14% from the first quarter, according to RealtyTrac.

Summarizing the economic situation, David Rosenberg, North American economist of Merrill Lynch, said in a research report: “Though fiscal stimulus will provide a lingering boost to 3Q, we expect GDP to plummet 2.5% in 4Q and see a similar decline in 1Q. In all, we have shaved our 2009 GDP forecast to -0.5%, a full percentage point lower than where it was previously, while 2008 is broadly unchanged at 1.5%.”

As far as interest rate policy is concerned, Asha Bangalore (Northern Trust) remarked: “It is … important to recognize that the Fed is not in a position to raise rates until there is financial market stability, the housing market crisis improves, and firms decide to expand their payrolls. Concerns about economic growth will prevail over inflation, for now. In other words, tough talk about inflation will continue but it cannot be translated into action in the near term.”

Across the pond, the UK was faced with a relentless stream of negative economic news. The minutes of the Bank of England’s (BoE) monetary policy committee meeting in June showed that the BoE was struggling to balance the downward price pressures of slowing economic growth against the upward price pressures of strong oil and food price growth.

A slew of weak data also came from the Eurozone, with the RBS/Markit composite PMI dropping from 49.3 in June to 47.8 in July, the lowest since November 2001 and clearly indicating a contracting economy. It appears unlikely that the European Central Bank (ECB) will hike rates any further in the second half of this year.

Elsewhere, Japan’s trade surplus was nearly 90% lower than last year’s surplus, and core inflation ballooned to a fresh decade high of 1.9% year on year in June.

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, July 25, 2008.

Next week’s economic highlights, courtesy of Northern Trust, include the following:

1. Real GDP (July 31): Real GDP is predicted to have advanced at an annual rate of 1.5% in the second quarter, supported by consumer spending. The fiscal stimulus package accounted for the strength in consumer spending, a one-off event. Real GDP grew by 0.6% in the fourth of 2007 and by 1.0% in the first quarter of 2008. The forecast range for growth in GDP in the second quarter is 1.4% to 3.0%. This report will contain revisions for the period 2005:Q1 to 2008:Q1. Consensus: 2.4%.

2. Employment Situation (August 1): Payroll employment in July is predicted to have declined by 75,000 after a loss of 62,000 jobs in June. The forecast range is -150,000 to -10,000. The unemployment rate is projected to have risen to 5.6% in July from 5.5% in June. Consensus: Payrolls: -72,000 versus -62,000 in June, unemployment rate: 5.6% versus 5.5% in June.

3. ISM Manufacturing Survey (August 1): The consensus for the manufacturing ISM composite index is 49.2 versus 50.2 in June.

4. Other reports: Consumer Confidence (July 29), Construction Spending, Auto Sales (August 1).

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, July 27, 2008.

Equities

Global stock markets, in general, maintained their positive tone during the past week after the strong recovery of the previous week, with the Dow Jones World Index registering an increase of 0.9%.

The Japanese Nikkei 225 Average was the strongest performer among developed markets, rising by 4.2% – its biggest weekly gain for five months.

The real stars, however, were among the emerging markets, including Pakistan (+7.8%), Taiwan (+6.1%), South Korea (+5.8%), the Philippines (+5.2%), Indonesia (+4.8%) and India (+4.7%). On the other side of the scale, previous strong performers Russia (-8.6%) and Brazil (-4.7%) suffered as oil and commodities fell further.

The US stock markets were mixed, with smaller and technology stocks outperforming their larger counterparts, as shown by the major index movements: Dow Jones Industrial Index -1.1% (YTD -14.3%), S&P 500 Index -0.2% (YTD -14.3%), Nasdaq Composite Index +1.2% (YTD 12.9%) and Russell 2000 Index +2.5% (YTD -7.3%).

Click on the thumbnail below for a market map, courtesy of Finviz.com, providing a quick overview of the performance of the various segments of the S&P 500 Index over the week.

The managed healthcare group was the best performer for the week, rising by 13%. The Internet retail group was the second-best performer (+9%), led by Amazon.com (AMZN), its largest member, with better-than-expected earnings and guidance.

The thrifts and mortgage finance group was the worst-performing group, down by 14%. Washington Mutual (WM) was down 35% after it reported second-quarter losses in excess of expectations. Fannie Mae (FNM) and Freddie Mac (FRE), the two largest members of the group, were each down by more than 10%.

The consumer finance group was the second-worst performer, declining by 12%. The largest group member, American Express (AXP), reported second-quarter earnings below analysts’ consensus estimate.

Halfway through the second-quarter earnings reporting season in the US, the numbers have generally been better than feared. Of the 248 S&P 500 companies that have reported results, 72.2% have registered positive surprises, 4.8% have been in line, and 23.0% have missed expectations, according to Bloomberg.

