Third Bear Fund Has Problems

From the WSJ:

Bear Stearns Cos., already forced to shut two hedge funds that bet heavily on the risky subprime-mortgage market, is now facing big losses in a third fund that has roughly $900 million in mortgage investments, according to people familiar with the matter.

The fund, known as the Bear Stearns Asset-Backed Securities Fund, ran into trouble in July and has refused to return investors' money for the moment, according to these people. One of these people said the redemption requests were postponed in hopes that the fund's assets would rebound in value. The fund contains a range of mortgages, but only a small slice of them that are considered subprime, the area that has given so many firms heartburn in recent weeks. Unlike the two other Bear funds that are being closed, this fund is not leveraged.

The asset-backed fund was up about 5% between the beginning of the year and the end of June according to these people. But faced with a slew of mortgage markdowns in July, its performance appears to have plummeted. It is not known how much, if anything, Bear owns of the fund. Its shares were down about 5% Tuesday, to $121.22.

And the hits just keep coming, don't they?

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Market Takes Another Dive

The reason?

American Home Mortgage Investment Corp. shares plunged 90 percent after the lender said it doesn't have cash to fund new loans, stranding thousands of home buyers and putting the company on the brink of failure.

Investment banks cut off credit lines, leaving American Home without money yesterday for $300 million of mortgages it had already promised, the Melville, New York-based company said in a statement today. It anticipates that $450 million to $500 million of loans probably won't get funded today, and the lender may have to sell off its assets.

``They can't function without access to capital,'' said Bose George, an analyst with KBW Inc. in New York. ``The company either has to file for bankruptcy or go through some type of rescue or restructuring, and either way will leave almost nothing for the common shareholders.''

And here's the result:

U.S. stocks fell after troubled American Home Mortgage Investment Corp. said it lacks cash to fund new loans and traders speculated Apple Inc. will cut production of its widely touted iPhone. The Standard & Poor's 500 Index posted its biggest monthly decline in three years.

Lehman Brothers Holdings Inc., Bear Stearns Cos. and Goldman Sachs Group Inc. led the brokerage industry to a 10-month low because the prospect of American Home liquidating assets threatened to depress the value of mortgage securities traded on Wall Street. The concern that Apple overestimated demand for its unique mobile telephone helped send the S&P 500 Information Technology Index to its lowest level since March.

The Dow Jones Industrial Average erased a gain of 140 points and fell 146.32, or 1.1 percent, to 13,211.99. The S&P 500 slipped 18.64, or 1.3 percent, to 1455.27. The Nasdaq Composite Index slumped 37.01, or 1.4 percent, to 2546.27.

``Anyone invested in the market is struggling because their portfolio is underperforming and they are wondering how long this is going to last,'' said Sam Rahman, who oversees $1.3 billion as head of U.S. equities at Baring Asset Management Inc. in Boston.

Let's see what the charts look like. The daily, 5-minute chart shows the damage from the announcement. The only good thing about this chart is the lack of big volume spikes on the way down.



Here's the 5-day, 5-minute chart. We're right back where we were at the beginning of the week.



And here's the three month chart. Again, about the only good thing about today's sell-ff is the volume spike wasn't as high as the end of last week and the SPYs are still above the 200-day SMA.

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Construction Spending Decreaces .3%

From the Census Bureau

In billions, total construction spending dropped .3%, from a seasonally adjusted annual rate of $1,178,436 to $1,175,425. Nonresidential spending increase .1% while residential spending dropped .7%.

On the nonresidential side, the biggest drop occurred in communication construction, which dropped 2.2%. Power construction dropped 1.3% and highway/street construction dropped 1.1%.

It's important to recognize that nonresidential spending has increased from 46% of total construction spending a year ago to 53% last month. This is probably a primary reason why construction employment had not dropped despite the drop in residential construction.

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Consumer Spending Slowing, Core Inflation Tame

From Bloomberg:

Consumer spending in the U.S. increased in June at the slowest pace in nine months as near- record gasoline prices and falling home values forced Americans to cut back.

The 0.1 percent rise in spending followed a 0.6 percent increase in May, the Commerce Department said today in Washington. The increase matched the median forecast of economists surveyed by Bloomberg News. The Federal Reserve's preferred measure of inflation rose less than forecast.

Consumer spending, which accounts for more than two-thirds of the economy, will cede its role as a mainstay of the expansion as increases in exports and business investment propel a rebound in manufacturing. At the same time, more jobs and rising incomes will prevent spending from slowing even more, economists said.

From CBS:

Core consumer inflation increased 0.1% for the fourth consecutive month in June, pushing the yearly gain in core inflation down to the lowest level in three years, the Commerce Department said Tuesday.

The core personal consumption price index rose 1.9% in the past year, the lowest inflation since early 2004, and just within the Federal Reserve's unofficial comfort zone of 1% to 2% for core inflation. Core inflation excludes volatile food and energy prices. Read the full government report.

Overall inflation also increased 0.1% in June, the lowest monthly inflation since November. Overall inflation is up 2.3% in the past year.

Expect to start hearing more talk about a Fed rate cut because of these inflation numbers. I still don't think that is a possibility right now. The Fed is still focusing on inflation and monitoring all incoming data.

There are two charts that are really important from this report. The first is the total dollar amount of personal consumption expenditures at seasonally adjusted annual rates. The amounts are expressed in 2000 chained dollars. Notice they have pretty much stagnated over the last 5 months.



Here is the month-to-month percentage change in chained 2000 dollar PCEs. Notice how these numbers are also slowing.



Consumer spending grew 1.5% in the last GDP report. If we continue to see these kind of numbers, don't expect an increase in the near future.

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A Summary Of Yesterday's Subprime Action

From the LA Times:

• Mortgage insurers MGIC Investment Corp. and Radian Group Inc. said they might write off their combined $1.03-billion stake in a venture that invests in sub-prime mortgages on which payments were past due.

• American Home Mortgage Investment Corp., which lends to people close to the sub-prime category, postponed payment of its dividend, took "major" write-downs and said its lenders were demanding that it put up more cash. Its stock plunged 39%.

• Insurer CNA Financial Corp. wrote down $20 million in sub-prime-backed securities.

• A German bank with U.S. sub-prime exposure cut its profit forecast and replaced its chief executive.

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Foreclosures Increasing At High Rates

From the AP:

In all, 573,397 properties across the nation reported some sort of foreclosure activity in the first half of this year, including receiving notices of default, auction sale notices or being repossessed by lenders, Irvine-based RealtyTrac Inc. said.

That was 58 percent higher than the 363,672 properties in the first six months of 2006 and 32 percent higher than the 433,504 in the last six months of 2006.

"We could easily surpass 2 million foreclosure filings by the end of the year, which would represent a year-over-year increase of over 65 percent," said RealtyTrac CEO James J. Saccacio.

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We've Still Got Problems

From the WSJ:

Sowood Capital Management told its investors that the hedge-fund firm suffered dramatic losses of more than 50% this month and that it will wind down its two funds -- becoming the most high-profile player to be cut down by the troubles roiling many parts of the bond market.

The losses dropped the Boston hedge-fund firm's assets to about $1.5 billion from what had been $3 billion, the firm told investors in a letter. Sowood, which was started by Jeffrey Larson, who helped pick investments for Harvard Management Co. before launching his own hedge-fund firm, said it will distribute its remaining cash to investors, closing down the hedge-fund firm.

.....

The Citadel transaction, likely worth hundreds of millions of dollars, is a sign that for all the recent troubles in the markets, and losses at a number of big investors, there remains ample money on the sidelines waiting to step in to buy cheap assets. That is potentially bullish for the markets.

And from the WSJ:

GMAC Financial Services, General Motor Corp.'s part-owned financing arm, reported a 63% drop in second-quarter profit as its Residential Capital LLC home-lending unit weighed on results, though the losses from the unit narrowed markedly from the first quarter.

The company, which significantly scaled back its nonprime portfolio during the quarter, said it expects continued improvement in earnings performance in the second half.

"We are encouraged to see that the aggressive risk-mitigation initiatives implemented in the first half of this year have reduced ResCap's losses -- quickly and significantly -- despite increasing challenges in the U.S. mortgage market," said GMAC Chief Executive Eric Feldstein.

