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Not a lot to say in this short review.

Looks like credit worthiness is on the mend thanks to federal deficit spending.

While what’s been done hasn’t been my first choice for public policy, it nonetheless has added net financial assets to the non govt sectors and helped bring down debt ratios.

As they used to say, when Detroit sneezes the economy catches a cold.

The Great Mike Masters Inventory Liquidation that began in July ended around year end.

The weakening economy caused the federal deficit to rise the very ugly way via the automatic stabilizers.

By year end the deficit was high enough to turn the tide.

The rising federal deficits added to savings of net financial assets and began easing debt ratios.

Headwinds remain, including US domestic loan loss issues and China looking like markets could take a breather with talk of government action to slow credit expansion, but as long as US federal deficit spending persists at sufficiently high levels, it looks like the worst is behind us for US GDP, with unemployment likely to peak later this year at about 10%.

This is creating unwelcome social tensions for the administration, with the apparent winners being banks, corporations, the investor class in general, and higher income earners.

State and local governments are also in a bind, as they lay off essential employees while funding a few ‘shovel ready’ federal infrastructure projects.

Health care reform held the promise of adding to aggregate demand but it now looks like the final bill will be ‘revenue neutral.’

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Karim writes:

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Copper fell with the Master’s inventory liquidation but then bottomed about the same time crude did. While gasoline demand started recovering from its modest declines back then it is doubtful if the same has happened with copper, as construction has continued to decline since then.

Market action feels like the producers got together and decided to cut back on supply.

Political leaders who understood markets would be looking into it.

Investors who recognize the economic value of oligopoly collusion might also look into it.

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Valance Chartbook update Mar 7, 2009- The Automatic Stabilizers are Quietly doing their Job

Q2 08 was the last up quarter (real growth up 2.8% annually), supported by the $170 billion fiscal adjustment.

Looks like all the last Congress had to do was keep doing a fiscal adjustment each quarter as needed to sustain positive output and employment growth.
Doesn’t seem like a lot to ask of them- spend more or cut taxes?

The subsequent declines could have easily been avoided.

Interesting the auto execs didn’t blame Congress for the falling car sales and the financial crisis.

Almost all of the indicators look like this. Demand that had been slowly weakening for a long time fell apart sometime in July 2008.

Like all recession’s I’ve seen, this one seems to have been characterized by inventory liquidation. Inventories now look to be very low.

The bulge in existing home sales was from the supply from foreclosures, which is also part of the inventory liquidation process.

In addition to crude oil, the entire commodity basket was subject to the Great Mike Masters Inventory Liquidation. The charts seem to indicate that liquidation had run its course by late December 2008.

The Saudis and OPEC had to let the inventory liquidation run its course before regaining control of price late in Dec 08. Price is now going back to wherever they want it to be, as they set price to their liking and let output adjust. And with the latest data showing US gasoline consumption up 2% year over year it looks like demand for Saudi output may actually climb even as prices rise.

These commodity currencies have also gone sideways.

Coincident with the precipitous inventory liquidation and economic weakness, the automatic stabilizers kick in just as hard, increasing federal deficit spending via falling tax revenue and rising transfer payments.

This adds to private sector ‘savings’ of financial assets to the penny-

The accounting identity is government deficit = non-government ‘surplus’ of financial assets. (non-government includes residents and non-residents)

Less debt is mathematically the same as more savings.

Think of it this way. At the macro level, government deficit up= non-government net debt down.

Meanwhile, the government deficit spending works to sustain personal income which works to support spending.

That’s how the automatic stabilizers work to keep recessions from turning into depressions.

There is some evidence beginning to surface, in addition to the above income and spending data, that maybe suggesting we are starting to move sideways rather than down.

While unemployment will most likely continue to grow, as it takes at least maybe 2% real GDP growth for total hours worked to increase, there is some evidence at the margin that the rate of decline has peaked after a post year end spike from businesses that didn’t want to cut staff before the year-end holidays.

There is also some marginal evidence that the worst of the housing setback is behind us.

While the deflationary forces remain elevated by excess capacity in general, there is some evidence prices are selectively firming.

With low inventories prices get supported by replacement cost, which include costs of raw materials and unit labor costs, as well as productivity gains.

The new fiscal package isn’t my first choice, to be polite, but it isn’t ‘nothing’ either, and will further act to support demand and end this down cycle.

But it does nothing for near term energy consumption, and therefore risks rising commodity prices and rising CPI, even as unemployment remains unacceptably elevated.

