Global Financial Conditions Monitor, Week ending March 21st 2008

Global equities seesawed across last week as investors grew jittery after the buyout of the troubled Bear Stearns at a fire-sale price by J.P.Morgan but garnered some confidence on the back of a string of positive moves by major Central Banks. The financial sector led most of the rallies throughout the week as investors hailed the Fed’s 75 bps cut in its key interest rate along with a host of broad based liquidity injection measures as a potential building block in the long term solution to the credit crisis. Stronger than expected first quarter results of investment banking giants Goldman, Lehman and Morgan Stanley also helped shore up global equities. The Dow gained 3.25% across the week while the FTSE gained 1.49%.

Citing a weakening economic outlook as well as an elevated inflation, the US Federal Reserve delivered another shot in the arm to the slowing economy as it cut the Federal funds rate as well as the discount rate by 75 bps each, thereby bringing them down to 2.25% and 2.5% respectively. Earlier in the week, Bear Stearns's sudden meltdown had forced the Fed to take the extraordinary measure of allowing securities firms to borrow from the central bank under terms normally reserved for regulated banks.

In an effort to bolster the ailing housing market, the OFHEO reduced the capital surplus that GSEs Fannie Mae and Freddie Mac must hold to 20% from 30% previously. The move is expected to provide a much-needed respite to the two hobbled GSEs as it provides up to USD 200 bn in immediate liquidity to the troubled MBS market. The Fed’s latest measures to unfreeze the credit markets appears to be working in the MBS market where yields have come off their recent highs. The difference on the yield on 30-year MBS compared with U.S. Treasurys fell to 2.74 percentage points, from a high of 3.7 on March 6th. However, upward risks remain abound as another collapse may trigger massive develeraging as investors, banks and others try to reduce their own exposure to risky markets. In what has become one of the most pervasive credit crisis, the issue no longer remains whether it will yield a recession, which seems certain, but whether the Fed’s novel efforts would help to cut the tail risk of a deeper and prolonged recession scenario.

Funding pressures unlikely to abate soon:

The Fed’s new direct lending program aimed at primary dealers coupled with a substantial 75 bps cut in its key interest rate eased funding pressures in the short term money markets over the last week. The size of the total borrowing from the Fed’s primary credit lending facility suggested broader interest amongst the securities dealers. The program drew an average of USD 13.4 bn in daily borrowing in the week ending March 19th ’08 with firms having USD 28.8 bn in loans outstanding.

The 3M USD LIBOR edged up 2.7 bps across the week to 2.606% while the 6M USD LIBOR rose 17 bps to close 2.53%. The ABCP market deteriorated for the third consecutive week with its outstanding value having dropped by USD 4.3 bn last week compared to a USD 5.7 bn dip previously.

A few spoonfuls of potent medicine by the Federal Reserve

In its bid to overcome growing recession and liquidity fears, the Fed had earlier announced that it would add further liquidity to money markets by raising the size of the Term Auction Facility (TAF) auctions to be held on March 10th and 24th to USD 50 bn each, an increase of USD 20 bn from the amounts that were announced on Feb 29. Fed officials also announced that it would initiate a series of 28-day term repurchase transactions that are expected "to cumulate to USD 100 bn" and increase the auction sizes further in future if conditions warrant. Yesterday, the Fed in coordination with four other Central Banks (BoE, SNB, BoC and ECB) stepped up its efforts to assuage the growing strains in global credit markets by significantly extending dollar loans to banks in their respective nations. The Fed supplemented its previous TAF and repo initiative with the Term Security Lending Facility (TSLF) thereby expanding its low securities lending program to enable bond dealers to borrow up to USD 200 bn of Treasury securities, collateralized by other securities, including Fannie and Freddie Mac backed bonds, Fannie and Freddie Mac backed MBS and other AAA rated MBS. Furthermore, the Fed also raised the size of its "swap" agreements with the European Central Bank (ECB) to USD 30 bn from USD 10 bn previously, and with the Swiss National Bank (SNB) to USD 6 bn from USD 2 bn previously. With many banks in the EU facing huge dollar loan obligations while being exposed to risk of US mortgage loans, the swap agreements would enable the respective Central Banks to borrow dollars from the Fed and lend the same to their own banks, thereby alleviating the funding pressures in these markets.

