Friday, August 22, 2008

Weekend Weimar and Beagle

It's that time of the week. It's time to not think about the markets and move into anything else but the markets. To that end....


The Weimar and the Beagle are enjoying the new couch...



For some reason this is comfortable. I have no idea why. And yes, we are still moving in......three months later......

The Auto Bail-Outs Are Starting

From CNBC:

Lobbyists for the U.S. automakers—General Motors, Ford Motor and Chrysler—briefed White House officials, as well as U.S. Rep. John Dingell and other Michigan Democrats, on a possible bailout and plan to unveil the proposal after Labor Day, according to the report.

The plan is for the government to lend some $25 billion to the automakers in the first year at an interest rate of 4.5 percent, or about one-third what the companies are currently paying to borrow, the report said.

First -- I called this a few months ago. So allow me a blatant ego boost.

This shouldn't surprise anybody. Detroit has been losing money in a big way for awhile now. GM's latest earnings report was terrible:

From Bloomberg:

General Motors Corp., the largest U.S. automaker, reported a second-quarter loss of $15.5 billion because of strains from truck leases, costs from labor disputes and plunging U.S. sales.


The mounting losses are siphoning resources Chief Executive Officer Rick Wagoner, 55, needs to develop fuel-saving cars to replace the pickup trucks and sport-utility vehicles being abandoned by U.S. buyers. Wagoner, now in his 9th year as CEO, won't project when GM will restore profit as he cuts costs by an additional $9 billion annually and carries out a plan to boost cash by as much as $17 billion.

``The trends that are out of their control, those are the things that have the potential to overwhelm them,'' Robert Schulz, a debt analyst at Standard & Poor's, said yesterday. He was referring to record gasoline prices that have transformed consumer behavior while a weakened U.S. economy drains auto sales to 15-year lows. ``We don't see the macro environment anywhere near on the mend,'' Schulz said.


S&P yesterday cut GM's credit rating one level to B-, or six steps below investment grade, because falling U.S. sales are causing the automaker to use more cash than anticipated. With the U.S. auto slump expected to carry into next year, GM faces a risk of further cuts, Schulz said. GM had the highest rating, AAA, from 1953 until 1981.

And the latest sales figures were equally bad:

From the AP:

General Motors, Ford, Toyota and other automakers said Friday that their U.S. sales fell by double-digits. Nissan Motor Co. was the only major automaker to report a gain, with truck sales up 18 percent thanks in part to the new Rogue crossover and a boost in incentives. Nissan's overall sales rose 8.5 percent.

Automakers were expecting a slide in July as high gas prices continued to cut into sales of trucks and sport utility vehicles and new troubles in the auto leasing sector further wrecked consumers' confidence. July's seasonally adjusted sales rate -- which shows what sales would be if they continued at the same pace for the full year -- was 12.5 million vehicles, according to Autodata Corp. That's down from 17 million as recently as 2005.

Automakers expect things to get worse before they get better.

Here's the real issue.

About 7 years ago, Toyota unveiled the Prius which has now sold 1 million cars. That's a company that is doing well. Honda, which got into trucks late in the game and still primarily relies on fuel efficient cars is doing well. Here are their charts:



Not great, but certainly not terrible.

Ford and GM -- which make non-fuel efficient cars -- are a different story.



So -- make a terrible product and get a government loan for your mistakes.

Manufacturing Is Not Looking Good

From the NBER (on what they look for in order to date a recession):

The committee places particular emphasis on two monthly measures of activity across the entire economy: (1) personal income less transfer payments, in real terms and (2) employment. In addition, we refer to two indicators with coverage primarily of manufacturing and goods: (3) industrial production and (4) the volume of sales of the manufacturing and wholesale-retail sectors adjusted for price changes.

We've had most of the industrial output information released for this month now (save for the Chicago index which comes out next week), so let's take a look at all the pieces to see what the result is.


The year over year (YOY) change in industrial production has been dropping for the entire year. In addition, it's starting to move into negative territory on the chart, indicating a yearly contraction. This is a macro level statistic -- a statistic for the whole country. Therefore, it's safe to say the country's manufacturing sector at best treading water.