We're going to be hearing stories like this for the foreseeable future. The question now becomes will these stories have an impact on trading sentiment? There is no firm answer for that. On one hand, the markets are now more braced for news like this, but on the other hand there is a limit to how much bad news a market can take. Add to that the temperamental nature of the investing public -- especially during volatile news periods -- and you have a rough patch ahead.

I've said that I expect the markets to weather the subprime storm, but there will be at least 3-5 big casualties. Now we have two big casualties.

The last sentence in the first article is key. So long as illiquid funds can be purchased by vulture investors, we'll be fine. Note how quickly that transaction occurred. My guess is there were a few harried back-phone calls, but everything eventually ended up OK.

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The Housing Crisis

Those of you who believe Gordon Brown's promise that he will help improve the housing crisis in Britain, may care to to refer to Andrew Gilligan's report on Channel 4's Dispatches last night.

In it he revealed a sorry tale of corruption, lies and underhand dealings between local councils and property developers.

There is absolutely no chance in hell that the property crisis will be alleviated, as long as these practices are allowed to continue.

See The FT for some background.

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Today's Market Action

OK -- We had a nice rebound in the market today. Here's a 5-minute chart of today's action. The market started rallying about 11 AM. It sold-off a bit at the end, but that's to be expected after a strong rally like today's.



But let's not get ahead of ourselves. Here's a 7-day 10-minute chart. It shows that today's action was a nice upswing, but we have a lot of ground to make-up.



And here's the daily chart. We had decent volume, but the last two days we had a ton of selling, so today's action should be placed in that perspective. The index did rebound off its 200 day SMA which is a good sign. But today's action can be attributed as much to a technical bounce as anything. We need to see how the week plays out before we start popping the champaign corks.

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GDP Report Leads To Questions About Future Growth

On Friday, the BEA reported that second quarter GDP came in at 3.4%. Now it appears the debate is if this pace is sustainable.

There are a few points to make regarding this debate.

1.) Probably the best way to look at the second quarter GDP report is to combine it with the first quarter number and average the results. This would give us growth of about 2%, which seems the most likely real underlying rate of growth.

2.) Second quarter growth got a big boost from government spending increases, which accounted for .82 of the 3.4% growth. In addition, there was a huge bump in nonresidential investment. These rates of growth aren't going to repeat in the third quarter.

Stronger investment in nonresidential structures, up 22.1%, and government spending, up 4.2%. Neither of these are remotely sustainable.

4.) Personal consumption expenditures increased 1.5%. This is the result of high gasoline prices.

Don’t read too much into the sharp moderation in real consumer spending — it is entirely attributable to the spike in gasoline prices… While the housing market is likely to show further deterioration, the biggest source of uncertainty in the outlook at this point is actually the future direction of gasoline prices.

To an extent, I agree with this analysis. Gasoline prices are very cyclical, rising in the summer and falling in the winter. However, this year the country had very high gas prices in the Spring. They rose very quickly and to very high levels starting in about February. Wal-Mart and other low-income targeting retailers mentioned these prices in their respective earnings reports. WM has started to mention high gas prices in their ads. The point here is gas prices broke with their usual cyclical pattern, rising when consumers weren't expecting them to rise. Now we're in the increasing part of the cycle when consumers are expecting higher gas prices. In addition, prices have come down a bit, although they are still high. This could have a somewhat positive effect on consumer behavior.

On the negative side of consumer spending, we now have a volatile stock market. Will the market dampen consumer sentiment? The chances are it will have an impact, but the degree remains to be seen. Frankly, what happens over the next few weeks will be very important from this perspective. If the decline is short lived, the chances it will impact consumer sentiment are small. But the longer this lasts and the more volatile it is, the more pronounced the effect on consumer behavior.

And there is housing, which has been declining for over a year and shows no signs of forming a bottom anytime soon. Inventory levels are at all time highs and credit is contracting. Frankly, I've been surprised this hasn't had a negative impact on consumer spending over the last year. However, this housing slowdown is somewhat atypical. Usually the economy slows, which leads to a faltering housing market. This time around, the housing slowdown happened during an economic expansion. This may have limited the downward economic pressure from the housing slowdown. But now that GDP growth has slowed, housing may start to increase in prominence from a consumer spending perspective.

Here's a good summation of the consumer spending situation:

"Maybe the equilibrium we had where jobs, wages and equities were offsetting the negatives of higher energy price and housing head winds has shifted to where we move to a slower growth profile for consumer spending," Gregory said. "We'll see in the next month or two, but that's definitely the risk that's out there."

3.) Net exports added 1.18 of the 3.4% increase. While this number might not come in as high in the third quarter, the dollar is cheap and other economies are growing. There is no reason to expect this number to not add positively to GDP in the third quarter.

4.) Business spending outside of structures added just .17 to the 3.4% number. This is a very weak area of the economy and runs counter to what some people have been arguing would happen (including myself). Although business balance sheets are in good shape, corporate boards may move to a more conservative perspective, arguing to ride out the weak domestic economy with their high levels of cash rather than increase money on expenditures. This would make a great deal of sense for most companies.

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The Metronet Debacle

It would appear that following on from the Metronet debacle, it is a case of once bitten twice shy.

That at least is the view of Terry Morgan, chief executive of the company responsible for maintaining and upgrading the Jubilee, Piccadilly and Northern lines, said he would not put Tube Lines at risk by simply taking on Metronet work.

"I think there's a number of things to happen yet," Mr Morgan said, referring to Metronet's decision to call in administrator Ernst & Young.

"First, someone has got to make certain it can't happen again. Tim O'Toole [London Underground managing director] and the mayor [Ken Livingstone] have made it clear there will have to be some changes with the way the Metronet contracts are let and London Underground will have to rescope the programme."

Source The Daily Telegraph

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Earnings Growth Is Good

From Bloomberg:

Earnings among the 313 members of the S&P 500 that reported second-quarter results rose 9.7 percent, twice the average of analysts' estimates on July 13. One hundred one members are scheduled to report results this week.

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Let's See Where Support For the SPYs Is

Just as a point of reference, I use the SPYs as a proxy for the market. The Dow is simply too narrow. In a universe of over 10,000 stocks, 30 just isn't large enough. The S&P 500 is, well, 500 stocks and is a much better proxy for the market overall.

Here's the chart we're working with. It's a 6 month SPY chart.



Considering last week's sell-off, let's look at the market to see where support is.

-- Let's use the 5%-10% range as a standard bull market correction.

-- The SPYs stopped out at about 155. 5% of that is 7.75 points. That means a 5% correction would be 147.25, which we went through on Thursday, and which we closed below on Friday.

-- 10% of that is 15.5, so a drop of 10% would send the market to about 139.50. Notice we have the support from the March lows about a point and a half below that number.

Let's add come complicating factors.

-- The SPY is already looking at the 200 day SMA as support. Standard TA is bull markets are over the 200 day SMA and bear markets are below the 200 day SMA. We've been below the 200 day SMA twice in the last two years and rebounded.

-- The SPYs are way below the 10, 20 and 50 day SMA. That means a few things.

-- The 10, 20 and 50 day SMAs all have a downward pull for the foreseeable future.
-- The SMAs will become technical resistance rather than support

-- The shorter SMAs are in danger of dropping below the longer SMAs, adding further downward pull to the market. The 10 day SMA will for all practical purposes move below the 20 and 50 day SMAs soon. How long that lasts is anybody's guess.

-- Volume has been really heavy, indicating we have probably witnessed some sort of selling climax.

-- The markets look oversold right now. Expect a technical bounce, probably from near the 200 day SMA.

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What Kirk Said

From the Kirk Report:

However, it frankly could have been far worse. We could have received evidence that most companies were not hitting their earnings estimates, that the economy was slowing down quickly, inflation was out of control, and/or some unknown event had increased the risk in the risk/reward equation, but that was not the case this week. Sure, there is legitimate fear that the problems over subprime, housing, and the M&A boom will turn to a bust and the market may be sending signals that these problems are ahead. But when I take a big picture look, I think there's a decent chance that the market overall was reacting to pure old-fashioned fear of the unknown. Moreover, I think we're also seeing a transition away from "everything is a buy mentality" to something far less aggressive. These kind of market transitions are never pleasant and can be very painful.