March 10th TAF Auction suggests increased demand for funds:

The result of the March 10th TAF auction suggests that funding pressures continue to exist amongst US banks despite substantial liquidity injection by the Fed through previous TAF auctions in addition to the discount window borrowing as well as open market operations. Until January, it seemed that the Fed had done considerably well in managing market liquidity and eased liquidity concerns in the short term money markets. This is evident from the table above, which depicts a significant drop in bid/cover ratio ( 1.25 in Jan 28th from 3.08 in December 17th) as well as total propositions submitted (USD 37.45 bn from USD 61.553 bn in December 17). However, credit conditions deteriorated markedly over the past two months as the contagion spread beyond the realms of subprime mortgage onto much safer Alt A and even prime mortgages to some extent, thereby hitting major banks, bond insurers, mortgage insurers, hedge funds among others. The latest TAF auction reflected heightened demand for funds with the number of bidders increasing to 82 from 72 previously while total propositions rose to USD 92.595 bn from USD 50 bn previously.

How is TAF different from TSLF?

The Fed has established the Term Auction Facility (TAF) program in order to auctions funds to depository institutions of approximately one-month maturity. The TAF is essentially a collateralized credit facility that allows all those depository institutions that are eligible under the Discount Window Facility, to bid for an advance from its local Federal Reserve Bank at a rate that is Auction determined. The collateral that is eligible to be pledged remains the same as under the Discount Window facility, which includes U.S. Treasury securities, State and local government securities, Collateralized mortgage obligations (AAA rated), and Investment-grade certificates of deposit.Under the Term Securities Lending Facility (TSLF) the Fed auctions U.S. Treasury securities, which includes Treasury bills, note and inflation indexed securities against AAA/Aaa-rated Residential Mortgage backed securities not on review for downgrade along with bonds and MBS which are backed by Fannie and Freddie Mac. The TSLF essentially extends the Fed's low-profile Securities Open Market Account (SOMA) lending program enabling banks to pledge a wider range of collaterals for a longer period of up to 28 days at a time rather than overnight, as was the case with SOMA.

Would TSLF serve its purpose?

Global financial markets have hauled the Central Bank's coordinated actions with the Dow climbing 3.5% yesterday while the S&P 500 gaining 3.71% yesterday. Conditions in the short term money markets eased considerably following Fed's initiatives to address hightenened liquidity pressures coupled with an assurance " to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary," The 3M USD LIBOR dipped further below the current fed funds target rate to 2.8675% from 2.938 bps last week while the 6M USD LIBOR touched a low of 2.74% from 2.86% last week. The TSLF provides an important outlet for stained MBS, thereby comforting dealers who were stuck with the soured paper after being dumped by investors facing margin calls. The move would also help partially mitigate the investor nervousness over financial condition of GSEs Fannie Mae and Freddie Mac, who had posted huge fourth quarter losses amidst rising delinquencies. However, there is a high risk that TSLF may prove to be a short term analgesic as the securities lending facility is a temporary transaction with the MBS returning to bank balance sheets after maturity. Also, with the ball now in the Fed's court, the Fed's own balance sheet looks much riskier thanks to the increased share of the risky MBS instead of the safe treasuries. The Fed, which would need to cushion these risky securities with extra collateral and guarantees, seems confident that the TSLF would play an important role in promoting liquidity in the financial markets for treasury and other collateral and thus foster the functioning of financial markets more generally.