Although we've seen three months of increases, the longer-term industrial production trend is down indicating the country is using less and less of its overall industrial capacity. Overall, this is another bearish signal.


The Chicago area is treading water, with consistent readings right around the 50 area. In other words, the sector is hanging on, but barely.


The New York are is not doing much better:

The general business conditions index, at 2.8, increased slightly from its July level of -4.9, indicating a marginal improvement in business conditions over the month. Roughly a quarter of respondents reported that conditions improved in August, while 23 percent reported that conditions had deteriorated. The new orders index, after increasing in July, fell slightly below zero to -2.2. The shipments index, in a similar pattern, gave up its July gains, falling to -0.9. The unfilled orders index held steady at -9.0, as did the delivery time index, at -3.4. The inventories index rose sharply after a steep decline last month, rising above zero to 5.6, its highest level in over a year.

The Philly Fed isn't doing much better:


From the related report:

The region's manufacturing sector remains weak, according to firms polled for the August Business Outlook Survey. Indexes for general activity, new orders, shipments, and employment were all negative again this month, although slightly higher than in July. Price pressures remain but were slightly less widespread compared to recent months. However, more than one-third of the firms continue to report higher prices for their own manufactured products. Most of the survey's future indicators moved higher this month, suggesting that the region's manufacturing executives believe growth in their sector will return over the next six months.

So, the bottom line is manufacturing is doing poorly (at best).

Forex Fridays --- The Dollar


On the weekly chart, notice the following:

-- The dollar broke through the downward sloping trend line that started at the beginning of 2006. That's a big development because it adds further evidence to the "trend reversal" argument. However, prices have fallen back through the line this week. It's possible we'll see prices gyrate around this very important level as traders decide how much higher they want to send the dollar. But for this to be a bona fide rally, the dollar must eventually move beyond this important technical indicator.

-- The 10 and 20 week SMA are both moving higher

-- The 10 week SMA crossed over the 20 week SMA

-- Remember the above two numbers are weekly numbers, so any change in trend is very important.


On the daily chart, notice the following:

-- All the SMAs are moving higher

-- The shorter SMAs are above the longer SMAs

-- Prices clearly broke through the upper trend line of the upward sloping trend channel.


-- Prices have moved below the 10 day SMA in a fairly convincing fashion, indicating a short-term correction is probably underway. But corrections are standard in rallies, so it does not mean (in any way) that the rally is over.


On the P&F chart, notice there is a great deal of resistance in the 80/81 area. That means there is plenty of upside room for prices to run at this point if they want to.

It's important to remember why the dollar is rallying right now. There are two fundamental reasons for people to buy a currency. Either the currency's interest rates are attractive relative to other currency's interest rates or the currency's economy is growing and therefore attractive for investment. The US does not have either fundamental development right now. From an interest rate perspective, notice the US' rates are not competitive compared to other rates:


And the US economy is not in a strong position:

The Labor Department's weekly tally of claims for unemployment benefits shows joblessness is at recessionary levels, while the Conference Board's index of leading indicators, released Thursday, dropped sharply last month, suggesting economic conditions will weaken further this year.

"A few months ago, there was some discussion about a second-half recovery," said Ken Goldstein, an economist with the Conference Board, a business research group based in New York. Now, "if there's a second-half recovery, it'll be the second half of 2009."

So -- why is the dollar rallying?

It's not. Instead, the euro is dropping.


Notice the euro's chart is a mirror image of the dollar's chart. While the dollar has been dropping over the last two years, the euro has been the prime beneficiary of the drop. However, over the last few weeks, the euro has dropped about 7.8%, indicating there is a fundamental shift in the euro trade. That occurred when ECB President Trichet acknowledged the EU economy was weak and he might actually have to lower rates (or at least not raise them). In essence, be became an inflation dove overnight.

So -- we have a technical rally in the dollar caused by weakness in the euro, not strength in the US economy or higher US interest rates. As a result, the 80/81 price area on the dollar's PF chart looks like a really strong area of upside resistance to this rally.

Thursday, August 21, 2008

Today's Markets

Let's look at the macro environment to remember where we are:


Since the end of last summer, the market has made a series of lower lows and lower highs -- a standard bear market formation.