My perception of last week's sell-off is very middle of the the road. It doesn't surprise me. Let's face facts: there are some major problems out there in the economy. Housing has been tanking for the last year or so; subprime loan delinquencies are increasing and consumer spending was slow last quarter. Despite these problems, the markets have rallied for the last year or so with a few speed bumps along the way.

But there are also some good points to remember. Let's start with this quarter's GDP and do some simple back of the envelope calculations. GDP growth came in at 3.4% last quarter. This was in spite of the weak housing market and slow consumer spending. Exports were a big part of that number; they were responsible for 1.18 of the 3.4%. There is no reason to think this won't continue with a weak dollar and a strong global economy. Government consumption added .82 and gross private domestic investment added .49, thanks to a big kick from nonresidential investment. Let's assume that gross private domestic investment drops to adding 0.00 to GDP next quarter and government spending drops to its 15 quarter median of adding .25 to growth. Assuming all other elements of the GDP report contribute the same amount, the US would have GDP growth of 2.34%. This isn't great, but certainly not terrible. Also remember this quick calculation assumes the PCEs remain at adding 1.5 to the overall number.

The one wild care out there is the LBO/CDO/CLO market. As I wrote in the post below, banks are in decent shape, although they are increasing their loan loss reserves. In addition -- and here is the really big problem -- we don't know who owns what percentage of their portfolio in what assets. If hedge funds reported their holdings, we could find out right now who is in the worst shape and deal with it. But right now, we simply don't know. And that's a big problem that we're going to have to contend with and hopefully solve in the next few months.

The point is the underlying fundamentals aren't great, but they're not terrible either. There are economic sectors that are in decent shape. However, overall growth is very uneven. So long as housing remains a problem -- and it will for at least another 4 quarters if not longer -- expect this trend to continue.

In my opinion, the US economy has a bad case of the sniffles and a slight fever, but we're not hacking every 5 minutes and burning with fever. We can still work, but not as efficiently as we would like.

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A More Optimistic View Of the Credit Markets

Let's start with what is happening right now:

``It's a story of heightened risk aversion,'' said Sue Trinh, a strategist at RBC Capital Markets in Sydney. ``The market is jittery that it's not contained to the U.S.''

Investors, whose confidence has been sapped by losses from subprime mortgages, are balking at absorbing more risky debt. More than 40 companies reworked or abandoned bond offerings in the past three weeks. The retreat forced banks to take on at least $32 billion of risky debt and threatens to bring an end to a record run for leveraged buyouts, which surged to a total $690.4 billion of deals this year.

``You have a stampede of the animals away from the watering hole,'' said Scott MacDonald, director of research at Aladdin Capital Management in Stamford, Connecticut, which manages about $20 billion in assets. ``Right now, everything that smacks of financial risk is backing out through the door.''

Let's translate the above eco-geek talk. Borrowers have gotten away with financial murder over the last few years. Lenders stopped asking for loan documentation and instead simply checked to see of a borrower had a pulse. Loan covenants went away or became incredibly lax. A loan covenant is a condition of the underlying loan. For example, a lender might stipulate that a borrower always have x% of his assets in liquid assets, or that the borrower always have X percentage of assets to liabilities, or any other of a number of other conditions regarding the loan. These conditions either ceased to exist, or were so lax that they essentially meant nothing.

The main reason this happened is easy credit. In the early 2000s, the Federal Reserve lowered interest rates to historically low levels. Here's a chart from the St. Louis Federal Reserve of the effective federal funds rate for the last 10 years.



Notice the rate was lower than 2% for 2 and a half years. This is the financial equivalent of lenders giving money away. From a negotiating perspective, record low rates give borrowers the advantage. A borrower can go to a lender and say "I'll give you x% over the prevailing rate, but you can't include really strenuous terms in the loan." When the borrower makes this offer, the lender is making loans at really low rates. Therefore it's harder to make money. When a borrower says "I'll concede a higher interest rate it you make the terms easier" the lender is more than likely to take the deal.

This has been the prevailing credit market sentiment for the last 5-6 years. Borrowers have been in control. This has led to the subprime problem in the housing market. Now that loose credit standards are starting to take their toll everyone is taking a step back to evaluate the situation.

However, the overall situation is nowhere near Armageddon levels.

First, overall interest rates aren't that high. Here is a chart of the AAA corporate interest rate followed by the Baa corporate interest rate.





Notice that while interest rates have gone up, they're not that high. AAA paper is a little below 6% and Baa paper is about 6.5%. Simply put, this isn't that high. Even if AAA paper increased to 6.5%, the rate would still be pretty low. The point here is interest rates were higher at the end of the 1990s and the economy still hummed along just fine.

It's also important to note that banks are in pretty good shape. Here are some charts from the latest FDIC quarterly report.

First, the non recurrent loan rate is pretty low.



Quarterly net-charge offs



Quarterly Change in Non-recurrent loans



From the financial side of the market, this is the first quarter when financial companies have stated that loan losses are increasing. That has everybody understandably spooked. However, as the above charts indicate, loan losses are pretty low and would have to increase pretty substantially before the financial companies were in terrible shape. That does not mean things are all rosy; but things are not all terrible either.

Most of what is happening right now in the credit markets is a reevaluation of credit risk. As firms and businesses go through this reevaluation they will stop all business. However, once this reevaluation is over, the chances are things will move forward albeit it at a slower pace. I would expect this process to last through the end of this year with credit becoming more available by the first quarter of 2008.

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Liars, Scammers and Bullies

'Britain's banks and building societies have lied to and threatened customers who complain about overdraft charges, the Government's financial regulator said.

The Financial Services Authority (FSA) has rebuked current account providers for making "false or misleading statements" to customers. The City watchdog said that some institutions had lied to account holders to deter them from reclaiming unauthorised overdraft charges.'

Source The Times

Says it all doesn't it?

The financial services industry in Britain truly has a most appalling reputation, one of its own making.

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Weekly Market Summary

Considering the action in the markets this week, it seems appropriate to take a look back at the week to see what happened.

Here's a 5 minute chart that goes back 5 days. Notice the action for the whole week was down.



Here's a 2 day chart. Notice the end of the day sell-off on Friday (today). This shouldn't be surprising. Considering this week's action, no one wants to hold a position over the weekend.



Here's the 3 month chart of the SPYs. Yesterday I noted that a drop to the 200 day moving average would be a drop of about 2%. This would make the total point drop for this sell-off about 10 points (roughly 155 - 145) or a total of 6.45%. This would be considered well-withing the range of a standard market correction.



Let's take a look at the 2 year chart to see how the SPYs have performed when they previously approached the 200 day SMA. Notice it's been awhile since the average was here. Late October 2006 and June July 2006. However, the markets traded around the average for about a month and then rallied.

However, note the increased volume 1.) during the latest rally, and 2.) during the latest top. We could be seeing a selling climax right now, followed by some down time for the average.



There are a couple of problem areas that we're going to look at.

The IWNs (Russell 2000/small cap) are clearly dropping.



People are still bolting from the financials.

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Second Quarter GDP Up 3.4%

From the BEA:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 3.4 percent in the second quarter of 2007, according to advance estimates released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 0.6 percent.

The Bureau emphasized that the second-quarter "advance" estimates are based on source data that are incomplete or subject to further revision by the source agency (see the box on page 3). The second-quarter "preliminary" estimates, based on more comprehensive data, will be released on August 30, 2007.

From Bloomberg:

The U.S. economy grew last quarter at the fastest pace in more than a year, propelled by rising exports, commercial construction and government spending.

The 3.4 percent annual pace of expansion followed a 0.6 percent gain in the first quarter, the Commerce Department reported today in Washington. The Federal Reserve's preferred inflation gauge rose at the slowest pace in four years.

Spending on commercial construction projects rose at the fastest pace in 13 years, helping to overcome another drop in homebuilding. Factories ramped up production to fill orders from Europe and Asia that made up for a slowdown in consumer spending. Smaller price increases may be of some comfort to Fed policy makers, who have said inflation is their biggest concern.