Data from Thomson Reuters show that S&P 500 earnings so far are down by 17.9% versus a year ago, but 7.7% higher when excluding financials.

Fixed-interest instruments
Government bonds experienced a mixed week, with yields declining in countries/regions with poor economic data (Eurozone, UK, Japan) and rising where the economic numbers exceeded expectations (US – consumer sentiment, durable goods orders and new home sales).

For example, the two-year US Treasury Note increased by 6 basis points during the week to close at 2.72%, whereas the UK two-year Gilt yield declined by 11 basis points to 5.05% and the German two-year Schatz yield dropped by 10 basis points to 4.44%.

US mortgage rates also increased, with the 15-year fixed rate rising by 7 basis points to 6.05% and the 5-year ARM 16 basis points higher at 6.04%.

The three-month US Treasury Bill jumped by 35 basis points during the week to close at 1.69% as investors’ risk appetite recovered.

Credit markets eased somewhat as shown by the slightly narrower spreads of both the CDX (North American, investment grade) Index and the Markit iTraxx Europe Crossover Index.

Currencies

Currency traders’ benign view of the US economic situation, together with lower oil and commodities prices, caused the US Dollar Index to rise by 0.9%.

Individually, the greenback gained against the euro (-0.9%), the British pound (-0.3%), the Swiss franc (-1.3%), the Japanese yen (-0.9%) and the Australian dollar (-1.6%).

Commodities
Oil prices declined further during the week under review, with West Texas Intermediate sinking by 4.8% to $123.26 by Friday’s close. The crude price has declined by 16.3% since reaching a record high of $147.27 on July 11.

The correction in oil prices again weighed heavily on the entire commodities complex (especially precious metals), with traders reducing their commodities exposure on the back of mounting global growth concerns. The chart below shows the past week’s negative performance of the various commodities.

Now for a few news items and some words and charts from the investment wise that will hopefully assist in preserving our capital in these demanding times.

Source: Ken Catalino, Slate

Jon Stewart (The Daily Show): It’s the stupid economy
Jon Stewart rightfully gets confused with the various utterances about the economic outlook, and in so doing brings laughter to an otherwise serious matter.

Source: Jon Stewart, The Daily Show, July 16, 2008.

Bloomberg: Faber says Fannie, Freddie should split up, not get aid
“Marc Faber talks about the future of Fannie Mae and Freddie Mac, the global economy, and the outlook for stocks and commodities.”

Source: Bloomberg, July 23, 2008.

David Fuller (Fullermoney): Predicting the markets
“Predicting is among the most hazardous of professions, as you know, because we can only guess. Nevertheless we need to focus on these challenging questions, so here are my guesses:

“US 30-Year Treasury Bond futures – I think Bill Gross’ deficit forecast is probably right, and I also maintain that the US government will err on the side of inflation, as debtor nations invariably do. Therefore increased government borrowing is likely to face a buyers’ strike at some point, turning US 30-year T-Bonds into one of the better shorts of the decade. Tactically, I will look to short the rallies as they lose momentum.

“The US Dollar Index – While the US government does not want a currency freefall, it can ill afford a strong dollar because it needs an export led recovery. Moreover, while the dollar remains the world’s main reserve currency, the US is unlikely to kick its addictive habit of printing too many greenbacks. This will also lead to a buyers’ strike, eventually forcing the US Dollar Index lower, with an even bigger decline occurring against the Chinese renminbi and the currencies of other high-growth economies. Tactically, I will look to short rallies as they lose momentum.

“Gold – In a fiat currency world, with the main reserve unit enfeebled, and resources inflation continuing when global GDP growth increases, people everywhere will continue to regard gold as real money for investment purposes. This will eventually support an extension of bullion’s secular uptrend, once the current medium-term consolidation has been completed. Tactically, I will continue to buy following setbacks within the overall upward trend.

“Crude oil – Assuming and very much hoping that there will not be a military strike against Iran’s nuclear installations, I maintain that oil has peaked for the medium term, defined as anything from a few months to two years and occasionally even longer. However as with gold and many other resources, there is a scarcity factor for oil resulting from increasing costs of production and finite supplies of light crude. Also, demand will rise following any significant correction in prices, not least because cheaper oil will boost GDP growth. Therefore crude oil will eventually resume its secular uptrend following what I suspect will be a lengthy correction. Tactically, I would consider longs in petroleum futures and also oil drillers and equipment stocks on evidence of renewed support building following a significant setback.”

Source: David Fuller, Fullermoney, July 23, 2008.