On Monday, the market fell through the support line started in July. The market is consolidating below that line. Notice the following:

-- Prices ran into the 50 day SMA today and fell back

-- Prices moved through the 20 day SMA

-- Prices are still below the trend line started in July. The longer they stay below this level, the worse off the technical side of the market.

Let's Look A Bit Deeper Into the Future Inflation Picture

Over the last few weeks, I've noted that with oil coming down in price we should also expect a drop in inflation. Here are the relevant inflation charts:


Y/O/Y inflation has remained stubbornly high for the last 6+ months


Import prices continue to rise, and


Producer prices continue to move higher as well.

Reference oil's chart below for its recent price movement. Here is a chart of gas prices from This Week In Petroleum, which shows prices are already dropping at the retail level:


However, this may not be the case with agricultural prices. While we've seen some noticeable drops in several commodities like corn:


and wheat:


We're not need a commensurate drop in the overall price of agricultural prices:


On the weekly agricultural price chart notice the following:

-- Prices have been moving sideways with a slightly downward bias since mid-Spring

-- Although prices dipped below the 50 week SMA a few weeks ago, they are now above that important technical indicator

-- Prices and the 10 and 20 week SMA are caught in a tight range, indicating an overall lack of direction in the market.

This is a chart that says consolidation with a possibility of downward movement.

At the retail level, agricultural prices are a bit more stubborn than gas prices:

The economics of the food business are partly to blame. Though crude oil is the main ingredient of gasoline, processed foods like cereal, crackers or cookies use only a small amount of corn, wheat and other grains, limiting manufacturers' pricing power.

"Basically, there's only a few cents worth of corn in a box of corn flakes, so food prices are much slower to react to the downside than energy prices, " said Richard Feltes, senior vice president and director of commodity research for MF Global in Chicago.

Another factor keeping food prices high: Though commodities prices have fallen from record levels, they're still well above historical levels. Corn and soybeans have dropped 24 percent and 17 percent, respectively, in the last two months but are still about double where they were two years ago.

These are interesting points, and ones I hadn't considered (largely because I didn't know about them). Basically, oil is a big part of gasoline but corn and wheat aren't as big part of the final food product. That means lower raw materials prices don't necessarily translate into lower final products prices.

Refer to the corn and wheat charts above. Note they are at very high levels even after coming down. Both wheat's and corn's price is more than double since 2006 which will have a negative impact on food prices.

But also consider this:

Looking ahead to next year, economists see a mixed bag for American consumers. While falling grain prices should slow the rate of increases for baked goods, the USDA's Leibtag says people can expect to pay more for other items like beef, pork and chicken.

That's because as grain markets took off, the cost of corn- and soybean-based animal feed skyrocketed. Now, livestock owners — who spend half or more of their production costs on feeding their animals — have had to thin the size of their herds and flocks to deal with the increases. Cow slaughter has jumped 22 percent over last year, while hog slaughter is up 10 percent.

Much of that meat has gone into freezers to handle excess supply, but as the inventory dwindles, livestock owners won't have the money to replenish their herds to meet demand.

"That's going to have some serious consequence at the retail level," said Jesse Sevcik, vice president of legislative affairs at the American Meat Institute. "The only thing left is for prices to go up."

Expensive animal feed has also battered poultry producers, who so far have resisted passing on those costs to consumers to safeguard chicken's image as a good value compared to ribeye steaks and pork chops. But that's about to change, said Bill Roenigk, senior vice president of the National Chicken Council.

"From a consumer standpoint, more and more of these feed costs are going to be passed on and that means higher prices at the supermarket," said Roenigk.

Falling grain prices have taken some

In other words, there is a longer cycle of food cost increases. It's similar to dropping a stone in a pond; some ripples don't appear for awhile.

Either way, this article has gotten me thinking about he future inflation picture and wondering whether the drop in commodity prices will lower prices at the retail level in a significant way.

Thursday Oil Market Round-Up


Let's start with the macro-view. The oil market started a rally in early 2007. Prices are now at that trend line started in early 2007. In addition, notice the following:

-- The 10 week SMA has turned lower and will probably cross the 20 week SMA within the next few weeks. This is the first time this has happened since 2006.