This can put us back to where we started from- some growth but both weakness and inflation, this time with a backdrop of a much larger output gap, along with policy makers who don’t understand monetary operations and reserve accounting.

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Something went wrong in July. Most of the charts look like this:

It might have been the fall off of the q2 fiscal adjustment, the Olympics, the Lehman collapse, and/or, of course, the GMIL (Great Masters Inventory Liquidation).

And inventories also took a dive, from not all that high levels, adding to the slowdown.
Low inventories also mean the slow down need not last long when demand picks up with the coming fiscal adjustments.

What the car companies need is higher sales. Capital injections won’t go far with demand looking like this.

Notice personal income turning south with the Fed rate cuts, as interest income takes its toll. Yes, I know correlation doesn’t prove anything, but that’s my story and I’m sticking to it! Households are net savers and rate cuts eliminate income. Also, rates for savings have fallen a lot more than rates for borrowing this time around.

It’s been a long, slow dive, recently accelerating, since q2 06 when we pointed out the federal deficit was too small to sustain output and employment growth, due to the financial burdens ratios getting too high:

Looks like batteries have finally been recharged some over the last few years, even with personal income sagging.

All these look like household ‘balance sheets’ are improving.
And with rising federal budget deficits providing additional net financial assets this should continue.

Yes, the housing graphs, not shown look terrible, there are some signs it could all turn quickly:

Actual new home inventories are very low and probably picked over, as affordability continues to pick up.

Also, home ownership is low, and rental vacancies under control.

All indicating the coming fiscal adjustment could act more quickly than expected.

No let up here, however.

Unfortunately some of the latest Congressional incentives reward delinquency, anecdotally causing some otherwise good paying borrowers to not make payments to qualify for assistance.

It’s government to the rescue, as the automatic stabilizers do their thing to increase federal deficit spending and add income and savings of financial assets to the non govt. sectors.

Might be the output gap cutting down the rise in prices, and might be the GMIL (great Masters inventory liquidation). It’s too soon to tell- probably some of both.

Opec cuts seem to have stemmed the tide, and pave the way for the Saudis resuming their role of price setter. Demand has dropped very little. This is not the 80’s when demand dropped by over 15 million barrels per day after natural gas was deregulated in 1978 and it and coal replaced crude oil for most power generation.

Talk is cheap- supporting their exporters is a priority!

Cautions about the coming Obamaboom.

Hints of credit spreads stabilizing.

The eurozone is fading quickly, and it could all go bad here again if (when?) their financial structure melts down.

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Karim writes:

Lower interest rates now starting to help this sector, but at the expense of interest income for others. Much of this is offset by government, however, as the deficit continues to rise counter cyclically (the ugly way- lower revenues and higher transfer payments).

• Initial claims rise 30k to new cycle high (and highest since 1982) of 586k; continuing claims drop 17k to 4370k

This may get a lot worse after the holidays.

• Core PCE unch m/m and up 1.9% y/y (core inflation down 0.5% in 3mths; so much for the flat Philips curve).

Yes, but not all that big a move for a negative 7% quarter and a 70% drop in crude oil and large declines in other commodities.

• Personal income down 0.2%, with wage and salary income down 0.1%.

Lower interest income biting.

• Savings rate up to 2.8% from 0.8% 3mths ago

It’s not so much that people are saving as it is they are not borrowing, as total mortgage and other credit measures decline.

• Personal spending down 0.6% m/m

Less than expected as lower fuel prices seem to be helping some.

• Durable goods orders -1% (prior month revised from -6.2% to -8.4%) and up 4.7% ex-aircraft and defense (this measure was down 12.3% in prior 3mths so correction was expected).
• Shipments (key for current qtr growth) down 2.6%

Falling fuel prices and automatic stabilizers increasing the federal deficit are beginning to have an effect, but this is a long, drawn out process that in the past has taken years to restore output and employment.

A full payroll tax holiday and maybe $300 billion in Federal revenue sharing with the states can cut that time frame down to months rather than years.

And, of course, without a plan to cut crude oil product consumption fuel prices can likewise quickly elevate.

The Fed is still obstructing bank functioning by demanding collateral from member banks when it lends. This is redundant and should be addressed at once.

Also, the Fed swap lines to foreign CB’s are again rising and approaching $700 billion. Not sure how this ends. Lines are scheduled to end in April, but hard to see this happening. It could turn out to be the largest international fiscal transfer of all time.

