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Worst Credit Environment In 22 Years

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At 2:PM on Friday the Dow was nearing positive territory when the Bear Stearns CFO said this was the worst credit environment in the last 22 years. That was all the market needed to hear and the Dow took an immediate -150 point plunge. Just when traders had begun to think it was safe to venture back into the market the evolving news in the financial sector came back to haunt them. BSC shares fell -$9 almost instantly but recovered some before the close.

Dow Chart - Daily

S&P-500 Chart - Daily

It was not a bad market until the Bear Stearns comments. The morning's economics headlined by the nonfarm payroll report were market positive. 92,000 jobs were created in July and while that was well below the 130,000 estimate it was considered right in the middle of the Goldilocks range. Not cold enough to fear an economic slowdown and not hot enough to wake up the Fed. There was also a change in the revision trend. Jobs in the prior two months were revised downward by a total of -8,000 jobs. The trend for many months has been for strong upward revisions. The unemployment rate rose slightly to 4.6% and the highest rate since January. Average hourly earnings were flat with the recent average at +0.3%. The 3rd quarter appears to be starting slowly and with new job creation declining to a level not seen since February the outlook is not positive. The impact of the housing sector on the U.S. economy is growing and the employment outlook for future months is dropping. A continued slowdown in housing will impact hiring in construction, financial, building materials and retail sectors.


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The housing induced slowdown was already evident in the ISM Services number, which came in at 55.8 in July. This was a significant drop from 60.7 in June and there were declines in nearly every component. Only order backlogs showed a material gain from 46.5 to 53.0. The Manufacturing ISM on Wednesday also fell from 56.0 to 53.8. There is definitely a downturn in progress in the U.S. economy and the Fed will have plenty to discuss when they meet on Tuesday.

The Tuesday FOMC meeting is the only major economic event next week. Given the breakdown in the financial sector and the buyer boycott for any manner of credit instrument the Fed is faced with another situation similar to the LTCM crash and the Russian debt default in 1998. One commentator was calling this financial crisis as 1998 in slow motion.

Economic Calendar

Friday was full of financial news and none of it was good. It started with S&P changing its outlook on Bear Stearns from stable to negative and warned that problems could impact performance for an extended period. S&P said Bear Stearns was one of the nations largest underwriters of mortgage securities and had significant exposure to the downturn in the mortgage market. This downgrade came after BSC said it was preparing bankruptcy filings for its hedge funds currently in default. That is not a good sign for investors even if BSC is not specifically liable for their defaults.

At 2:PM Bear had a conference call when they should have been hiding from analysts. On the call the CFO said the credit markets were in the worst shape in 22 years. There are no buyers for any type of paper and billions in loans are going unsold. Bear said they were canceling their stock buyback to "preserve capital" for future problems. That is not what you want a major financial institution to disclose. If preservation of capital is a major concern then there may be serious problems we don't yet know about. The CFO said revenue was under significant pressure in July but they did expect to post a profit for the period. That could be the first cautionary statement in a string of warnings to come.

Bear could be approaching levels where a takeout is possible. JP Morgan CEO James Diamond has previously expressed interest in BSC but could not make the numbers work at the values BSC was trading at in the past. Now that BSC is 40% cheaper than it was in Jan-2007 the door may be open for a JP Morgan acquisition. Bear is in serious trouble but not in financial trouble. It will not be able to sell any future hedge fund participations after having three of their funds blow up so visibly in the public eye. With their inability to sell commercial paper today they need an outlet for the billions in loans they have hung on their books. Left alone Bear will eventually extricate itself from this problem but it will be years before their reputation has healed. In the financial sector reputation is a key asset that allows a firm to attract and place those large deals and profit from monster fees. Bear now has two black eyes and there could be more problems ahead.