-- Prices are the farthest below the 20 week SMA in almost two years


On the daily chart, notice the following:

-- All the SMAs are headed lower

-- The shorter SMAs are below the longer SMAs

-- Prices are below the 20 and 50 day SMAa and are just above the 10 day SMA

-- Prices have broken through the downward sloping trend line started in mid-July

Bottom line: the market looks like it wants to either rally or consolidate sideways. Given the extreme over-sold position of the MACD and the failry oversold condition of the RSI, a rebound would not be unexpected. But this will run into the increasingly strong downward momentum from the downward sloping 10 week SMA. I think the best we can expect is some kind of short-term rally.

Wednesday, August 20, 2008

Today's Markets


On this chart, notice the following:

-- Prices are below all the SMAs

-- Prices are below the trend line that started in early July

-- The long-term SMAs (50 and 200) are both heading lower

-- The 10 day SMA has moved neutral

-- Prices are still below the 200 day SMA

Now -- let's look at the 1-month chart


Specifically notice the last two days. Note that prices have gotten over the 10 day SMA, but have not closed above that level. In addition note the lack of movement as indicated by the candles with small bodies. Traders are still trying to figure out where they want to go.

Fannie and Freddie Tumble

From Bloomberg:

Fannie Mae and Freddie Mac tumbled in New York trading to the lowest valuations since at least 1990 as speculation increased that the U.S. Treasury will bail out the mortgage-finance companies, wiping out shareholders.

Fannie, based in Washington, slumped as much as 20 percent and McLean, Virginia-based Freddie dropped as much as 32 percent, extending its losses to 90 percent for the year.

``Using taxpayer money to bail them out looks like it's becoming reality now,'' said Michael Nasto, the senior trader at U.S. Global Investors Inc., which manages $5 billion in San Antonio. ``That's going to leave the shareholders holding worthless paper.''

What I find really interesting about this story is the blogs got it right from the very start while the main business press, well, didn't. I've gone over this before, but it's worth a second look. Fannie has about $40 million in equity. But they also have "long-term investments" totaling $650 million (and that's down from $787 million the previous quarter). Raise your hand if you think that portfolio is valued properly. Freddie has about $12 million in equity and a long-term portfolio at $760 million. Raise your...never mind. Freddie is one breath away from negative book value -- and Fannie isn't that far behind.

Let's go to the charts:


Notice the following:

-- Prices are below all the SMAs

-- All the SMAs are headed lower

-- The shorter SMAs are below the longer SMAs

-- Prices are below the 200 day SMA


Notice the following:

-- Prices are below all the SMAs

-- All the SMAs are headed lower

-- The shorter SMAs are below the longer SMAs

-- Prices are below the 200 day SMA

These charts say on thing: bankruptcy.

A Closer Look At Gold

Considering this is Wednesday, let's take a look at the gold market. I use the gold market as an inflation proxy, meaning gold's price is a decent indicator of inflation expectations. To that end....


This is big news. The gold market has been rallying for the last three years. However, we now see that gold has broken below the three year trend line. This signals a reversal of trend. Also note this is the most liberal trend line available -- the trend line that connects the lowest lows of the last three years. Using a trend line that connects more of the bottoms yields this result:


In other words, no matter how you slice it, the trend has been changed.


On the daily chart, notice the following:

-- Prices are below all the SMAs

-- All the SMAs are headed lower

-- The shorter SMAs are below the longer SMAs

-- Prices have broken two trend lines. The first is the upward sloping trend line that started at the beginning of May and the second is the low point from early May.

Bottom line: this is a chart that has changed directions, indicating inflation expectations are dropping.

Wednesday Commodities Round-Up


Let's start with the macro-level view:

-- The CRB started to rally at the end of last summer, and has risen about 58% from low to high.

-- The CRB clearly broke that trend earlier this month, signaling a new trend (or at least a consolidation).

-- Prices are now below all three weekly SMAs

-- The 10 week SMA is about to cross below the 20 week SMA. Remember -- these are weekly SMAs, so it takes longer for them to move. But when they do move the moves are that much more important

-- The 50 week SMA is now acting as resistance as opposed to technical support.