From CBS.Marketwatch:

After hitting a pothole in the first quarter, the U.S. economy rebounded in the second quarter, growing at an annual rate of 3.4%, the fastest pace since the first quarter of 2006, the Commerce Department said Friday.

The increase in real gross domestic product was slightly below market expectations for a gain of 3.6%, according to a survey of economists conducted by MarketWatch. See Economic Calendar.

GDP rose just 0.6% in the first quarter.

Let's go a bit deeper into the numbers.

Personal Consumption Expenditures Increased at a seasonally adjusted annual rate (SAAR) of 1.3%. This is the lowest quarterly increase since the fourth quarter of 2005. Consumer purchases decreased across the board -- durable goods, non-durable goods and services. Considering that 70% of U.S. growth comes from consumer spending, this is not a welcome development.

Residential investment decrease 9.3% SAAR. The previous four quarters came in at decreases of 11%, 20%, 16% and 17%. That makes this quarters number a bit of an increase from the previous 4 quarters. Considering the news from the housing sector, I have to wonder if this slower rate of decrease in investment will continue.

Non-residential construction increased at a 22.1% SAAR. This is the biggest increase we have seen this expansion. That means it may be a one time affair. Companies may have decided to make one last push on investment before they shuttered projects for the next few quarters. Whatever the actual reason, this pace is probably unsustainable.

Exports increased 6.4%. Thank-you cheap dollar.

Government spending increased 4.2%.

I think the best way to look at this report comes from CBS. Marketwatch:

Economists said the weakness in the first quarter and the subsequent strength in the second quarter are both overstated, and the best way to understand the economy was to average the growth rate over the past six months. This produces a 2.0% average growth rate in the first half of the year.

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What the Hell Happened Today?

Wow -- the trading day is over and it was very bad for the SPYs. Let's take a look at the charts to ses what happened.

Here's a chart of the SPY in 5 minute increments going back 7 days. Notice the market tried to make new highs several times and couldn't cross the thresh hold. Also note the SPYs went through the previous support level and went down quickly from there.



Here's a 5 minute chart going back two days to see today's action in more detail. Notice the average dropped for most of the day. There were simply no buyers in the market until right before 2 PM



Here's the SPYs daily chart. Note there were two previous selling periods in the last 3 months. The first occurred in late May/early June and the second occurred in mid-June. This indicates there has been an underlying skittishness to the markets for awhile.

Note we are still in bull market territory because we are over the 200 SMA. Also note he have about 2% more to go before we hit the 200 day SMA. If the average hits 145, then the correction will be about 6.5%. This would be a standard market correction.

Finally, note the incredibly high action on today's selling. Lots of people were heading for the doors. In the long run, this is a good thing because it clears out the dead wood in the market. Short term, however, it's obviously very painful.



Here are two culprits. The first is the financial sector, which is basically in free fall right now. Investors are concerned about the debt markets. The CDO/CLO markets have gotten hammered lately. However, there is also concern about the health of the LBO market. The Chrysler deal may not go through. Overall financing for the recently announced LBOs is coming into question. Countrywide Financial's latest earnings announcement certainly didn't help. And the ongoing weakness in the housing sector is increasing the concerns related to foreclosures.

Note the average is below the 200 day SMA and the latest volume has been incredibly heavy.



Finally, here is the IWNs -- a proxy for the Russell 2000. Investors are clearly getting out of the small cap game right now.



So -- what does this mean?

1.) The market is clearly correcting. That's a no brainer.

2.) The market sold-off about 5.5% in late February/early March after the China market sell-off. We're 1% below that level right now, so there may be some more downside room.

3.) There are a lot of questions about the health of the financial industry right now. Until those questions are resolved, the markets will be nervous.

4.) There have been some earnings concerns. Exxon's slight drop did not help. However, there have also been some good numbers as well.

5.) Tomorrow's GDP report is now doubly important to the bulls.

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Markets Having a Terrible, Horrible, No Good, Very Bad Day

As of this writing, the SPYs are down 2.36% and the IWNs are down 3.14%. By my rough calculation we're down about 4% for the week.

I'll have a market wrap after the close.

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New Home Sales Drop 6.6%

Here's a link to the Census report.

From Bloomberg:

Purchases of new homes in the U.S. dropped more than forecast in June, signaling no end to the real- estate slump that's weakened the economy.

Sales fell 6.6 percent, the most since January, to an annual pace of 834,000 last month from a revised 893,000 rate the prior month that was less than previously estimated, the Commerce Department said today in Washington.

Builders may have to cut prices even more and sweeten incentives to turn sales around and trim bloated inventories. Rising mortgage rates and stricter rules to qualify subprime borrowers with poor credit histories will extend the worst housing slump in 16 years and continue to slow growth.

``The subprime debacle is definitely hurting,'' said Zoltan Pozsar, senior economist at Moody's Economy.com in West Chester, Pennsylvania, whose forecast matched the lowest at 850,000. ``This points to further construction drag on growth.''

The South -- which is the biggest region -- saw an increase of 7.6%. This was the only region with good news. The Midwest dropped 17.1%, the West dropped 22.5% and the NE dropped 27.1%. The number of new houses for sale remained the same, but the months supply increased to 7.8%.

These are really big drops and they indicate the correction may be accelerating.

The short version is simple: this report stinks. It confirms all of the bad earnings reports we have been getting from the homebuilders. It also indicates the credit tightening we have been hearing about is probably taking effect and tightening demand.

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Ryland Homes, DR Horton and Pulte Post Big Losses

From the Street.com

Pulte reported a second-quarter loss of $507.5 million, or $2.01 a share, compared with profit of $243 million, or 94 cents a share, a year earlier. The loss was in line with the company's projection last week of $2 to $2.10 per share.

...

Elsewhere, Ryland posted a loss of $52.4 million, or $1.25 a share, compared with profit of $94.8 million, or $2.03 a share, a year earlier.

From CNBC

D.R. Horton Inc. said Wednesday it posted a deep loss in the fiscal third quarter as the homebuilder recorded one of the largest charges to date to write down the value of unsold inventory.

The Fort Worth, Texas, company posted a loss of $823.8 million, or $2.62 per share, in the period ended June 30, compared with year-earlier net income of $292.8 million, or 93 cents per share.

The most recent quarter included pretax charges of $835.8 million for inventory impairment and $16.2 million to forfeit deposits on land. Horton said the quarter also included a goodwill impairment charge of $425.6 million.

Raise your hand if you're surprised. Me neither.

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Fed Releases Beige Book

Here's a link to the whole report

From the WSJ:

The overall economy continued to expand at a moderate pace in the past six weeks, say reports compiled by the 12 regional Fed banks. The Fed typically releases the anecdotal reports, known as its "beige book," two weeks before its policy makers meet to consider interest rates.

In an apparent reaction to the housing slump and rising energy prices, consumer spending rose at only a moderate pace in June and July. Many regions indicated retail sales were below expectations. Five of the 12 said sales of housing-related items, such as furniture or home-repair supplies, were weak or declining.

Here are some key points from the report:

On balance, consumer spending rose at a modest pace, although a number of Districts indicated that sales were mixed or below expectations Cleveland, Chicago, St. Louis, and Minneapolis all shared the general assessment that consumer spending rose modestly, while Philadelphia said retail sales growth was quite strong in May but "closer to trend" in June. New York, Atlanta, Kansas City, and Dallas reported sales as flat and/or below expectations. The remaining regions described sales as mixed

This is not the most glowing statement of consumer spending. It seems the housing slowdown and rising gas and food prices are starting to take a toll on discretionary purchases.

Most Districts said that residential construction and real estate activity continued to decline on balance. Many Districts, however, noted increased activity in some individual market locales or segments.

....

Commercial construction and real estate markets were generally more active than during the previous reporting period.

Over the last year, we've seen commercial/nonresidential construction spending increase. Now this makes up the largest portion of total construction spending. In his Congressional testimony, Bernanke stated residential construction workers had shifted to commercial projects, which explains why construction employment hasn't decreased.

Most District reports indicated that manufacturing activity continued to expand during June and early July.

....

In most Districts, the increases in demand for factory goods were spread across a number of industries.

This jibes with what the industrial production and various Federal Reserve District manufacturing reports have been saying.