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View original at: Investment Postcards from Cape Town

(FNM) Words from the (investment) wise for the week that was (July 21 – 27, 2008)

Furthermore, Treasury Secretary Henry Paulson’s plan to rescue the Government Sponsored Enterprises (GSEs), Fannie Mae (FNM) and Freddie Mac (FRE), left investors unconvinced.

The US government plan caused some agitation since Paulson was essentially asking for a blank check to ensure the funding backstop would be successful in helping the GSEs fulfill their role of providing financing for the US mortgage market. Debt holders were happy with the implications of the plan, but equity holders faced the possible dilution from a government purchase of the equity and/or the possibility of the equity becoming worthless.

As the credit crisis approached its first anniversary – literally a “year of living dangerously” – SEC Chairman Christopher Cox’s announcement that naked short selling of 19 financial companies, including the GSEs, would no longer be allowed, set the stage for a reversal of fortune.

The SEC’s announcement, together with a sharp drop in oil prices and a series of better-than-feared earnings announcements from US banks – including JPMorgan (JPM), Citigroup (C) and Wells Fargo (WFC) – triggered a recovery in investors’ risk appetite, resulting in a strong stock market rebound.

This type of event was precisely what Charles Kirk (The Kirk Report) was referring to when he said: “Technically, we are scraping against the bottom of the long-term trend channel in the S&P 500 but we need something to go right for a change for this constant selling pressure to end.”

Fed Chairman Ben Bernanke was in the hot seat on Tuesday, delivering his semi-annual monetary policy testimony before the Senate Banking Committee in Washington. In short, he abandoned his June assessment that the threat of an economic downturn had diminished, telling lawmakers that growth and inflation risks were increasing. There were “significant downside risks to the outlook for growth”, and “upside risks to the inflation outlook had intensified”, said Bernanke. His testimony had little impact on financial markets.

“So is the decline over?” asked Richard Russell (Dow Theory Letters). “I’ve said that I can’t see the market hitting bottom until at least the financials stop declining. Did the financials make the crucial turn to the upside yesterday? We should know shortly.”

David Fuller (Fullermoney) adds: “There is still plenty of fear and uncertainty out there. However, I think most stock markets have reached medium-term lows and should range higher in tradable rallies over at least the next month or two.”

On the other hand, Bill King (The King Report) sees more pain: “For about one year we tried to make two points: 1) If you’re not scared, you’re not doing your work; and 2) If you aren’t negative, there is no fathomable non-violent environment that would make you negative.”

In my opinion, it’s too soon to call a major market bottom, but the short-term picture has certainly improved for the better. Technical rallies aside, I still believe the convalescence period will not be an overnight affair. Why is it that Cat Stevens’ lyrics “… oh baby baby it’s a wild world …” keep mulling through my head?

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.

Economy

“Global business confidence has remained in a tight range since late May consistent with a global economy that is barely growing. Developed economies including the US, Europe and Japan are contracting moderately, while most developing economies are expanding moderately,” reported the Survey of Business Confidence of the World conducted by Moody’s Economy.com.

A barrage of economic reports was released in the US over the past week (as summarized in the table below), none of which changed the outlook for economic growth, housing and inflation in any meaningful way.

Regarding the outlook for interest rates, Asha Bangalore (Northern Trust) said: “Chairman Bernanke’s testimony suggested that the Fed is on hold, for now. The Fed is in a tight spot and the best it can do in the months ahead is to help stabilize financial market conditions, with one of the prerequisites for this being an accommodative stance … given the backdrop of a housing market recession, a credit crunch, and weak real consumer spending.”

No short-term remedy for the economic woes exists, as John Mauldin (Thoughts from the Frontline) stated: “… we are in for a period of very tepid growth that will last through at least 2009. We have to work our way through the after-effects of the twin bubbles of housing and the credit crisis bursting. There is no magic Fed wand. That simply takes time. No (rational) government or Fed policy is going to change the facts on the ground (although they can make things worse). But, in the fullness of time, we will in fact get through this.”

It was not only in the US that surging inflation was on centre stage, but elsewhere in the world Thailand, Mexico, the Philippines and Turkey increased interest rates in reaction to mounting inflationary pressures.

Mildly good news, however, was that Chinese consumer price inflation declined from 7.7% in May to 7.1% last month, whereas the economy grew by 10.1% in the second quarter, down from 10.6% in the first – the fourth successive quarter in which growth has slowed and the lowest rate since the last quarter of 2005.

The annual rate of Eurozone consumer price inflation in June was 4% while last month prices in the UK rose by 3.8% in year-ago terms. Both figures were significantly higher than the European Central Bank and Bank of England’s inflation targets.

As widely anticipated, the Bank of Japan left the overnight call rate target at 0.5% following last week’s two-day monetary policy meeting.