On the daily chart, notice the following:

-- Prices are below all the SMAs

-- All the SMAs are headed lower

-- The shorter SMAs are below the longer SMAs

-- In two instances over the last month, the 10 day SMA has provided upside resistance as opposed to support. This is a bearish development for the index

Bottom line -- this market is clearly in a solid correction. The main question now is how long until this starts to show up in CPI/PPI numbers.

Tuesday, August 19, 2008

Today's Markets


This is the big news today -- a possible break of the upward trend. The market started to rally on July 15 and has been in a clear uptrend since then. As prices rose they pulled the SMAs higher. However, today prices moved below the trend line established at the beginning of the latest rally. Prices are also below the SMAs.

This is an initial move -- and could turn into nothing more than a simple correction as the market rallied higher. However, the news this week has not been good. It started with Fannie and Freddie concerns (which are very well founded) and today we learned the housing market is nowhere near bottom.

Simply put, the bad news is really starting to weigh on the market.

PPI Comes in Hot ... But.....


The PPI number came in really hot yesterday, printing a 10% year over year number.



My guess is that so long as we have commodities dropping like this we'll start to see that number come down in the coming months.

Former IMF Economist Sees Big Bank Going Under

From Reuters:

The worst of the global financial crisis is yet to come and a large U.S. bank will fail in the next few months as the world's biggest economy hits further troubles, former IMF chief economist Kenneth Rogoff said on Tuesday.

"The U.S. is not out of the woods. I think the financial crisis is at the halfway point, perhaps. I would even go further to say 'the worst is to come'," he told a financial conference.

"We're not just going to see mid-sized banks go under in the next few months, we're going to see a whopper, we're going to see a big one, one of the big investment banks or big banks," said Rogoff, who is an economics professor at Harvard University and was the International Monetary Fund's chief economist from 2001 to 2004.

"We have to see more consolidation in the financial sector before this is over," he said, when asked for early signs of an end to the crisis.

"Probably Fannie Mae and Freddie Mac -- despite what U.S. Treasury Secretary Hank Paulson said -- these giant mortgage guarantee agencies are not going to exist in their present form in a few years."

This is not an outlandish claim in the current environment. We've seen about a year worth of writedowns and terrible news in the financial sector. Bear Stearns has already gone under. In short, it's surprising that Bear Stearns isn't the only institution to go under at this point.

So, let's look at this guys statement and see what institutions look like they're on the brink. I'll use Yahoo's Yahoo's Money Center Bank List organized by market cap.

Bank of America

BAC bought Countrywide, which BAC is still saying was a good deal. OK -- stop laughing. Here's a 1-year chart of BAC:


Clearly, the market is having second thoughts about this company. The stock has lost 43.6% of it's value since its peak in mid-October last year. While it has enjoyed a nice bounce over the last month or so, my guess is short covering was at least partially responsible. Regarding the Countrywide merger, BAC used a forward triangular merger, which is a standard corporate reorganization tool under the IRS code (for those of you who are really curious, the actual code section is 26 USC 368(a)(1)(B)). What BAC is doing is creating a "bankruptcy remote" vehicle. Essentially, BAC is placing all of Countrywide's assets into a third company and then looking at them before they bring them onto BAC's balance sheet. This is completely legal and a damn smart move on BAC's part.

But, let's return to BAC's stock chart and make this observation. Traders are not thrilled with this company. They have $147 billion in owner's equity. That's basically total assets minus total liabilities. However, there's a really big rub with this number. According to their balance sheet, BAC has $1.1 billion (65% of their assets) in "long term investments. That means portfolio assets. Those are the assets that everybody is writing down right now. This explains why BAC's stock price has been dropping for the last year -- the market really has no idea what these assets are worth.



That chart looks like a winner, doesn't it? (Of course, if I were to go on a televised news show, I would have to say it was time to buy it because it was so low it must be a bargain at right now). Citigroup has lost 63% of it's value since October of last year -- not a good sign.

Here's problem number one. With a balance sheet in the billions, owner's equity is in the millions. Not good. And it gets worse. Long term investments (think portfolio investments) are 7 times the size of owner's equity. In other words, one good writedown and Citigroup goes to negative net worth. Not a good development in any way shape or form. Citigroup has also reported three straight quarterly losses. Bottom line -- this company is ripe for a fall.