Rising foreclosures + plummeting home equity = worsening housing crisis

Credit rating agencies have put ratings of various insurers on watch for downgrades because of continued weakness in the U.S. mortgage markets, especially foreclosures on mortgages backed by subprime and limited-documentation borrowers. Bond as well as mortgage insurers are under tremendous pressure to raise billions of dollars in capital to forestall possible downgrades in their credit ratings as worries about the value of the securities they've insured persist. Failure to make higher payments on ARMs by property owners has lead to a surge in bank seizures of US homes. With property owners failing to make higher payments on adjustable rate mortgages, U.S. home foreclosures have jumped 90% YoY to 45,327 in January. Total foreclosure filings, which include default and auction notices as well as bank seizures, have increased 57% YoY in January, its highest level since August last year. According to Realty Trac, more than 1% of U.S. households were in some stage of foreclosure during 2007. The situation is expected to worsen in the months to come with an estimated USD 460 bn of adjustable mortgages scheduled to reset in 2008. Delinquency rates have already touched their highest levels since 1985 having increased by 87 bps since December 2006 to 5.82% in the last quarter. As long as house prices continue to plummet rising foreclosures would compel banks to resell the foreclosed properties (estimated to be 1 mn in 2008), adding further to the glut of inventory and forcing prices down even further. The vicious circle is expected to persist unless house prices recover. However, a housing bottom looks nowhere in sight with Mr. Bernanke expecting housing to weigh on the economy "in current quarters". The sharp fall in house prices has also created negative equity for home owners as they find it difficult to secure funds on housing stock whose net worth is depleting sharply. Share of homeowners' equity, the market value of a home minus the size of its mortgage, has plunged to 47.9% in the fourth quarter of 2007 from a high of more than 80% in 1945, a reflection of surging delinquencies and housing foreclosures. Value of housing related assets (including mortgaged assets) have fallen by USD 170 bn to USD 20.2 tn last quarter.

Over the recent past, policy markers in coordination with various financial institutions have announced multiple measures aimed at comforting homeowners squeezed by the housing mess. The U.S. Department of the Treasury and the Department of Housing and Urban Development in collaboration with the country's largest mortgage servicers convened the "Hope Now Alliance" whose objective is to try and halt the flood of foreclosures either by freezing mortgage rates, extending payment periods, counseling and postponing or eliminating scheduled rate reset increases. Further more, six major mortgage lenders, namely, Washington Mutual, Bank of America, Wells Fargo, JPMorgan, Citigroup and Countrywide Financial in coordination with the Bush administration have worked out a plan titled "Project Lifeline", wherein the lenders promise to seek contact with homeowners who are 90 or more days overdue on their mortgages. In some cases, homeowners will be given the chance to "pause" their foreclosure for 30 days while lenders try to work out a way to make the loans affordable. The New York State Insurance Department met with banks to persuade them to inject capital into the monolines - reportedly in the region of USD 5 bn in immediate capital and ultimately to commit up to USD 15 bn as concern mounted that further guarantor downgrades could force a fresh round of write-downs. In a move to boost the housing market in expensive areas, the government has raised the cap on the size of mortgages that can be bought by government-sponsored mortgage giants Fannie Mae and Freddie Mac or insured by the Federal Housing Administration (FHA). Furthermore, Fed Chairman Ben Bernanke has urged lenders to reduce the principal amount of troubled mortgages and proposed that the FHA's authority be expanded so that it can then insure the written-down loans.

Although the steps taken by the Bush administration towards rescuing homeowners on the brink of foreclosure are definitely in the right direction, the measures undertaken might prove to be just a short term palliative rather than providing a permanent solution. While lenders need to move more aggressively to reduce loan balances to current home values and make monthly payments affordable, these lenders face the risk of lawsuits from troubled investors that own the loans if they believe that borrowers have been given overly generous terms. One also wonders how many of the bigger loans Fannie Mae and Freddie Mac will be able to finance when they themselves are heavily cash strapped having recorded massive fourth quarter losses of USD 3.56 bn and USD 2.45 bn each. While Bernanke's rescue proposals have recieved a positive response from policy makers and are expected to effectively address the housing crisis if implemented succesfully. It is, though, a huge, 'if'.