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Securitized Products Weekly Update: 12/22/08

Overview

Securitized products continued to have a positive tone last week assisted by momentum from FOMC announcements. The RMBS sector benefited the most in hopes that aggressive downward pressure on mortgage rates will increase prepay speeds (thus enhancing yields in a deeply discounted market). CMBS shorter pays and junior AAAs firmed on the week along with more seasoned super dupers.

CMBS/X

• CMBS cash continued to stabilize (from violent Nov swings) last week on lighter flows, with shorter pay A1-A3 supers and AM/AJ classes tightening the most and LCF’s (Last Cash Flow classes) firm but generally unchanged
• LCF’s trading around +950 (~$70 price; 12% yield) although the market is becoming more bifurcated between deals considered to be safer and those perceived to have real credit risk; the trading range between the most/least desirable ‘07 LCF’s is now in the 350bps range
• Non-super AAAs seeing renewed buying interest; AMs were up another 5-6 pts week-over-week now trading in hi 40s
• The market is taking increased note of relative value in shorter pay A1-A3 classes, as those classes tightened 50-75bps on the week
• CMBX.AAA.4 tightened 77 bps on the week on relatively light flows and profit taking
• The street reports spending increasing efforts to educate opportunity funds interested in CMBS; appx 25% have started buying and 75% still completing due diligence
• Fitch reports that CRE loan delinquencies (held in CRE CDOs) declined from Oct to Nov from 3.1% to 2.8% as a result of increasing loan extensions being granted
• Centro, distressed Australian retail REIT who levered up to buy U.S. shopping centers, averted bankruptcy by transferring 90% ownership control to lenders in exchange for loan extensions on maturing debt
• GGP, a major U.S. mall REIT, was able to extend maturing secured loans in exchange for lender concessions
• Both the Centro and GGP situations reflect lenders reluctance to foreclose/liquidate in this market and indicate that more extensions/modifications are likely for maturing CRE (commercial real estate) loans that cannot be refinanced
• Market chatter about the Federal Reserve possibly buying CMBS directly in secondary markets continues to get some press
• JPM liquidated a portfolio of CMBS securities on margin from Guggenheim, a levered CRE strategy fund and large TRS player
• CMBS market tone improving and feels like it will be better bid after the turn, although the fact that new loan origination remains in a deep freeze is of concern

RMBS

• RMBS continued to rally this week, Jumbo and Alt A super seniors were up 3-5 pts and Option ARMs were up 2 points
• ABX 06 AAAs were up 2-4 pts and 07 AAAs were up 4-5 post FOMC moves and the government’s stated objective of driving down mortgage rates
• Optimism in RMBS was sparked by hopes that lower mortgage rates will drive faster prepay speeds as the non-agency market presently prices to rock-bottom CPR assumptions
• Both ML and JPM announced buy recommendations on non-agency AAA MBS based upon assessments that increasing traction from aggressive federal actions will accelerate the bottoming of the housing market and mitigate the risk of an over-correction on the downside
• Affordability in a number of MSAs has now fully corrected to pre-bubble levels and lower mortgage rates will speed up the process across all markets
• Although affordability metrics have improved and will further benefit from lower mortgage rates, rising unemployment will be a major headwind
• Although mortgage modification efforts have yet to show results, the market senses a growing conviction on the part of the new administration to aggressively pursue mortgage modifications that will entail removing loans from securitized pools and encouraging principal reductions
• JPM expects bottoming of house pricing to now occur in mid-09, escalating this timeframe from a prior expectation of 1H10
• Citi is aggressively buying Option ARM super seniors and effectively setting market levels for this sector
• Housing starts dropped to the lowest level in 50 years
• JPM is advocating buying RMBS AAA Mezz trading in the $30s as it has the greatest convexity upside to increased mods/prepays
• ML/Citi issued buy recommendations on super senior Option ARMs and certain Alt A AAA structures
• Although most government actions have been initially directed towards improving conforming mortgage markets, non-agency RMBS is expected to become the beneficiary of 2009 actions expected to focus on foreclosure forbearance and more aggressive modification/principal writedowns