Contacts generally reported ongoing input cost pressures, particularly for petroleum-related inputs, while prices at the retail level continued to increase at a moderate rate. Notable exceptions were the Richmond District, which reported faster rates of price increases as local businesses passed along higher input costs, and the Kansas City region, which experienced an easing in overall price pressures. Almost every region said that oil and gasoline prices were either rising, high, or "an issue."

For an organization that focuses on core inflation, the Fed seems to talk an awful lot about energy inflation.

Short version: consumer spending could be an issue in the upcoming GDP report.

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The Metronet Debacle

Workers from Metronet facing redundancies, following its demise last week, are urging the prime minister to bring its contracts back into the public sector.

When Gordon Brown was Chancellor he bulldozed the Public Private Partnership (PPP) initiative through, despite fierce opposition, this was the scheme under which Metronet bid for its contracts.

RMT general secretary Bob Crow has asked for infrastructure work to be the control of London Underground.

In a letter to Brown, Crow said:

"The collapse of Metronet means there has to be a fundamental rethink on how the London Underground infrastructure is maintained and renewed.

We support the view of the Mayor of London that infrastructure work should be taken back in-house under the control of London Underground."

Brown will have to make quite a political contortion, something that he is not prone to do, if he is to meet the desires of the Metronet workers; ie it won't happen.

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Back Up And Running

Hey all --

I had a technical meltdown with Google. They have these things called robots that search the web looking for Spam web sites. They thought I was one, but I guess I'm not.

So, I'm back. Sorry for being away.

A

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Friends Financial

UK life insurance companies Friends Provident PLC and Resolution PLC are to merge.

The companies' boards have agreed to an all-share combination creating Friends Financial Group PLC, the United Kingdom's fourth-largest insurer with an approximate value of £8.6BN.

The deal is contingent on shareholder and regulatory approval, and is expected to be finalised in the fourth quarter of 2007.

The firms say they expect cost savings of at least £100M, by the end of 2010.

Doubtless the market will be alive with gossip as to other possible mergers.

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Debt Market Update

From Bloomberg:

The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.

Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $3.7 billion in the U.S. this month from $42 billion in June, analysts at New York-based JPMorgan Chase & Co. said yesterday. The market is ``virtually shut,'' the bank said in a July 13 report.

Investors are shunning CDOs after the near-collapse of two hedge funds run by Bear Stearns Cos. that owned the securities. Standard & Poor's downgraded bonds from 75 CDOs as mortgages to people with poor credit defaulted at record rates. Concern about losses on home loans are rattling investors across the credit spectrum.

This slowdown shouldn't surprise anyone. Bear Stearns announced a hedge fund the invested primarily in CDOs and CLOs was essentially worthless. That's enough to get anyone's attention and force a reevaluation of the market.

And other deals are hitting snags:

Allison Transmission, a highly profitable unit of General Motors Corp. based in Speedway, Ind., has gotten stuck in a traffic jam in the debt-financing market.

Wall Street firms postponed a sale of $3.1 billion in loans that would pay for the leveraged buyout of Allison by private-equity firms, said a person familiar with the matter. While the sale of Allison to Carlyle Group LP and Onex Corp. is highly likely to proceed, the trouble raising debt from investors complicates matters for the company and its bankers.

The snag reflects difficult conditions in the market for risky corporate loans and bonds and raises questions about the prospects of other buyout-related debt financings that need to be completed this summer. That includes a $20 billion loan deal for Chrysler Group. Cerberus Capital Management has agreed to buy a majority stake in the auto maker from DaimlerChrysler AG.

While I don't think this mess will blow over, I do think it is overdone. The basic structure of CDOs -- that is grouping assets into a pool and then dividing the unerlying risk across various bonds -- has been around for about 15-20 years. Here's a brief refresher on how this works.

The basic premise of these investments is simple: pool a group of similar assets to diversity the risk and then parcel out the risk to separate investments carved from the pool. Let's create a simple hypothetical deal to explain this concept. We'll start with a $100,000, 30-year five percent mortgage. After the mortgage closes -- that is, after the borrower and lender have signed all of the paperwork and the borrower is "officially" a borrower -- the lender will usually sell the loan to an investment bank. The investment bank will then pool this mortgage with similar mortgages (same interest rate, maturity etc...) and create one giant pool. This process of pooling asserts can occur with literally anything that has a cash flow -- account receivables, loans, bonds -- you name it, and it can be pooled and carved into separate bonds or cash flows.

Suppose the investment bank creates a pool worth ten million dollars. That means there are now 100 mortgages in the pool. The basic investment concept of diversification tells us that a problem with a few of the loans will not impact the overall performance of the entire pool. Suppose five homeowners in this pool eventually default. There are still 95 mortgages that are making payments on time. This limits the problems created by the five loans that defaulted.

Let's add a complicating factor to this scenario. Suppose there is a problem with a larger percentage of the loans -- say 10 percent or higher. This is when the concept of "structured finance" comes into play. The investment back will create different bonds from the large pool and allocate the pool's payments to these different bonds at different times and at different rates.

Here's an example using the previously mentioned pool. Remember, we have a giant mortgage pool worth ten million dollars, and the pool is made-up of 100 mortgages each worth $100,000 that pay five percent interest. The investment bank will "carve" the ten million dollars into three different "tranches." For all practical purposes, each of these "tranches" is a bond.

Investment banks will usually create three types of bonds from these pools. The riskiest bond is usually called an equity bond, and when there are problems with the underlying pool, most of its loses are allocated to this bond. Using our previous, hypothetical example, suppose 10 percent or 10 of the mortgages in the pool are in default. The equity portion of the bond will absorb all of these losses. As a result, the other two bonds are still receiving their regular payments.

Let's suppose the number of defaults increases to 20 percent, so that 20 mortgages in the $10 million pool aren't making payments. The investment bank will now allocate most of the losses to the equity bond, but will also allocate any spillover losses to the mezzanine bond. This is the next riskiest bond in the structure.

Finally, there are investment grade bonds which are the last bonds to be hit by defaults. Because of the concept of diversification, this bond will usually not experience any problems.

One of the central problems with the CDO market is liquidity. Because there isn't a very active secondary market, there is no market pricing mechanism to determine what each bond is worth. Instead, fund managers use various formulas and methods to determine what the value of a security is. That's where the real problem is coming from. Had there been an active secondary market, market participants would have seen a gradual decline in the value of various bonds. Instead to Bear suddenly announcing two funds were worthless, investors in the market would have seen the funds decline in value over a specific period of time. This would have limited the shock from the Bear collapse.

Back to where we are now. Credit terms have been very lax for the last 2-3 years. What we are seeing now is a backlash against easy credit terms -- in essence, a massive tightening of credit standards. My guess is we will start to see the pendulum start to swing back within the next 12-18 months to a point between easy and tight.

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Bricks and Mortar

The increasing reliance of the British economy on the housing market was revealed yesterday, when the government released figures that show that a staggering 60% of the UK's £6.5 trillion wealth is now tied up in property.

The Office for National Statistics (ONS) said that the value of Britain, if it were up for sale, has risen by over 5% (an increase of £326BN in 2005).

The increase was more than accounted for by the rise in the market value of Britain's housing stock.

The ONS figures show that the wealth of the UK is now highly sensitive to movements in the housing market, particularly given the declining importance of manufacturing to the economy.

Britain is now worth £6.5 trillion, with the UK housing stock accounting for £3.9 trillion of that figure.

The trouble is that a large factor within the "value" of the housing stock is that of speculation, rather than fundamentals.

This bodes ill for the economy as a whole, given that speculative bubbles have an annoying tendency to burst.

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When Will the Dollar's Decline Stop?

From the Financial Times:

How long before the dollar hits $1.40 to the euro? That is the question many analysts are asking after a week when the US currency struck a new low of $1.3843 to the euro and fresh multiyear lows against a range of currencies, including sterling.

The US currency has fallen 4.5 per cent against the euro this year and 4 per cent against sterling, hitting a new 26-year nadir against the pound last week. The trade-weighted dollar index dropped to its lowest since 1992.

The dollar exchange rate is important because the US relies on hefty foreign purchases of securities and other assets to fund its current account deficit.