Bear Stearns Chart - Weekly

American Home Mortgage Chart - Weekly

I wrote about American Home Mortgage on Tuesday and after a rebound on Thursday things got a lot worse for investors and employees on Friday. AHM said it was firing its 7000 employees and would cease most operations. A bankruptcy filing is expected next week. This was the 10th largest U.S. mortgage lender originating $59 billion in loans last year and primarily lent to people with good credit not subprime loans. What killed them was the lack of a bid on mortgage loans in the secondary market and a rising default rate. Once they were unable to continue closing loans it was a quick trip to bankruptcy. They left nearly $1 billion in loan commitments unfunded leaving homebuyers scrambling to find another mortgage on the eve of their real estate closings. Without credit lines AHM could not cover the margin calls from loans going into default and the house of cards came tumbling down. Several states revoked their license to do loans after the company failed to follow through on loan commitments. The founder and CEO owned 9.47% of AHM shares on Monday but had 2.97 million shares liquidated at $1.72 per share due to margin calls. He had pledged his shares in Oct-2005 to secure a revolving margin loan. They were worth $35 each at the time. Ouch!

This has not been a good week for financial stocks, builders or homebuyers. In the last 72 hours rates for home mortgages have spiked significantly reflecting the risk to lenders in reselling the loans. Wells Fargo raised the rate on a $425,000 loan from 6.78% to 8.0% with 20% down. Rates were also rising at Greenpoint to 7.875%, Chase 7.25%, and Citi 7.5%. No doc, low doc and no down loans have disappeared from the scene replaced with full qualification, full doc loans at rapidly rising rates. The Indymac CEO said "the secondary loan market has ceased to function." Without a secondary loan market those still writing loans will quickly fill up their short term credit lines and cease taking applications. Wachovia said they were halting all but the best loans.

There is also a move in congress to legislate loan requirements and it is being called the lock out bill because it would lock out 50% of borrowers from qualifying. 14 million people closed on a mortgage loan in 2006 and more than 7 million of them would not qualify under the new rules. Reportedly those are the same 7 million that may lose their homes when those loans reset over the next 18 months. The peak of the $1.2 trillion reset will occur in October 2007. With home prices falling, loan rates rising and loan requirements increasing the odds are very good many who are currently making payments on time will end up being forced to sell by year end.

Is there no hope for the financial sector or is it all in the spin being produced for your benefit in the press. Larry Goldstone, CEO of Thornburg Mortgage (TMA), was interviewed on Thursday regarding their delinquency problem. He said he did not have a problem. Thornburg only writes prime loans and has 38,000 on the books with an average loan amount of $630,000. Their delinquency rate has doubled over the last year. Doubled to 57 loans out of 38,000. Yes, only 57 loans are in 60-day default. That is 0.21% and not even worth mentioning. It is not even a footnote for them that defaults rose from 27 in 2006 to 57 in 2007. Larry said it was all in the definition of prime, alt-A and subprime. Industry wide lenders claim a default rate on prime ARMS of 2.3%. That is more than 10 times the rate at Thornburg. The Mortgage Bankers Association says default rates on true prime loans are "virtually unchanged" from 2006. Larry claims the problems came from banks that wrote loans to customers who could not qualify at the full rate. They were making so much money from fees they continued to come up with creative ways to qualify individuals with no verifiable income and no down payments and then repackaged these "liar loans" as alt-a or prime using their own grading rules and package structures. Those loans are the ones that are defaulting not the true prime loans. Since Thornburg has the stats to back up their prime default rates I believe this financial crisis may not be as bad as it is being represented. Unfortunately many lenders did write millions of those liar loans and those will be flushed through the system over the next 12-18 months.

The current credit crunch may have originated with the subprime problem but it has spread to every area of the financial spectrum. In the last 30 days 46 LBO deals have been pulled from the market totaling over $60 billion. Unsold loans are piling up at major banks according to Dealogic. According to Dealogic there are $269 billion "hung loans" in the US and $208 billion in Europe with over $500 billion worldwide. Three banks admitting unsold loans last week were JPM $17.4B, RBS $18B and Barclays $16.2B but that is just the tip of the iceberg. There are increasing worries that there are bigger problems ahead. As each deal blows up or gets postponed that causes other banks to withdraw a little further into their shell and retract any outstanding bids. Nobody knows what is going on and nobody wants to get stuck holding loans if the music stops. This buyer boycott has paralyzed the market even though there have not been any defaults of those deals. It is simply a prime example of gridlock while everyone waits for the smoke to clear. With news of closures or bankruptcies nearly every day there is no rush to venture back into the loan market.