Credit Cards/Autos

• Better tone to ABS market at higher-end of credit stack although flows were generally light and domestic Auto ABS continues to struggle
• New Unfair or Deceptive Acts or Practices (”UDAP”) legislation passed will increase regulatory cost to card issuers but will have no significant adverse impact on profitability or trading levels
• Some additional TALF details were announced including a term extension from one to three years; since TALF will only apply to newly issued ABS, it is likely to create a bifurcated market between TALF eligible and non-eligible ABS; TALF rate and haircut terms have yet to be announced
• The BACCT (BofA) Credit Card Master Trust began trapping excess spread at the C class (BBB) level, prompting Card mezz classes to widen 50-75bps on the week
• JPM significantly enhanced the WAMU Credit Card Master Trust by swapping out $6B of weaker accounts for stronger accounts
• Although Nov results showed card charge-offs increased ~20bps to 6.7%, this was more than offset by margin improvement from declining Libor which boosted overall excess spread to 6.0%, up from 4.3% in Oct
• Many synthetic CDOs invest note issuance proceeds in AAA credit card ABS due to cards historic ratings stability and available liquidity; liquidations of synthetic CDOs continues to adversely impact AAA card technicals as more AAA classes are forced back into the market
• Auto ABS was buffeted by news highlighting rapid deterioration at GM and Chrysler and culminated with an announced bridge loan to get them over the turn
• Independents and foreign issuer shelves continue to outperform domestic Auto ABS
• Volkswagen was able to issue a new $1B ABS transaction last week; 1 year AAAs came at L+350

CDO/CLO

• Little trading activity last week. BWIC with a AAA CRE CDO bond was talked in single digits (although didn’t trade) reflecting the rating agencies unwillingness to downgrade AAA CRE CDO paper. Market consensus on the bond was that there was little likelihood for any return of principal
• Moody’s cautioned today that it will be reviewing their ratings on 109 CRE CDOs. AAAs may be downgraded 2-6 notches (4-8 notches on lower rated tranches). Moody’s expects to complete their review by Feb 09
• JPM has been a large buyer of super senior AAA CLO paper the last few weeks. Huge OWICs over the last few weeks in 450a for high quality managers, which is about 100bps tighter than where BWICs had been trading. Current count has JPM adding $1.1BN to their $14BN AAA CLO exposure
• A large wave of S&P downgrades on high yield loans last week threaten to trigger OC test failures in CLOs. Failure of OC tests results in cash flows being redirected from mezz class to senior note holders
• S&P announced that they are reviewing the assumptions used to model CLOs and placed many mezz classes on negative watch over the last few weeks. BBB/BB classes are expected to be most impacted

Securitized Products

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FACTBOX: What is quantitative easing?

Tue Dec 16, 2008 3:30pm EST

NEW YORK (Reuters) - The Federal Reserve on Tuesday cut its target for overnight interest rates to zero to 0.25 percent, bringing it closer to unconventional action to lift the economy out of a year-long recession.

“The message is they’re instituting quantitative easing on a fairly large scale,” said Doug Roberts, chief investment strategist at Channel Capital Research.com.

Under quantitative easing, central banks flood the banking system with masses of money to promote lending.

Central banks exchange non or low interest bearing assets- reserve balances- for longer term higher yielding securities.

Since lending is in no case ‘reserve constrained’, the ‘extra’ reserves do nothing for lending.

The purchase of the longer dated securities results in lower longer term rates than otherwise. The lower borrowing rates may or may not alter aggregate demand.

The lower rates for savers definitely lowers aggregate demand.

They usually do this when lowering official interest rates no longer is effective because they already are at or near zero.

True!

The central banks add cash by buying up large quantities of securities — government debt, mortgages, commercial loans, even stocks — from banks’ balance sheets,

Yes.

giving them plenty of new money to lend.

No, they already and always have infinite ‘money to lend’.

Available funds are not a constraint for the banking system.

The constraints are regulated asset quality and capital requirements that are expressed in the rates bank charge.

Not the total quantity of funds available.

It is a tool used by Japan earlier this decade to combat deflation and stimulate the economy.

Didn’t work then either. It was fiscal policy that kept them afloat, though not a large enough deficit to sustain output at full employment levels.

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Through Q2 08 GDP was muddling through with modestly positive numbers.

Then it hit the wall in July as crude oil and the commodities in general broke down courtesy of Mike Masters and Joe Lieberman.

Soon afterward the main street credit crunch intensified.

What I now suspect happened is that the US energy/commodity industry got the rug pulled out from under it as the transfer of nominal wealth from pension funds to passive commodity strategies to energy and commodity producers fell?

The straw that broke the camel’s back?

This sector had been holding up well with the higher prices, and energy producing regions had been doing reasonably well.

Domestically, the US produces about 8 million bpd of crude plus a lot of natural gas and other commodities that fell in price.