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, July 18, 2008.

Next week’s economic highlights, courtesy of Northern Trust, include the following:

1. Leading Indicators (July 21): Interest rate spread and supplier deliveries are the only two components likely to make a positive contribution in June. Stock prices, initial jobless claims, manufacturing work week, consumer expectations, real money supply and building permits are expected to make negative contributions. Forecasts of money supply and orders of consumer durables and non-defense capital goods are used in the initial estimate of the leading index. Consensus: -0.1%

2. Existing Sales (July 24): The market consensus is a decline in sales of existing homes during June to an annual rate of 4.94 million from 4.99 million in May. Existing home sales have dropped by 15.9% from a year ago. The largest year-to-year decline in the current business cycle is a 23.8% drop in February 2008. Consensus: 4.94 million versus 4.99 million in May.

3. New Home Sales (July 25): Sales of new homes are expected to post a drop in June to an annual rate of 505,000 from 512,000 in May.

4. Other reports: Consumer Sentiment Index (July 25).

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, July 21, 2008.

Equities

Global stock markets staged a strong recovery last week after having declined for six consecutive weeks. The Dow Jones World Index registered an increase of 0.9% for the week, after a positive about-turn on Wednesday as a result of a dramatic slide in oil prices, better-than-feared earnings numbers for a number of US banks, and the SEC’s moves to curb short selling of certain financial firms.

The Japanese Nikkei 225 Average (-1.8%) was the only developed market not participating in the rally and shared this dubious honor with emerging markets in general (-2.0%). Pakistan (-12.5%), Thailand (-9.0%), Indonesia (-7.2%), Taiwan (-5.9) and South Korea (-3.7%) all had a torrid time, with Turkey (+8.4%) being one of the few emerging markets gaining ground.

The US stock markets all improved, as shown by the major index movements: Dow Jones Industrial Index +3.6% (YTD -13.3%), S&P 500 Index +1.7% (YTD -14.1%), Nasdaq Composite Index +2.0% (YTD 13.9%) and Russell 2000 Index +2.7% (YTD -9.5%).

Four financial industry groups were among the top ten performers in the US this week: other diversified financial services (large banks), thrifts and mortgage finance, diversified banks, and investment banks and brokers were up 22%, 18%, 16% and 15% respectively. The homebuilding group (+19%) was also among the outperformers.

On the red side of the scale, the coal and consumable fuel group (-18%) was the worst performer, selling off in sympathy with declining prices of crude oil and natural gas. Similarly, other oil- and gas-related groups (integrated oil and gas, oil and gas exploration and production, and gas utilities) underperformed.

Click on the thumbnail below for a market map, courtesy of Finviz.com, providing a quick overview of the performance of the various segments of the S&P 500 Index over the week.

As far as specific companies were concerned, Wells Fargo (WFC) added to the spark that fueled the rally in financials. The company delivered better-than-expected earnings, accompanied by an announcement of a 10% increase in the annual dividend.

The coming week will be another busy week of earnings reporting and should provide some clarity on whether last week’s good numbers were an aberration or perhaps the start of a new trend.

Fixed-interest instruments
Government bonds experienced a volatile week, with yields benefiting from safe-haven buying early in the week, but then rising as investors switched from bonds to equities.

Yields kicked up as investors agonized about accelerating inflation throughout the world. The ten-year US Treasury Note increased by 13 basis points during the week to close at 4.09. Similarly, the UK ten-year Gilt yield rose by 14 basis points to 5.04% and the German ten-year Bund yield by 12 basis points to 4.58%.

US mortgage rates also increased sharply, with the 15-year fixed rate rising by 22 basis points to 5.98% and the 5-year ARM 20 basis points higher at 5.88%.

Credit markets eased somewhat as shown by the slightly narrower spreads of both the CDX (North American, investment grade) Index and the Markit iTraxx Europe crossover Index.

Currencies

The US dollar fell to a record low of $1.6038 against the euro before reversing course and improving in line with US stock markets. Expressed against a basket of currencies, the greenback ended the week 0.4% higher.

Individually, the dollar gained against the euro (-0.6%), the Swiss franc (-0.7%) and the Japanese yen (-0.7%). The last-mentioned two currencies were negatively affected by less risk-averse investors seeking higher yields elsewhere. The British pound (+0.4%) confounded pundits and was the only major currency making headway against the dollar.

Thailand and the Philippines raised interest rates in an attempt to combat inflation, resulting in the baht (+0.9%) and the peso (+2.9%) gaining against the dollar.