The Fed meets Tuesday and right now all eyes are focused on the Fed announcement as the light at the end of the tunnel. Almost everyone expects the Fed to come to the market's rescue by changing their bias and putting calming sentences in their statement. Since Bernanke has already said it was not the Fed's job to rescue the equity markets I think we are facing a disappointment. I am sure they will change the statement but it may not be what the market is hoping for. It is commonly thought that the Fed is the backstop for the market and that is where the we got the term "Greenspan put." With the weakness in the housing market, a slowing in the ISM manufacturing and services and slowing job growth the Fed should be thinking about a rate cut. Most feel it won't happen until 2008 and that is creating a scenario similar to Nero fiddling while Rome burned. Some analysts feel that by not cutting rates now Bernanke is fiddling while the U.S. housing sector goes down in flames.

In the stock news Network Appliance fell -20% to $22 after warning that corporate customer spending had slowed. NTAP is now forecasting 19-20 cents where analysts had been expecting 25 cents. That number had already been adjusted lower from 31 cents when NTAP guided lower back in May. Bear Stearns said two quarters of soft sales could be a harbinger of deeper problems and cut them to an under perform. Citi upgraded NTAP to a buy saying the dip was a buying opportunity. The Citi analyst said bookings were up +30% year over year and he expected a sizeable buyback program soon. I would think a drop to a 2-year low would be a good opportunity to buy back stock.

Apple Inc (AAPL) lost another -$4.64 despite expectations for a new Macintosh computer line to be announced next week. The move is just in time for back to school and the holiday shopping to come. Apple sold 1.76 million Macs in the last quarter, a +33% increase over the year ago quarter. The patent infringement suits have started with several different companies claiming the iPhone violated their patents. Most will probably be frivolous in the hopes Apple will pay them to go away. There was also a warning that a power failure in a Samsung flash memory factory could cause a shortage of iPod and iPhone components. That report was quickly squashed when research firm iSuppli said production could be restarted as soon as this weekend.

Take-Two Interactive said it was delaying the next installment of Grand Theft Auto (IV) until 08Q1 and miss the entire holiday shopping season. TTWO fell -2.75 on the news. TTWO is now expecting a large loss for the next quarter instead of a profit. Activision (ATVI) gained +50 cents in a very bad market after reporting strong sales of Guitar Hero II, Spiderman 3 and Shrek the Third.

Rent-A-Center (RCII) continued its plunge with another -5% drop after warning of lower earnings on Monday. Rent-A-Center customers are those homeowners and renters that cannot afford to buy furniture. With that sector of the population undergoing severe stress from rising mortgage/rent payments and higher gasoline prices it only makes sense that RCII would take a hit on revenue. I would not expect that business to improve before mid 2008 or later.

Cerberus Capital completed its acquisition of 80.1% of Chrysler despite multiple restructuring problems. Cerberus had to put up more capital and several banks had to eat their loan commitments but the deal got done. DaimlerChrysler, now just Daimler AG, will continue to hold a 19.9% interest. Chrysler was acquired by Daimler nine years ago in a $33 billion merger. It was a stormy marriage and now divorced for $7.4 billion Chrysler is free to "make the long term investments with laser-like focus" according to CEO Tom LaSorda. Chrysler still faces $18 billion in long-term retiree health care costs and Cerberus has agreed to assume that burden. What in the heck were they thinking?

Oil prices fell sharply to settle at $75.20 after hitting an intraday high of $77.36. The nearly $2 drop closed a week that saw a new historic high at $78.76. That 4.5% drop was prompted by many factors. OPEC continues to say global supplies are more than adequate and will not discuss increasing production until September. They repeated their claims that $65 was a fair price when oil was over $78. That took some strength out of the rally. Secondly the hurricane forecasters cut their estimates of hurricanes to only 15 named storms for the year with 8 in the Atlantic/Caribbean region. With no storms around the gulf to date and none on the radar the lowered forecast prompted additional profit taking. September 10th is typically the peak of the season so still plenty of time for some trouble to appear. Gasoline production continues to increase with gasoline prices barely clinging to the $2 support level. Once that $2 level breaks we could see oil back under $70. Oil stocks were particularly week with the Oil Service Index losing -6.2% for the week. That was only exceeded by the broker index losing -7.6%.