Recession jitters balloon in the US as labor market sheds 63K jobs in February

Recession jitters ballooned in the US economy after its labor market shed 63K jobs in February, its fastest rate since March 2003. The February NFP numbers belied market expectations of a 25K increase. Job losses suffered in January were worse than first reported, revised to -22K from -17K previously. Two successive months of negative jobs growth does not augur well for an economy slated to be on the brink of a recession. The payroll declines hit almost every sector of the US economy, except for government jobs. However, the gains in government jobs (+38K) did little to offset the massive fall in private employment (-101K). While the goods producing sector extended its downfall, cutting an additional 89K jobs in February (-54K previously), dwindling support from the services sector (+26K from +32K previously) is a major concern for the embattled U.S economy. Substantial job losses in retail trade (-34K) and financial services (-12K) have been primarily responsible for the slowdown in services employment. Within financial activities, employment in credit intermediation (which includes mortgage lending and related activities) has fallen by an additional 5K last month. The manufacturing sector, which has been slashing jobs continually for the past 20 months now, axed 52K more jobs in February (-31K previously) while the construction sector followed suit as employment slumped by 39K from -25K previously. The construction sector has been on a downtrend since the sub prime fiasco unfolded as declining home sales and tightening mortgage lending standards have together dented builders' sentiment. The industry has lost a total of 321K jobs since its peak in September 2006. Meanwhile, the February unemployment rate edged down to 4.8% from 4.9%. This is primarily because some job seekers dropped out of the labor force. The size of the US labor force declined by an estimated 450,000 in February, thereby driving down the unemployment rate. Average hourly earnings increased 0.3%, up 3.7% on a YoY basis. The bleak job report has reinforced the widening view that the US economy is falling into a recession. Amidst the ongoing turmoil in the housing and financial markets, the report has heightened fears of a 'negative feedback loop" in which financial market strain lead to a weaker economy, which in turn leads to more financial market turbulence. The February data supports the Fed's recent aggressive response to signs of economic weakness and suggests further easing at its next FOMC meeting.

US Manufacturing slumps to a five year low as ISM slides to 48.3 in February

Manufacturing activity across the US weakened to a five year low as the US ISM manufacturing breached the 50 threshold in February falling to 48.3 from 50.7 in the previous month. The February reading, which came in slightly below consensus expectations of 49, further aggravates recessionary concerns in the US economy. A reading below 50 signals contraction, while any reading above 50 signals expansion. Digging deeper into the data, the major components new orders and production have also registered a decline with the new orders index continuing to remain in the contraction territory, dropping further to 49.1 from 49.5 in January while the production component of the index edged down, although still above the expansion threshold. (50.7 from 55.2 previously). This underlined the ongoing weakness in capital spending, previously reflected in the January durable goods orders release, which depicted a 5.3% MoM decline in new orders. Inventory liquidation continued for the 22nd consecutive month as anufacturer’s inventories contracted again in February with the Inventories index falling to 45.4 as compared to 49.1 in the previous month. Labor market conditions in the manufacturing sector continued to remain iffy as reflected by the manufacturing employment index, which fell to 46 from 47.1 in January. Meanwhile, inflation concerns remained anchored with the prices paid index still at elevated levels, despite edging down to 75.5 from 76 previously. Historically, ISM has been a reliable predictor of US recessions and the current slump in US manufacturing
has added onto concerns about an impending US hard landing. A slowdown in manufacturing may also end up decelerating trade improvement, a significant factor to support growth during such distressed times. Recent speeches by top Fed officials coupled with the dismal nature of economic and financial news over the past fortnight strongly suggests that the Fed officials are prepared to ease interest rates further in order to stave off a possible recession in the U.S.

Bernanke signals further easing amidst multiple economic risks

Key economic data released over the past fortnight revived angst about a stagflation in the U.S. economy, an unwelcome combination of slowing growth and persistent inflation. Economic jitters finally caught up with U.S. capital spending as new orders for manufactured durable goods plummeted by 5.3% MoM in January after having climbed substantially (4.4% MoM) in December 2007. The housing market continued to plummet as January new home sales declined by 2.8% (588k vs. 605k previously), thereby posting the weakest reading since February 1995. An iffy labor market has begun to weigh heavily on consumer confidence, which fell to its lowest reading since March 2003. Meanwhile, inflation qualms came to the fore, fueled by oil’s rally to records over USD 100 a barrel. US headline CPI increases 0.4% MoM in January, a pace akin to that in the previous month. Inflation of core prices (excluding volatile food and energy costs), which is closely watched by the Fed, edged up to 0.3% MoM (the fastest pace since June 2006) from a steady 0.2% in each of the preceding 9 months.
While the higher than expected CPI data release had caused some apprehension amongst market participants about the future Fed stance, the Federal Reserve Chairman Ben Bernanke’s semi annual testimony before the House Financial Services Committee effectively dispelled any doubts on this front. Although the chairman did acknowledge that inflation risks are skewed slightly to the high side, he made it clear that the growth still remains the Fed’s primary concern. Offering no indication that the struggling housing sector is approaching a bottom, Mr. Bernanke noted that housing would weigh on the economy “in current quarters” and that nonresidential construction which had held up well so far “is likely to decelerate sharply”. He acknowledged that the contagion had begun to affect other sectors of the economy like consumer and business spending, which had survived the housing turmoil for most of 2007. Noting that some small banks could yet fail because of the recent housing crunch, the Chairman reminded investors of possible risks remaining in the financial sector .He added that financial markets remained under ‘considerable stress’ and that officials will monitor financial developments ‘closely’.
Bernanke’s dovish comments reverberated Donald Kohn’s speech earlier in the week. The Vice Chairman had warned that the turmoil in credit markets and the possibility of even slower economic growth posed a ‘greater threat’ than inflation. He had also added that the housing correction had further to go, and financial market recovery was likely to be prolonged. In line with the gloomy outlook, the FOMC members lowered their growth forecasts for 2008 which were released along with the minutes of the January 30th FOMC meeting. While the minutes clearly focused on the downside risks to growth in the near term, the real GDP central tendency range was shifted down from 1.8 - 2.5 to 1.3 - 2.0 for 2008 and unemployment rate moved higher to 5.0 - 5.3. Although the minutes did revise its inflation forecast higher to 2.0-2.2% for 2008, the focus remained on inflation expectations, which are believed to be still under control.
Recent speeches by top Fed officials coupled with the dismal nature of economic and financial news over the past fortnight strongly suggest that the Fed officials are prepared to ease interest rates further in order to stave off a possible recession in the U.S. This has further reinforces another 50 bs cut in the Fed funds rate at the March 18th FOMC meeting with risks definitely skewed on the downside