Commodities
In the midst of all of the action last week, oil prices corrected sharply. After touching $146.37 at its high on Monday, West Texas Intermediate ended Tuesday’s session at $138.74. The selling persisted for the remainder of the week, with prices settling at $134.60 on Wednesday, $129.29 on Thursday and $128.96 on Friday. The latter price marked an 11.2% decline from the previous week’s close.

Worries about demand destruction, an easing of geopolitical tensions and bearish oil and natural gas inventory reports all played a role in driving prices lower.

The sharp pull-back in oil prices weighed on the entire commodities complex. The chart below shows the past week’s negative performance of the various commodities.

In summary, although the near-term outlook has improved and the long-awaited technical stock market rally has probably commenced, it is premature to cast caution to the wind. Now for a few news items and some words and charts from the investment wise that will hopefully assist in navigating the topsy-turvy markets.

Source: Gary Varvel, Slate, July 16, 2008.

Goldman Sachs: Macro-economic themes for 2nd half of 2008

“We have left a volatile first half of the year behind us and now need to determine what we think will happen in the 2nd half of 2008. It is clear that a number of themes that we saw in the first half of this year did not end on the 30th June but continue to dominate the economic environment:

“Renewed pressure on the US consumer – The ongoing deterioration in the housing, labour, equity and consumer financing markets will force US consumers to tighten their purse, which they, surprisingly, have kept open over the last six months. We believe that this was because they spent their tax rebate in the past months.

“Continuing losses and capital raises by the global financial sector – Our equity analysts believe that the peak of credit losses globally will be in the first quarter of 2009. In the meantime, we will continue to see write-offs and requirements for new capital by financial institutions in Europe and the US.

“Slower growth in Europe – The high euro and higher interest rates are starting to have a negative impact of the data that is coming out of the Eurozone. The UK is showing mounting signs that a recession may hit the economy.

“Inflation pressures to recede but risks to renewed pressure – Slower global growth will in our opinion lead to lower global inflation (from 5.6% to 4.2% in 2009) with inflation in the advanced economies falling below 3% and emerging markets from ~9% to ~6%. The risks to this view are commodity prices and inflation expectations which make this forecast one which we are monitoring very closely.

“Softer growth and lower inflation in China – Inflation data from China has shown a moderation (from 9% to 7% now) and we believe it will be about 5% by year end. This will help global inflation. We forecast Chinese growth to moderate from around 12% in the last two years to 10% in 2008 and 2009.

“Central banks balancing policy between inflation and growth – Central banks are having to chose between stimulating growth or tightening monetary policy to prevent inflation from running away. We believe the ECB and Fed will keep rates on hold for the rest of the year (based on our moderating inflation view). A number of emerging market policy makers appear to be behind the curve and this could create more broad-based problems if no action is taken.”

Click here for the full report.

Source: Goldman Sachs, July 16, 2008.

MarketWatch: Text of Paulson statement on Fannie, Freddie
“Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction.

“GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets. Therefore we must take steps to address the current situation as we move to a stronger regulatory structure.

“In recent days, I have consulted with the Federal Reserve, OFHEO, the SEC, Congressional leaders of both parties and with the two companies to develop a three-part plan for immediate action. The President has asked me to work with Congress to act on this plan immediately.

“First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.

“Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed.

“Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer.

“Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator’s process for setting capital requirements and other prudential standards.

“I look forward to working closely with the Congressional leaders to enact this legislation as soon as possible, as one complete package.”

Source: MarketWatch, July 13, 2008.

Bloomberg: Rogers calls Fannie, Freddie rescue plan a “disaster”
“Jim Rogers talks with Bloomberg from Singapore about the US government’s efforts to bolster Fannie Mae and Freddie Mae, the outlook for financial stocks, the dollar and commodities, and his investment strategy.”

Click here for the full article.

Source: Bloomberg, July 14, 2008.

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View original at: Investment Postcards from Cape Town

(FNM) Words from the (investment) wise for the week that was (July 14 – 20, 2008)

Markets had investors feeling dazed and confused after another roller-coaster week amid further evidence of the deteriorating health of the US financial sector and a renewed rise in oil prices. Adding to the pain, Barron’s Randall Forsyth said: “Now that the bear market has officially arrived, it may stick around and gnash its teeth for a while – until it’s scared away those who remain.”

Government Sponsored Enterprises (GSEs) Fannie Mae (FNM) and Freddie Mac (FRE) were the main sources of volatility for the market, as speculation was rampant that they were destined for a government bail-out despite numerous assurances from government officials and their regulator that they were adequately capitalized. Between them, these enterprises own or guarantee about half of the $12,000 billion of outstanding US home loans.