“At some point, the fall in the dollar will translate into foreign investors no longer buying US assets and selling their existing holdings,” said William Strazzullo, chief market strategist at BellCurve Trading.

The last paragraph states a really important question: when will the dollar's value decline to a level that makes investing in US debt securities a bad idea? There is no answer for that. However, consider the following chart from the St. Louis Federal Reserve which shows total foreign holdings of US debt securities. Notice the amount has more than doubled in the last 7 years.



How long will this trend continue when the dollar's chart looks like this?

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Earnings Growth Pretty Good

From Bloomberg:

More than one-quarter of S&P 500 companies have posted second-quarter results. Their average profit growth was 8.1 percent. Analysts estimate index members will post average quarterly profit growth of 5.8 percent, up from a 4.8 percent estimate a week ago, according to data compiled by Bloomberg News.

It's not double-digit growth, but 8.1% isn't bad.

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Metals Still A Buy?

From CBS MarketWatch:

"The long-term story for the base metals remains the same: Demand for metals continues to increase steadily," said Lawrence Roulston, editor of Resources Opportunities. Meanwhile, "production growth is constrained by the long lead times to develop new production and by the shortage of high-quality development projects."

"All metals have small inventories, which means any supply disruption can lead to a price bump," said Dr. Harlan Meade, president and chief executive officer of both Selwyn Resources Ltd. (CA:SWN: news, chart, profile) and Yukon Zinc Corp. (CA:YZC: news, chart, profile).

Base metals are even likely to find support from the rally in oil prices, "since the principle in economics is simply supply/demand fundamentals," according to Cary Pinkowski, chief executive officer of Vancouver, Canada-based CP Capital Group and director of Centrasia Mining

This has been a constant theme of the last few years. With China growing at high rates and India not far behind, demand for metal and other raw materials continues to increase. Here are some charts from Futures Charts.

Copper

Copper sold off at the end of 2006. However, demand pick-up again in 2007, and the metal has been rallying since. Since April it has been consolidating in a triangle formation.



Palladium

Palladium has had a slow and steady price increase since October of last year. That's a 10-month rally, which indicates the strength of the underlying increase in demand



Gold

Gold had a 6 month rally starting in October of last year. For the last three months it has been consolidating in a triangle formation.



Keep an eye on the dollar's level. As the dollar approaches the $80 level it may apply upward pressure to gold.



Silver

Silver rallied starting in June of last year. Since April it has been consolidating in a slightly downward forming triangle pattern.



Aluminum

Aluminum is the one metal that hasn't had a strong rally. Instead, it's price has been near constant for the last year or so. However, note that it's price is still high on the chart, indicating demand is still higher now than it was a year or so ago.

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Inflation Figures Fudged

Mervyn King, the Governor of the Bank of England, has finally has admitted (albeit in a coded manner) that the inflation figures on which UK economic policy is based are fudged.

King stated that he was "surprised" that rising house prices are not included in the official inflation figures.

Given that the house price figures are included in the Retail Price Index (RPI) but that Gordon Brown, during his heady days as Chancellor, changed the official inflation index on which policy is based to the Consumer Price Index (CPI) which excludes house price inflation, I am surprised at King's "surprise".

Since 1997 King and the Monetary Policy Committee at the Bank of England has had the task of keeping the CPI around a target of 2%.

Currently the CPI stands at 2.4%, but the RPI stands at 4.4%.

There you have it, interest rates are being set on the basis of erroneous figures. This fudge has caused the credit boom of the past decade, which has lead to the house price boom which in turn has lead to the debt crisis that is facing Britain today.

The architect?

None other than our new Prime Minister Gordown Brown.

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Health Care Jobs

This chart is from Business Week. The author argues:

Basically, the non-health job market is in free-fall. I suspect that when the BLS issues the next round of revisions to the job numbers, the picture will look even worse.

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The S&P 500 Going Into Next Week

First, here is a chart of the S&P 500



Here are some notes from my trading journal. They are in no order of importance.

-- The trend started in late June is still intact.
-- Daily MACD = +
-- Daily CMF = +
-- Daily OBV = Neutral
-- NYAD and NASDAQ AD = Bearish
-- NY and NASDAD NHNL = Fair
-- Subprime is still a problem.
-- Energy is good
-- Industrials are good
-- Tech to the rescue?
-- Financials are a big problem, and will probably continue in that vein
-- Friday market sentiment = Bearish (contrary indicator)
-- M&A is getting hit with stricter loan terms. But, I think this is more a return to prudent lending terms. Conditions have been incredibly lax and lenders have let borrowers get away with murder.
-- Zach's says earnings are good. Thompson says they're not:

Following a heavy week that saw 125 companies of the S&P 500 reporting, earnings growth for the second quarter is so far pegged at 5.2%, an improvement from 4.2% last week, according to Thomson Financial.

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Financials Are Still Under Pressure

Remember that financial stocks are the largest percentage sector in the S&P 500, coming in at a little over 20%. Last week there was a ton of bad news in the sector.

Bear's two funds are worthless.

S&P downgraded over 400 bonds.

Several financial institutions increased their loan loss reserves.

As a result, investors are nervous about what will happen to various financial companies.

That means they are selling financial shares. Also note the increased volume in this sector over the last three days. The selling is accelerating.

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Weekend Weimar

The markets are closed.

Get off your computer.

See you tomorrow.

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Great Paper on the Housing Market's Problems

Mike Larson -- who writes on the blog Interest Rate Roundup -- has written a paper titled How Federal Regulators, Lenders, and Wall Street Created America’s Housing Crisis Nine Proposals for a Long-Term Recovery. While the title is less than exciting (when will economists learn to get great titles to their papers?), the paper is very good and I highly recommend it.

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So Far, Earnings Look Good

From Zack's

Through the close of Tuesday, Jul 17, a total of 55, or 11.0% of the S&P 500 firms have reported their second-quarter results. So far the results look very encouraging with positive surprises outpacing disappointments by a ratio of nearly 4:1. The median year-over-year growth rate is a very healthy 11.7% and the median surprise is 3.7%. Seven sectors have had at least one firm report, and of those, five are seeing double-digit median growth rates. There are only three sectors which have yet to have any firms report.

While it's too early to draw firm conclusions, the trend is promising.

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Borrowers Are Sweetening Deals

From the WSJ:

Banks raising nearly $40 billion in buyout-related debt for Chrysler Group and the United Kingdom's Alliance Boots PLC are being forced to sweeten terms for investors and face delays in their sales, in another sign of turbulence in global debt markets.

Chrysler is being taken over by Cerberus Capital Management, a New York hedge fund, and is raising $20 billion in loans as it separates from DaimlerChrysler AG. Alliance Boots, a chain of U.K. drug stores and a wholesale pharmaceutical-distribution firm, is being taken over by Kohlberg Kravis Roberts & Co. and is raising the U.S. dollar equivalent of $18.4 billion.

In both cases, bankers are shopping interest payments to investors that are around a half percentage point more than originally planned. And in both cases, they're putting off plans to close the deals in the next few days. The Alliance fund raising might be delayed by months, people familiar with the situation said. The Chrysler debt sale is expected to close next week.

This is far from the end of the world for the M&A market. Credit terms have been incredibly lax for the last few years. A better description of events would be a "return to prudent lending standards".

As an example, here is a chart of the daily baa yield for the last 10 years. While rates have increased, they are still below the levels at the end of the 1990s.

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The Metronet Debacle

Yesterday I asked, in a somewhat ironic tone, how is it that Metronet managed to get itself into such difficulties.

The answer lies in it's "jobs for the boys" approach to its contracting. More formally known as "tied supply chain", this ensured that Metronet's five shareholders (WS Atkins, Balfour Beatty, Bombardier Transportation, EDF Energy and Thames Water) were guaranteed most of its work maintaining and upgrading the Underground.

A nice little earner for those with their fists in the honey pot. However, rather a poor arrangement for the tax payers and commuters who find themselves holding the shitty end of this rather unpleasant stick.

This arrangement has been criticised regularly by London Underground, Ken Livingstone and Chris Bolt, arbiter of the £30BN Underground public-private partnership.

A prophet seemingly receives no honour in their own country!