Global Financial Conditions Monitor - Week ending February 29, 2008

Global equity markets remained depressed last week amid a succession of downbeat corporate news, and weak economic data. Earlier in the week, investors had grown hopeful that the worst might be over for firms saddled with soared mortgage-related bets following positive developments in the monoline industry. However, that optimism quickly evaporated following a string of negative headlines as the week progressed. AIG’s fourth quarter results coupled with UBS estimates that losses from the global credit crisis will top USD 600 bn reawakened investor’s financial fears, after the insurance major reported a USD 5.29 bn loss, the deepest in its history, and took a USD 11.2 bn write down related to the estimated market value of credit derivatives. The Dow ended down 2.42% over the week, while the FTSE slipped 1.92%.

Shaken by the credit market malaise, Government sponsored mortgage lenders, Fannie Mae and Freddie Mac, recorded massive fourth quarter losses of USD 3.56 bn and USD 2.45 bn each amid a sharp rise in delinquencies. With Standard Chartered having abandoned a plan to bail out Whistlejacket Capital, the SIV booked losses of USD 300 mn and became the first bank-sponsored SIV to default. In an odd silver lining, the monoline industry got a temporary breather last week as Moody’s became the second ratings agency to reaffirm MBIA’s AAA rating after S&P on Monday. Both rating agencies have moved MBIA to negative outlook from ‘on review from downgrade’, thereby reducing the possibility of imminent ratings cut.

The embattled municipal bond market received a major setback last Friday after hedge funds were forced to unwind complicated bets and in the process dump billions of dollars of the securities. The hedge funds fire sales sent yields on debt from munis to historic high levels, with the average AAA-rated, 30-year muni bond yielding 5.14% on Friday as compared to 4.42% on a U.S. Treasury 30-year bond. The future looks gloomy for the munis with two short-term municipal markets, for auction rate and variable demand note obligations, having frozen in recent weeks because investors are apprehensive about the credit worthiness of bond insurers as a result of their bad bets on subprime mortgage investments.

Short term money markets beginning to feel the pressure:

The Federal Reserve's sixth auction through its Term Auction Facility (TAF) lent USD 30 bn of 28-day credits at 3.080 pct, above the 3.0 pct Fed funds target rate and well below the 3.5 pct discount window rate. The auction reflected increased demand for funds with the number of bidders (72 from 66), and the spread between the stop-out rate and the minimum bid rate (27bp from 15bp) going up.
The 3M USD LIBOR dipped marginally to 3.0575% while the 6M USD LIBOR edged down 1.25 bps over the previous week to close 2.93%. The total weekly borrowing from the discount window fell to USD 0.845 bn from USD 1.1 bn previously.

The Asset backed commercial paper (ABCP) market showed some improvement after deteriorating for 4 consecutive weeks after its outstanding value rose by 7.6 bn as compared to a USD 11.6 bn dip in the previous week