Henry Paulson, Treasury secretary, downplayed a government takeover, saying: “Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission.” (And “tomorrow”, Mr Paulson?) Describing Fannie and Freddie as “very important institutions”, President George W. Bush said the nation’s top economic officials would be “working this issue very hard”.

A Reuters report on Friday cited a source as saying that Fed Chairman Ben Bernanke had told the GSEs they would be eligible to borrow from the Fed’s discount window. However, the Fed said there had been “no discussions” with Fannie and Freddie on access to the discount window.

Separately, Bernanke suggested that the “temporary” Term Auction Facility to Wall Street might be extended into 2009. Bill King (The King Report) did not find this particularly reassuring, asking: “… isn’t this evidence that there is something very wrong in the financial system and it is troubling to solons?”

This is a nasty market and, irrespective of oversold and short-covering-induced technical rallies, one’s emphasis should be on the return of capital rather than on the return on capital. There is an old and appropriate saying, “I’d rather be out of the market wishing I were in than in the market wishing I were out.”

GMO’s Jeremy Grantham echoed that the key to surviving bear markets was capital preservation. You want to “live to fight another day. You may see amazingly cheap asset opportunities in the next couple of years as distressed pricing might become more commonplace. It would be nice to have the money to take advantage.”

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance round-up.

Economy
“… developed economies including the US, Europe and Japan are contracting moderately, while most developing economies are expanding moderately. On net, the global economy is growing, albeit barely,” reported the Survey of Business Confidence of the World conducted by Moody’s Economy.com. “Pricing pressures spurted higher again last week and is approaching a new record high.”

Against the backdrop of what happened with GSEs, and the financial sector as a whole, US market participants paid less attention to fresh economic data. However, the past week’s economic reports included the following notable releases:

• Pending home sales for May slipped 4.7% from April. The main message is that the bottom of home sales is not here after sales of existing homes peaked in September 2005. The fact that there is a large inventory of unsold homes in the market place suggests that additional declines of home prices should follow.

• Initial jobless claims fell by 58,000 to 346,000 during the week ended July 5. However, the sharp drop reflects the shortened week due to the July 4 holiday and distortions arising from auto retool shutdowns in the summer. The decline in initial claims is a distortion and is not an indicator of a marked improvement in labor market conditions.

• Chain store sales rose by 4.3% in June, well ahead of expectations, thanks to the spending of tax rebates. Rising gasoline prices also played a role in the strength, lifting sales at warehouse clubs. Discounters performed particularly well as financially pressed consumers focused on necessities and lower-priced goods.

• The nominal trade deficit narrowed to $59.8 billion in May from $60.5 billion in April. In terms of the impact on GDP, the inflation-adjusted trade deficit of goods was nearly $90 billion in the April-May period compared with a $102 billion in the first two months of the first quarter, suggesting that trade will have a positive influence on the second quarter GDP.

• Prices of imported goods continued to advance in June, which is problematic for the Fed. The import price index rose by 2.6% in June, reflecting higher prices for petroleum and non-petroleum imports. The price index of petroleum imports moved up 7.4%, putting the overall quarterly gain at 24.4% and the year-on-year gain at 20.5%. Import prices excluding fuel rose by 0.8%, with the year-on-year gain at 6.6%.

David Rosenberg, Merrill Lynch’s chief North American economist, warned in a research report that the US remained firmly in an economic recession in spite of economic growth figures to the contrary. Pointing to last week’s news that employment has now declined for six months in a row, he said that “at no time in the past 50 years has this happened without the economy being in an official recession”.

Elsewhere in the world, the Bank of England’s Monetary Policy Committee left the repo rate unchanged at 5.0% in the light of conflicting risks of rising inflation and slowing economic activity. The UK’s annual rate of inflation hit 3.3% in May, whereas the Halifax House Price Index was down 9.6% since August 2007.

The economic slowdown under way in the Eurozone was highlighted by steep declines in industrial production across the 15-country region, raising the risk of technical recessions in at least some member countries.

Further afield, Japanese consumer confidence fell to an all-time low in June, reinforcing expectations that the Bank of Japan will announce an unchanged target interest rate on July 15.

WEEK’S ECONOMIC REPORTS

Source: Yahoo Finance, July 11, 2008.

In addition to the release of the minutes of the FOMC’s meeting of June 24 and 25 (July 16) and Fed Chairman Bernanke’s semi-annual monetary policy testimony in Washington (July 15 and 16), next week’s economic highlights, courtesy of Northern Trust, include the following:

1. Retail Sales (July 15): Auto sales declined to an annual rate of 13.6 million units in June from 14.3 million in May. Price-related gains in food and gasoline will dominate the non-auto retail component of retail sales in June. Overall retail sales should post a 0.4% increase while non-auto retail sales should be stronger, mostly due to higher prices. Consensus: 0.5% versus 1.0% in May; non-auto retail sales: 1.0% versus 1.2% in May.