Here's another chart that is clearly in a bear market pattern. WB has lost 70% of it's market value over the last year. And again, there's a really good reason for this. Wachovia purchased Great Western Financial over the last few years. Great Western issued a ton of ARMs, which are now doing poorly. Those ARMs still on the books are really digging into WB. In addition, this is another bank that is hanging on by the skin of its teeth. Long-term investments are 7.8 times the size of owner's equity. In other words, one good writedown and book value turns negative. Not a good development.

The above three are good candidates for big problems down the road. The primary reason is their precarious net worth position -- one good writedown and all three turn negative from a book value perspective. And that's not good in any way.

Treasury Tuesdays

Let's first look at the macro-level picture to put the latest action in perspective.


On the year long chart the credit crunch rally is very clear. It started in October of last year and continued until March 2008. Notice that prices continually made new highs, breaking through previous resistance and then consolidating gains. The 50 day SMA provided strong technical support for this rally.

In March of this year, the Federal Reserve brokered and backstopped the Bear Stearns buy-out. This sent a signal to the market that the federal government was in bail-out mode. Therefore traders sold treasuries and bought stocks.

Since the end of June, we've seen the market consolidate in a triangle pattern. Also notice this move occurred right around the 200 day SMA -- the line between bull and bear markets.


The P&F chart shows two points very clearly.

1.) The rally that took place last year, and

2.) The triangle consolidation pattern that is currently occurring.


On the three month chart, notice the following:

-- Price have broken through the top line of resistance in the triangle consolidation pattern that started in mid-June

-- The SMAs are lining up in a very bullish configuration: the shorter SMAs are above the longer SMAs, all the SMAs are moving higher

-- Prices are above all the SMAs

-- Prices are above the 200 day SMA

-- Refer back to the year-long chart above. Notice the 200 day SMA never headed lower.

Bottom line: this chart is technically lining up in a very bullish way.

Monday, August 18, 2008

Today's Markets


Although the market dropped hard today, the real issue is where is the market in relation to the uptrend that started in mid-July. As the chart above shows, we're right at the trend line. Another drop tomorrow with a decent follow through day to the downside this week could signal the end of the run for now.

Housing is Nowhere Near a Bottom

From Bloomberg:

Confidence among U.S. homebuilders was unchanged in August at a record low, signaling there is no relief in sight from the worst housing slump in a quarter century.

The National Association of Homebuilders/Wells Fargo sentiment index held at 16 for a second month, the Washington- based group said today. Readings under 50 mean most respondents view conditions as poor.

Builders are delaying projects as sales drop, foreclosures throw more houses on the market and prices tumble. Job losses, stricter lending rules and growing buyer pessimism indicate builders will need to cut prices further to stimulate demand.

And why should they be anything except really bummed by the future?

KB Homes: Loss in 2007; last four quarters, losing money.

Centex: Lost money for the last four quarters.

Hovnanian: Four quarters of losses

Lennar: Four quarters of losses

Am I the only one seeing a pattern here? These are terrible numbers. And there is no reason to expect it to get any better.

Questions on residential real estate lending. Large majorities of domestic respondents reported having tightened their lending standards on prime, nontraditional, and subprime residential mortgages over the previous three months. About 75 percent of domestic respondents—up from about 60 percent in the previous survey—indicated that they had tightened their lending standards on prime mortgages.2 Of the 32 respondents that originated nontraditional residential mortgage loans, about 85 percent—up from about 75 percent in the April survey—reported having tightened their lending standards on such loans.3 Finally, 6 of the 7 respondents that originated subprime mortgage loans—a somewhat higher proportion than in the April survey—indicated that they had tightened their lending standards on those loans over the past three months.4

I can't wait to see how the perennial bottom callers will spin this into happy news.