Crude Oil Chart - Daily

The markets are not healthy and several analysts attributed much of the selling to hedge fund redemptions. Reportedly they have been very strong over the last couple weeks due to the blowup at the three Bear Stearns funds and the -50% loss and closure at Sowood. Investors are very skittish despite enormous profits at those funds that bet against the subprime slime and the equity markets. Some of those funds are up +40-60% for the year but they are in the minority. I reported for three weeks ahead of the decline that short interest and margin loans were at record highs and trouble was brewing. It appears to have come to a boil.
The Dow has lost triple digits for three consecutive Fridays. That is a feat not seen since Feb-2000. The Dow closed under its 200-day average and a new 3-month closing low at 13181. The Dow was trading at 13454 at 2:00. It closed -273 points lower at 13181 only two hours later. The Bear Stearns comments derailed a midday rebound that had the Dow within 10 points of positive when they were made. Apparently Bear Stearns needing to "preserve capital" for the "worst credit market in 22 years" were not what investors waned to hear. Market internals were very bad with another 12:1 advantage to declining volume over advancing. I was watching the sell on close orders and there were very large imbalances on almost every issue. You might notice in the internals table below that the two lowest volume days for the week were the up days. The three largest volume days were all down days and all three days went into the record books in the top ten volume days of all time. Massive drops on strong volume and lackluster rebounds on weak volume are not positive for market sentiment.

Market Sentiment

The Nasdaq finally closed under its 100-day average but is still holding up better than the other indexes. The Nasdaq-100 is still the strongest of all. The chip sector was a major drag after the Semiconductor Industry Association said chip sales fell -2% from the prior quarter. Shipments were actually up +7% but deteriorating prices kept sales growth in check. Silicon Image (SIMG) lost -1.78 after reporting a decline in earnings and warning that Q3 would miss estimates. Analysts feel margins for chipmakers will continue to shrink as global competition increases. The SOX declined to an 8-week low at 487. Major resistance has appeared at 500 over the last three days.

Nasdaq 100 Chart - Weekly

The S&P-500 fell significantly below its 200-day average at 1450 to close at 1433 and a new 4-month low. This is a major sell signal for funds and that suggests next week could be trouble, especially if the Fed doesn't say something market friendly on Tuesday. If the decline continues the S&P could test major support at 1375. That would be just over a -10% drop from the record closing high at 1553 on July-19th.

Most of the major indexes with the exception of the Russell 2000 still need about another -3% drop to hit full correction status. The table below shows the drop from the recent highs for all the major indexes. The Dow has suffered the least despite its high profile moves with the broker/housing sectors correcting the most. It is interesting that energy has already corrected more than 10% as well.

Correction Table

The Russell-2000 closed at a new 9-month low on Friday at 755. This is only a small step away from minor support at 750 with major support well below at 675. Since the Russell has already corrected more than the rest of the majors I would be looking for a bounce attempt at 750. If that fails we could be in serious trouble. The Russell is well below its 200-day at 805 and uptrend support at 770. There is little to prevent another major flush if 750 breaks. I still view the Russell as the sentiment indicator for mutual fund managers and based on this indicator the market has not yet found a bottom.

Russell-2000 Chart - Weekly

I would be very cautious next week. The Tuesday Fed meeting will be the focal point and unless Bernanke has changed his spots over the last couple of weeks I am not expecting any major concessions to the market. Other news of other financials in trouble will also keep the pressure on stocks. Because of the alternating triple digit days we have been seeing I would also expect investors to be shy about throwing money at the market. Trimtabs said investors took $11.3 billion out of mutual funds in the week ended July-25th with $5.5 billion coming out on Tuesday alone. That was the second highest withdrawal this year with Feb-27th being the highest at $6.5 billion when the Chinese stock market crashed. For the week ending on Wed-8/2 there were $9.5 billion in outflows. Those are some strong redemptions from individual investors and that gives you some idea of the problem the hedge funds are having to deal with. With four funds blowing up in the last two weeks there are some major players taking money out of their hedge fund investments. This will continue to keep pressure on the market until something happens to change the market sentiment. It could be a big new LBO deal announced or possibly a major concession from the Fed or just the passage of time without any new problems. We won't know for sure the bottom is behind us until we can look back from the safety of a much higher level to see an obvious low. I would maintain a bearish bias until proven wrong. I am already compiling a list of stocks I want to buy once that bottom is behind us. I suggest you do the same.

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