While the fall in prices benefited consumers, they were/are slow to react with more spending.

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from Cesar at Valance:

(Click to see more)

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Twin themes remain - weakness and higher prices.

In Q2 2006 it seemed to me that the financial obligations ratio couldn’t get much higher which meant consumer debt could not grow at a faster pace.

With the budget deficit in decline and the trade gap still widening, it would have taken increasing rates of growth of consumer debt to sustain GDP, so my forecast was for gradually declining GDP growth rates over time.

At the same time, I was calling for ever higher crude prices as I saw the Saudis as a swing producer/price setter intent on hiking prices.

This was all temporarily derailed in Aug 2006 when Goldman changed the composition of its commodities index and liquidated substantial amounts of gasoline and crude from the basket of futures purchased and held by its fund, and another fund that followed the Goldman index also re-weighted funds and liquidated substantial numbers of futures contracts. This action pushed prices down until the liquidation was over, but then at year end Goldman and also AIG at year end changed their indexes and again drove prices down. Shortly thereafter it was announced that Goldman was turning its index over to S&P to avoid related party conflicts, or something like that, and the Saudis have resumed their clandestine price hiking.

In general, the Valance charts show economic weakening since Q2 2006. The subprime blow up took away demand in the housing sector as fewer buyers qualified for mortgages when the number of undetected fraudulent applications was reduced, with exports first picking up the slack in 07, and government kicking in soon after in 08.

With the government deficit now proactively growing again, and the financial obligations ratios starting to relax, GDP should continue to muddle through.

“Muddling through” also means, however, that demand will be high enough to support the current level of crude/food/import prices and allow core prices to catch up with headline CPI as the rising food/crude/import prices are also factors of production that are driving up costs.

So far, GDP has muddled through as domestic demand has weakened.

All the surveys look about like these - working their way lower over time, with some turning up recently from the lowest levels.

Government spending is on the rise, as a conspicuous drop in the rate of spending in 2007 is making a comeback in 2008, along with the fiscal package now kicking in.

Housing is way down, to the point where it could recover by 50% and still be depressed.

Rising affordability and the passage of time to digest the disruption of the subprime related issues along with increased government spending and increasing exports are beginning to turn things around from the bottom that may have been reached last October/November.

The outlook for the future may have bottomed at these very low levels.

Actual inventories of unsold new homes are steadily falling and median prices are showing signs of a bottom also pointing to a possible bottom for the housing sector.

Government spending and exports have kept the economy from getting a lot worse.

No matter how you look at it, the ‘labor markets’ are on the soft side.
Productivity increases have allowed positive GDP growth with reduced labor input.

Government to the rescue! GDP will be sustained as long as this holds up.

Not terrible here either, apart from the auto industry getting caught out with too many large trucks to sell.

Inflation will only get a lot worse as crude keeps rising.

NOTE: The dip from the Goldman effect in August 2006 has been largely reversed in CPI with the others following with a lag.

And these are the wholesale prices and import prices that have also more than recovered from the Goldman effect and are in the process of getting passed through to retail prices.

Export prices are booming, expectations way too high for the Fed, the CRB back on trend after the Goldman dip, and demand for Saudi crude holding firm at current prices.

All the price surveys look about like this.

Demand looks strong here as well.

Meanwhile wages remain ‘well-anchored’ as real wages go negative after being about flat for a few decades. And even the most liberal members of Congress seem to think this is a ‘good thing’ as they congratulate the Fed Chairman for keeping wage pressures low.

We are in the process of discovering it IS possible to have inflation without wages leading the way, just like the rest of the banana republics with weak currencies, rising import prices, export led growth, and declining real terms of trade.

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Hard to see any recession here, and the consensus is for Q1 to be revised up to 0.9%, bringing year over year up to 2.8%.

I also think the estimates of the effects of the fiscal package are on the low side.

Income and spending continue to chug along, ahead of core but not headline ‘inflation’.

Still moving higher.

Fiscal rebates now kicking, with other government spending on the rise as well - should be a decent Q2 and better Q3.

And revenues seems to be holding up also indicating no recession yet.

While headline CPI took a slight breather due to seasonal factors, the drivers of the current bout of inflation continue without let up, as crude oil touches $135 and the USD fall resumes.

Saudi crude output remains above 9 million bpd, indicating world demand is holding at the higher prices.

Booming exports and export prices work in tandem.

Inflation expectations have alarmed the FOMC with recent speeches indicating there will probably be no more rate cuts if inflation continues to escalate .