The Financial Sector Is Still In Deep Trouble

From IBD:

It's the 5th bank [Wachovia] to agree to repurchase auction-rate securities under pressure from federal and state regulators who said the banks misled investors. It'll buy $8.5 bil worth that investors couldn't sell. Citi, (C) UBS, (UBS) JPMorgan Chase (JPM) and Morgan Stanley (MS) also have agreed to buy back the securities. N.Y. may sue Merrill Lynch over the issue and is probing Fidelity and Charles Schwab. (SCHW)

Here's a list from CNBC of who has settled and for what amounts:

UBS agreed on August 8 to buy back $18.6 billion of debt securities, starting with $8.3 billion from retail and charitable clients beginning on October 31, and as much as $10.3 billion from institutional clients beginning in June 2010. It also agreed to pay a $150 million fine.

CITIGROUP agreed on August 7 to buy back $7.5 billion of its investors' auction rate paper at par to settle charges by the SEC and New York State Attorney General Andrew Cuomo. That would cover an estimated 40,000 retail customers. By November 5, Citigroup plans to have fully reimbursed retail investors. It also plans to try by the end of 2009 to liquidate $12 billion of debt held by more than 2,600 institutional investors. Citigroup will pay a $100 million fine.

MORGAN STANLEY settled with New York State Attorney General Mario Cuomo on August 14 and agreed to buy back $4.5 billion of auction-rate securities from individuals, charities and small- and mid-sized businesses by Dec. 11 and pay a $35 million fine. It will also reimburse customers who sold debt at a loss.

JP MORGAN CHASE settled with New York State Attorney General Mario Cuomo on August 14 and agreed to buy back $3 billion in debt by Nov. 12 and pay a $25 million fine, and reimburse customers who sold debt at a loss.

At a time when everybody in the financial sector is writing down the value of a bunch of these assets, we're seeing some of the largest firms buy-back more trash. This will make the next few quarters of earnings releases that much more interesting.

All of these firms settled these ARS cases very quickly -- as in within a few months of the investigation opening. As a lawyer this signals one point very clearly: somewhere all of the companies have a gaping liability somewhere. And that liability is industry wide. The lawyers looked at this situation and said, "you have no choice but to settle this thing." Bottom line: there was some serious misrepresentation/misdirection going on with all of these firms and they were caught red-handed.

But that's not where the problems end. In fact --- the problems are still really bad:

Let's look at this week's Baron's article on Fannie and Freddie:

Similarly, the balance sheets of both companies have been destroyed. On a fair-value basis, in which the value of assets and liabilities is marked to immediate-liquidation value, Freddie would have had a negative net worth of $5.6 billion as of June 30, while Fannie's equity eroded to $12.5 billion from a fair value of $36 billion at the end of last year. That $12.5 billion isn't much of a cushion for a $2.8 trillion book of owned or guaranteed mortgage assets.

What's more, the fair-value figures reported by the companies may overstate the value of their assets significantly. By some calculations each company is around $50 billion in the hole. But more on that later.


Note, too, that Fannie and Freddie have nonpareil lobbying operations and formidable political strength, owing to their hefty donations and penchant for hiring former political operatives. Besides, the agencies claim they've landed in their current predicament through no fault of their own. As Freddie Mac Chairman and CEO Richard Syron recently put it, the GSEs have been hit by a "100-year storm" in the housing market, accentuated by some higher-risk mortgages that they were forced to buy to meet government affordable-housing targets.

The latter contention is more than disingenuous. A substantial portion of Fannie's and Freddie's credit losses comes from $337 billion and $237 billion, respectively, of Alt-A mortgages that the agencies imprudently bought or guaranteed in recent years to boost their market share. These are mortgages for which little or no attempt was made to verify the borrowers' income or net worth. The principal balances were much higher than those of mortgages typically made to low-income borrowers. In short, Alt-A mortgages were a hallmark of real-estate speculation in the ex-urbs of Las Vegas or Los Angeles, not predatory lending to low-income folks in the inner cities.


The cost of selling new preferred stock, meanwhile, would seem to be prohibitive for Fannie and Freddie. The dividend yields on their preferreds have soared to around 14%, in part because of a recent rating downgrade by Standard & Poor's. Yields that high would blight the future earnings prospects of both concerns.