I look forward to seeing how the "listening" clunking great fist tries to get himself out this mess.

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Fed Still Focused on Inflation

From the Federal Reserve

At its May meeting, the Federal Open Market Committee (FOMC) maintained its target for the federal funds rate at 5-1/4 percent. The Committee’s accompanying statement noted that economic growth slowed in the first part of the year and that the adjustment in the housing sector was ongoing. Nevertheless, the economy seemed likely to expand at a moderate pace over coming quarters. Core inflation remained somewhat elevated. Although inflation pressures seemed likely to moderate over time, the high level of resource utilization had the potential to sustain those pressures. The Committee's predominant policy concern remained the risk that inflation would fail to moderate as expected. Future policy adjustments would depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

The Fed has been saying the same thing for about 6 months now. No one should be surprised by this statement.

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Subprime Problems Not Over

From Bloomberg:

Subprime mortgage defaults will increase this year and holders of securities linked to those home loans may experiences losses well into 2008, JPMorgan Chase & Co. analysts said.

``The worst is not over in the subprime mortgage market,'' analysts led by Chris Flanagan, the head of structured finance strategy, said in a report today. ``We expect continued deterioration in subprime loan performance through the balance of this year, and it is likely to be well into 2008 before the problems in securitized portfolios begin to abate.''

Home price declines will lead to ``substantial increases in subprime mortgage defaults and losses,'' Flanagan, who is based in New York, said in a report titled ``Subprime Meltdown, the Repricing of Credit and the Impact Across Asset Classes.'' Borrowers of as much as 50 percent of the $500 billion of mortgages that will reset in the next 18 months may not be able to refinance, Flanagan estimates.

Mortgages defaults at 10-year highs have reduced prices of some bonds backed by home loans to people with poor or limited credit by more than 50 cents on the dollar. The increased risk of default prompted Moody's Investors Service, Standard & Poor's and Fitch Ratings to begin cutting credit ratings on hundreds of bonds last week.

Nobody should be surprised by this. The Fed's most recent Monetary Report to Congress stated:

Delinquency rates on subprime mortgages with variable interest rates -- which account for about 9% of all first lien mortgages outstanding, continued to climb in the first five months of 2007 and reached a level more than double the recent low for this series, which was recorded in mid-2005.

Here's a chart of the result -- an increase in foreclosures from the blog Interest Rate Roundup



And don't expect this stop in the near future. One of the reasons for the financials poor performance (see post just below) is concern over foreclosures and an increase in loan loss reserves at financial institutions.

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Financials Still Hurting S&P

Remember that financials are the largest sector of the S&P 500, comprising about 20% of the average. Yesterday the sector dropped because of issues in the subprime market:

Bear Stearns fell 0.4% after reports that investors in two of the investment bank's hedge funds that made big bets on subprime mortgages have been practically wiped out, in more evidence of the turmoil in that corner of the bond market. Dick Bove, an analyst at Punk Ziegel, said the Bear Stearns woes are likely an industrywide problem and cut his ratings on eight top banks and brokerages.

The news and the downgrade were felt throughout the sector and the broader market. Goldman Sachs Group fell 2%, and Merrill Lynch was off 3.3%. Dow component Citigroup declined 1.6%, and Bank of America fell 0.8%. Even J.P. Morgan Chase, which reported a better-than-forecast 20% profit rise, was down 2.4%. Shares of Lehman Brothers, meanwhile, fell 1.9% amid those market rumors of losses from its subprime business.

Here's a chart of the sector. Notice that all short-term moving averages are headed lower. Also note the shorter-term SMAs are below the longer term SMAs. This pulls the longer term SMAs lower, adding to bearish pressure in the sector. Finally, the index is below the 200 day SMA, another bearish signal.

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The Price of The Metronet Failure

Gordon Brown has not escaped quite so cleanly, as he may have hoped, from the Metronet debacle.

Transport for London (TfL) has promised to stump up £750M to prevent the "meltdown" of London's primitive and shameful tube system, following on from yesterday's announcement by Metronet that they have placed themselves into administration.

Alan Bloom, an insolvency expert from Ernst & Young, has promised the hapless commuters of London who endure on a daily basis the third world tube system that he had an "overriding obligation" to ensure that the tube network does not grind to a halt.

Well, he would say that wouldn't he?

Ken Livingstone, Mayor of London, to his credit had resolutely opposed the PPP Metronet scheme. However, he was bulldozed out of the way by the "big clunking fist" aka Gordon Brown.

Chickens now are coming very firmly home to roost; and the Mayor has warned that the refitting of over 100 tube stations might have to be pushed back years, in favour of a multibillion-pound overhaul of the underground's signalling systems that Metronet was due to carry out.

Mayor Livingstone said that London now faced a "difficult period", while TfL tried to handle Metronet and "the clunking fist's" legacy of a £2BN cost overrun, a lending freeze from its banks and question marks over who inherits its two PPP contracts.

One has to ask some blindingly obvious questions:

1 How were things allowed to get to this stage in the first place?

2 Was no one overseeing this fiasco?

3 Who will be held to account?

4 What has the clunking fist got to say for himself now?

Needless to say, it will be the long suffering taxpayer who gets saddled with another one of this government's financial foul ups.

Tim O'Toole, a senior TfL executive and head of London Underground, said that he expected the taxpayer to plug any financial gaps left by the Metronet intervention.

"This will feed in with the larger discussion with the government about the funding of TfL and transport in London."

Quite!

The cash bung of £750M will be enough to cover Metronet's funding gap until the end of this year; after that...who knows?

By the way, the reason the clunking fist imposed PPP contract was to transfer the financial risk of managing public sector assets to the private sector.

Yes, you did read that correctly!

It would seem that the risk has been very speedily transferred back, which would indicate that PPP contracts are not worth the paper that they are printed on.

Well done Metronet and the clunking fist.

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JP Morgan Triples Loan Loss Reserves

From Reuters:

JPMorgan Chase & Co. (JPM.N: Quote, Profile, Research) said on Wednesday it tripled the amount set aside for loan losses as even borrowers with good credit defaulted on home equity loans, hurting the bank's quarterly profit.

.....

But the bank set aside $1.53 billion for loan losses, up from $493 million a year earlier. About a one-third of the increase resulted from higher loss estimates on home equity loans in which borrowers had little equity in houses with falling values.

This is something to keep an eye on going forward.

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Bernanke's Testimony

Here is the complete opening statement

Here are the highlights.

Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the unemployment rate having remained at 4-1/2 percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the past decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors, but the underlying pace of productivity gains may also have slowed somewhat.

There is controversy about the labor picture. Some economists have argued the BLS' birth/death model has skewed recent numbers higher. Here is a full explanation of the problem. While statistic issues are not my strong suit, the previous link provides a convincing argument that current employment numbers are too rosy.

To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales and construction have slowed substantially and house prices have decelerated. Although a leveling-off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders’ inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace in the second half of last year.

Notice that Bernanke is finally admitting the housing market is a bigger problem than currently thought and is largely responsible for the current economic downturn. However, it's also important to remember the Fed Chair is in a difficult position. He can't simply come out and say housing is dropping like a stone; part of his job is to offer assuring statements and a calm outlook. But considering the length of the housing downturn and the severity of the inventory overhang, I personally think Bernanke has understated the problem to a larger degree than prudent.

Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace, aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases.

This statement slightly contradicts Bernanke's "the employment outlook is good" statement. If job growth were as robust as the numbers illustrate -- and if wage growth were as strong as indicated by the low unemployment rate-- then consumer spending would probably be stronger.

In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter, as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year, motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth.

Business investment will help, but not in as large a degree as we would like. In other words, the bullish argument's belief in a strong business sector may be overshooting the mark.

The global economy continues to be strong. Supported by solid economic growth abroad, U.S. exports should expand further in coming quarters. Nonetheless, our trade deficit--which was about 5-1/4 percent of nominal gross domestic product (GDP) in the first quarter--is likely to remain high.

Exports should grow, but not enough to tame the trade deficit.

So here's his conclusion:

Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.

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Housing Starts Up 2.3%

From the Census

Housing inventory is at inter-generational highs, home builders are reporting terrible earnings and credit is tightening.