2. Producer Price Index (July 15): The Producer Price Index for Finished Goods is expected to have risen by 0.9% in June, reflecting higher food and energy prices. The core PPI is most likely to have risen by 0.2% after a similar gain in May. Consensus: +1.4%, core PPI +0.3%.

3. Consumer Price Index (July 16): A 0.4% increase in the CPI is predicted for June following a 0.6% gain in May. Once again a food and energy story is expected in June. The core CPI is expected to have moved up 0.2%, matching the gain reported in May. Consensus: +0.6%, core CPI +0.3%.

4. Industrial Production (July 16): The 0.5% drop in the manufacturing man-hours index in June points to a soft industrial production report in June. A reversal of four monthly declines in utilities production could raise the headline but the fundamentals remain weak. Consensus: 0.0%; Capacity Utilization: 79.3 versus 79.4 in May.

5. Housing Starts (July 17): Permit extensions for new single-family homes fell by 2.2% in May. The weakness in permits and inventories of unsold new homes are indicative of fewer housing starts in June (955,000 versus 975,000 in May). Consensus: 960,000.

6. Other reports: Inventories (July 15), NAHB Survey (July 16) and factory survey of the Federal Reserve Bank of Philadelphia (July 17).

Markets
The performance chart obtained from the Wall Street Journal OnlineWall Street Journal Online shows how different global markets performed during the past week.

Source: Wall Street Journal Online, Julie 13, 2008.

Equities

The MSCI World Stock Index experienced a full-house of down days and declined by 1.3% during the past week as concerns about further credit-related trouble, surging inflation and deteriorating corporate earnings intensified. The MSCI has declined by 20.1% since its high on October 31, 2007, thereby meeting the “official” bear market definition of a drop in excess of 20%.

Emerging markets (+1.2%) fared relatively well as a result of strong performances from the Shanghai Composite Index (+7.0%) and the Hong Kong Hang Seng Index (+3.6%). The MSCI Emerging Markets Index has given up 22.1% since its high on October 29, 2007, resulting in sideways relative performance compared with developed markets since October last year.

The US stock markets all declined on expanding volume. The major index movements were as follows: Dow Jones Industrial Index -1.7% (YTD -16.3%), S&P 500 Index -1.9% (YTD -15.6%), Nasdaq Composite Index -0.3% (YTD 15.6%) and Russell 2000 Index +1.4% (YTD -11.9%).

The best-performing industry group was the Dow Jones Platinum & Precious Metals Index (+12.6%), whereas the DJ Mortgage Finance Index (-41.2%) performed catastrophically on the back of the Fannie Mae (FNM)/Freddie Mac (FRE) saga.

Dow components Alcoa (AA) and General Electric (GE) officially kicked off the second-quarter earnings reporting season with as-expected profit reports. The reporting season will kick up several notches next week with reports from a number of major financial and technology companies.

The final word on equities comes from Bill King (The King Report): “Stocks are grossly oversold on a short-term basis. But … in a bear market with a negatively charged environment, grossly oversold means the conditions are right for a major storm. Ergo, the stock market needs some grand act of capitulation to generate a significant rally. … the earnings reporting season might be the catalyst for capitulation. So for the time being, sit tight and wait for ‘blood in the streets’ for a buy opportunity.”

Fixed-interest instruments
Government bonds around the globe ended the week little changed from the previous Friday’s levels, although US yields kicked up on Friday as investors agonized about the prospect of increased bond issuance should the US government bring the GSEs onto the federal balance sheet.

The perceived safety of three-month US Treasury Bills resulted in rates falling sharply by 24 basis points to 1.57%. On the longer end, the ten-year US Treasury Note dropped by 5 basis points during the week to close at 3.94%. Similarly, the UK ten-year Gilt yield declined by 7 basis points to 4.90% and the German ten-year Bund yield by 4 basis points to 4.46%.

Mounting economic woes in New Zealand resulted in three-year bond yields declining by 35 basis points to 6.10% and nine-year yields by 22 basis points to 6.14%. (The All Blacks’ rugby defeat against the Springboks on Saturday happened after close of trade!)

Currencies

Concerns about the US financial sector and the realization that the Fed would not be able to raise interest rates any time soon put pressure on the dollar, causing the greenback to decline by 1.3% over the week against the euro, 0.4% against the British pound, 0.7% against the Swiss franc and 0.7% against the Japanese yen.

Efforts by the South Korean central bank to support the won resulted in the currency’s biggest rise in ten years. The Bank of Korea said it would use its $258 billion of foreign exchange reserves to defend the won in an attempt to fight escalating inflation.