Should the agencies fail to raise fresh capital, the administration is likely to mount its own recapitalization, with Treasury infusing taxpayer money into the enterprises, according to our source. The infusion would take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie's and Freddie's existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends. Then again, the administration might show minimal kindness to preferred shareholders; local and regional bankers have been lobbying the Bushies not to wipe out the preferred since the bankers own a lot of that paper and rely on the bank preferred-stock market for much of their own equity capital.

An equity injection by the government would be tantamount to a quasi-nationalization, without having to put the agencies' liabilities on the nation's balance sheet, and thus doubling the U.S. debt. Treasury would install new management and directors at both, curb the GSEs' sometimes reckless investment and guarantee operations, and liquidate in an orderly fashion the GSEs' troubled $1.6 billion in on-balance-sheet investments. Then the companies could be resold to the public without their explicit government debt guarantees, or folded into government agencies like Ginnie Mae or the FHA.

Let's look at the above mentioned bullet points with the following fact in mind: Fannie and Freddie touch some 70% of the US mortgage market. In other words, they are vital to the current US housing market -- now more then ever. They are simply too big to fail.

1.) They are essentially worthless entities based on immediate liquidation value. This is not the first article to make this claim. Mish has been all over this story, and I pointed out last week that there were serious questions regarding Fannie and Freddie's balance sheet valuation.

2.) They are making political claims (all this regulation made us do this) when in fact they were like everyone else in the financial sector over the last cycle. Company X engages is risky lending behavior and increases their earnings for a few quarters. Now their competitors have to engage in the same behavior in order to "keep up with the Jonses". The bottom line is Fannie and Freddie bought crap loans in order to protect their market share.

3.) We've seen financial companies raise a ton of capital over the last 6-12 months. How much longer can this continue before creditors/investors start to really want a larger amount of flesh in the deal? Simply put, people who have invested in the financial sector have been taken to the cleaners by the market:


Notice the following points on the five year chart of the financial sector ETF:

Prices consolidated in 2004 and 2005, essentially moving sideways between $27 and $30 (roughly). Prices rallied from the end of 2005 until the beginning of the third quarter 2007. Also notice the index formed a double top in 2007 with the first top occurring in the first quarter and the second top occurring at the end of the second quarter/beginning of the third quarter. Then came the beginning of the financial market problems when Bear Stearns (remember them?) announced they lost $6 billion in two hedge funds. That's what started the giant cliff-diving move down.

Also note the following

-- The average is trading near the lowest level in 5 years.

-- The average is clearly moving in a lower low/lower high pattern.


On the daily chart notice the following:

-- The 200 and 50 day SMAs are moving lower--

-- The 10 and 20 day SMAs are moving higher. These SMAs have done this several times over the last year. However, the 50 day SMA has rebuffed these move convincingly.

-- Prices are in a clear lower high/lower low pattern

The daily charts longer-term indicators (50 and 200 day SMA) are down while the shorter-term indicators (10 and 20 day SMA) are up. This tells us the current moves are temporary.

But the fun doesn't end there (click on link for a video snippet):

Merrill Lynch, Wachovia and other financial companies are at risk of failure as the cost of raising capital soars at a time when the banks need to pay settlements over auction rate securities, David Kotok, chairman & chief investment officer from Cumberland Advisors, told CNBC Monday.

The cash companies need to shore up bad investments, "is up to about $50 billion and will probably top $100 billion before it's over," he added.

Refer back to point number three from the above discussion of Freddie and Fannie's problems.

Here's the real bottom line: the problems in the financial sector aren't over by a long-shot.

Market Mondays

Let's start with a macro-level view of the market -- where we are in the bigger picture.


The market is clearly in a downward sloping trend. Notice the following:

-- There is a clear lower high/lower low pattern that started in late September/early October last year.

-- Prices are below the 200 day SMA

-- The 200 and 50 day SMA (the long-term averages) are heading lower

-- The 50 day SMA is below th2 200 day SMA



Stocks have been rallying since mid-July. Notice the following:

-- The 10 and 20 day SMAs are moving higher

-- The 10 day SMA has crossed over the 50 day SMA

-- The 20 day SMA is about to move through the 50 day SMA

In other words, all of the short-term indicators are heading higher. But for this to be a legitimate rally that gets us out of a bear market, we'll need to see prices move through the 200 day SMA and through the downward sloping resistant line started in September of last year.