This is a great time to add to inventory.

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CPI Up .2%

From the BLS:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2 percent in June, before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The June level of 208.352 (1982-84=100) was 2.7 percent higher than in June 2006.

There are a couple of interesting points in this report.

1.) For those of you who consume food and energy, those prices are up Y/Y on an unadjusted basis of 4.1% and 4.6%, respectively.

As CBS Marketwatch noted:

Energy prices fell 0.5% in June after surging the previous three months at an annual rate of more than 70%. In June, gasoline prices fell 1.1% and natural gas prices fell 0.1%.

Gasoline prices have inched higher in recent weeks, however.

Food prices continued to climb, rising 0.5% in the month. Dairy prices rose 3.2%, and poultry prices rose 2.1%, on higher prices for corn as a feed for poultry and livestock. Fresh fruit and vegetable prices fell.

Food prices are up at an annual rate of 5.1% in the past three months, driven higher by adverse weather, strong global demand and the diversion of much of the corn crop and the nation's arable land into the production of ethanol for fuel.

2.) From the BLS report:

Consumer prices increased at a seasonally adjusted annual rate (SAAR) of 5.2 percent in the second quarter after advancing at a 4.7 percent rate in the first three months of 2007. This brings the year-to-date annual rate to 5.0 percent and compares with an increase of 2.5 percent in all of 2006.

Those are not happy numbers for the Fed.

3.) The unadjusted 12-month core rate of change is 2.2% which is still above the Fed's comfort zone of 1% to 2%.

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Pulte Homes Reports Big Loss

From the Street.com

Pulte Homes (PHM - Cramer's Take - Stockpickr - Rating) projected a hefty loss for the second quarter and posted a 20% drop in orders for the period, joining other homebuilders in reporting still-dismal conditions for the housing market.

The Bloomfield Hills, Mich.-based builder said Tuesday that it expects to report a second-quarter loss of $2 to $2.10 a share due to numerous charges. The company expects land impairment charges of $1.85 to $1.92 a share, as well as 10 cents a share in charges for a previously announced restructuring.

Previously, Pulte predicted results ranging from break-even to a loss of 10 cents a share, before any charges. Analysts, on average, forecast a loss of 17 cents a share, according to Thomson Financial.

This is simply another announcement from the housing sector that shows housing is nowhere near a bottom in any way shape or form. Expect more of the same as other builders make their respective announcements.

Pay particular attention to the announcement that came with the announcement:

"The difficult conditions that plagued the homebuilding industry in the first quarter of 2007 worsened in the second quarter, with increased competitive pricing pressures, elevated levels of new and resale home inventory, and weak consumer sentiment for housing affecting the entire industry," said Richard Dugas Jr., president and CEO of Pulte Homes, in a press release.

Note the statement "worsened in the second quarter." This is not a cheery report and indicates management is extremely concerned about the market right now.

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Metronet Goes Into Administration

Metronet, the London Underground contractor, has announced that it will go into administration after overspending by a staggering £2BN; it has asked Mayor of London (Ken Livingstone) to appoint the administrator.

Alan Bloom, an insolvency specialist at Ernst & Young and the former administrator of Railtrack, is expected to be appointed to run Metronet.

Metronet said that its two Public Private Partnership contracts to renovate and maintain London's tube system were unsustainable. Its Metronet BCV programme, for the Bakerloo, Central and Victoria lines, had an unpluggable funding gap of just under £1BN. Metronet's creditors and shareholders – Balfour Beatty, WS Atkins, Bombardier, EdF and Thames Water – had refused to provide more funding.

Quote:

"Metronet Rail BCV requires additional funding to enable it to carry out its contractual obligations during the period of the Extraordinary Review.

This company has now established that it has no access to such further funds."

The second contract, Metronet SSL, for London's sub-surface tube lines, has an an overspend of £1BN. Metronet said blamed the PPP regulator for not providing emergency funds for Metronet BCV.

Quote:

"Applying the logic of the PPP Arbiter's draft direction to the circumstances of Metronet Rail SSL, the Board of this infrastructure company has come to the conclusion that any application for Extraordinary Review... would come to a similar position."

The collapse of Metronet is a kick in the groin to the then chancellor, Gordon Brown, and his PPP policy. Brown bulldozed the tube PPP through despite strident objections from those who knew it would be a disaster.

Hardly surprising that he was so keen to become PM, thus avoiding the mess that he created.

The head of London Underground, Tim O'Toole, has assured Londoners that the service on the lines that Metronet is responsible– nine of the capital's 12 – will continue as normal.

Hardly much of a reassurance, given that the service is a shambles anyway.

We can expect this to be a shambles, not just for the current tube passengers but also for the Olympics 2012.

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This Is Not Good

From the WSJ

Weeks after the meltdown of two prominent Bear Stearns Cos. hedge funds that bet heavily on the market for risky home loans, the brokerage has told the funds' investors that the portfolios' assets are almost worthless, according to people familiar with the matter.

The assets in Bear's more-levered fund, the High-Grade Structured Credit Strategies Enhanced Leverage Fund, are worth virtually nothing, according to people familiar with the matter. The assets in the larger, less-levered fund are worth roughly 9% of the value since the end of April, these people said. The April valuations were not immediately available, but in March, before their sharp losses, the enhanced leverage fund had $638 million in investor money, while the other fund had $925 million.

The two funds have been in the spotlight for weeks after suffering heavy losses in the subprime market. Late last month, Bear helped stabilize the less-levered fund with a $1.6 billion secured loan; the enhanced fund began trying to unwind its remaining $1.1 billion in debt.

Bear disclosed this information to investors earlier today and is expected to make a statement this evening, these people said. A spokeswoman for Bear did not return calls for comment.

These losses, which took more than two weeks to calculate because of the fluctuating values in the market for risky, or subprime, mortgage securities, came amid another tumultuous day for the broader mortgage market. One particularly wobbly slice of the market tracked by a closely watched index called the ABX fell to an all-time low of 44.

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Homebuilder Confidence Drops

From Bloomberg:

Confidence among U.S. homebuilders fell this month to the lowest level in 16 years, signaling the housing market continues to tumble.

The National Association of Home Builders/Wells Fargo sentiment index declined to 24 this month, the lowest since January 1991, from 28 in June, the Washington-based association said today. Readings less than 50 mean most respondents view conditions as poor.

Builders are pulling back on construction of new homes as inventories remain high as sales haven't recovered. Housing probably will be a drag on economic growth the rest of this year, economists said.

``Higher inventory levels would suggest that builders are going to have slow down their activity,'' said Jeffrey Roach, chief economist at Horizon Investments in Charlotte, North Carolina, before the report. ``We still expect to see, for the next couple of months, building being a drag on economic growth.''

This should surprise no one. Consider the following recent housing news.

M/I Home warns on earnings

M/I Homes Inc. warned investors Thursday to expect as much as $75 million in charges to snag its second quarter results.

M/I Homes said it expects to record up to $70 million in pretax asset impairment charges and write-offs related to its homebuilding assets and investments. Another $5 million charge will come from writing off intangible assets related to the 2005 acquisition of Orlando, Fla.-based Shamrock Homes.

Realtors forecast weak housing market into 2008:

he slump in home sales and prices will be deeper and last longer than previously expected, according to the latest forecast Wednesday by the National Association of Realtors.

The trade group is now looking for flat prices for existing homes in the first quarter of 2008 compared to the first quarter of 2007, and a more year-over-year declines for new home.

DR Horton sales down:

The traditional spring home-selling season was a bust for D.R. Horton Inc., one of the biggest nationwide homebuilders. Horton said Tuesday it will post a loss from operations for its latest quarter after net orders fell 40 percent and it wrote down the value of unsold houses.

Ryland expects loss:

Luxury homebuilder Ryland Group Inc. said Tuesday its expects to post a second-quarter loss as a result of the continued slump in the housing market.

According to preliminary figures, Ryland expects to report a loss of $1.25 to $1.35 per share for the quarter.

The news has been uniformly bad. Considering that inventories are at inter-generational highs, credit is tightening and the subprime financing market is experiencing problems, there is no reason to expect this trend to reverse anytime soon.

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