Commodities
Robert Barbera, the chief economist of ITG, said in an article in The New York Times: “Recession, we believe, is firmly in place in the US and is taking hold in Europe. And recession for developed world economies will burst the bubble for commodity prices.”

The performance of commodities was a mixed bag during the past week with agricultural commodities retreating from recent highs, industrial metals (with the exception of copper) moving higher, precious metals benefiting from safe-haven buying, and oil prices challenging $150 a barrel.

US dollar weakness, together with financial and geopolitical worries, resulted in gold bullion rising by 3.0% on the week, silver by 2.5% and platinum by 0.8%.

Oil prices experienced wide swings, with West Texas Intermediate crude touching $135.14 a barrel at its low on Tuesday before rallying back to a new record high of $147.27 on Friday. The price eventually settled for the week at $145.66 – little changed from its close the previous Friday. Reports discussing military posturing on the part of Iran and Israel, coupled with ongoing supply concerns, were at the heart of last week’s trading action.

Now for a few news items and some words and charts from the investment wise that will hopefully assist in keeping head above (the very murky) water. It’s best to remain cool and collected about these markets, and not take unnecessary risks.

Hat tip: Barry Ritholtz’s The Big Picture

Barron’s: The bear’s back
“Now that the bear market has officially arrived, it may stick around and gnash its teeth for a while – until it’s scared away those who remain. Barron’s Online Editor Randall Forsyth warns investors about the bear wear. Keep cash ready, he suggests.”

Click here for the text version of this report.

Source: Randall W. Forsyth, Barron’s, July 5, 2008.

Financial Times: Paulson stands by Fannie and Freddie
“The Bush administration on Friday attempted to quash suggestions that the US government might have to nationalize Freddie Mac and Fannie Mae, the giant mortgage companies that have unsettled the financial markets.

“Hank Paulson, Treasury secretary, said: ‘Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission,’ signalling that the Bush administration was not contemplating a rescue takeover of the two groups and wanted public shareholders to continue owning them.

“Describing Freddie and Fannie as ‘very important institutions’, President George W. Bush said Mr Paulson and Ben Bernanke, head of the Federal Reserve, would be ‘working this issue very hard’.

“Chris Dodd, Democratic chairman of the Senate banking committee, on Friday also said the Fed and the Treasury were considering opening the Fed’s discount window to Fannie and Freddie.

“However, the Fed said there had been ‘no discussions’ with Fannie Mae and Freddie Mac on access to the discount window.

“Fears that Fannie and Freddie could become victims of the credit crisis have gripped investors this week. The institutions are pillars of the financial system, holding or guaranteeing nearly half of the $12,000 billion in outstanding US mortgages and three-quarters of new loans.

“Shares in both companies opened sharply lower on Friday – with Freddie down as much as 50% – but rebounding following Mr Dodd’s comments. Freddie ended the day 3.1% lower at $7.75 while Fannie fell 22.4% to close at $10.25.

“As house prices have fallen and foreclosures have soared, Fannie and Freddie have suffered deep losses, which they have tackled by raising more capital.

“Many observers believe a collapse of Fannie and Freddie could bring the US mortgage market to a complete standstill.”

Source: James Politi and Saskia Scholtes, Financial Times, July 11, 2008.

Reuters: Fed offers hand to Fannie, Freddie
“According to a Reuters source, Federal Reserve Chairman Ben Bernanke had told Freddie Mac chief Richard Syron that his company and sister firm Fannie Mae – two pillars of the American housing market – could take advantage of an emergency funding source known as the ‘discount window’.

Source: Reuters, July 11, 2008.

Charlie Rose: Conversation with JPMorgan’s Jamie Dimon

Comments on video from Paul Kedrosky (Infectious Greed):

“After watching it, go read selectively from the viewer posts – including some scathing stuff from at least one ex-JPM employee – on the Charlie Rose site. For his part, and to his credit, Dimon explicitly takes on his critics, explaining why he thinks claims of ‘moral hazard’ are wrong-headed and stupid, like refusing to save a drunk who was drowning. He also has a nice line justifying the $2 original Bear share price, saying that ‘buying a house and buying a house on fire’ are different things.

“Somewhat surprisingly, Dimon gives considerable credence to rumors that the downfall of Bear Stearns was orchestrated. He says ‘Where there’s smoke, there’s fire’, calls for an SEC investigation, and says it wouldn’t surprise him if there was more to Bear’s collapse than mere leverage.”

Source: Charlie Rose, July 7, 2008.

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View original at: Investment Postcards from Cape Town

(FNM) Words from the (investment) wise for the week that was (July 7 – 13, 2008)