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Breakfast At Paulsons

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After another week of declining fortunes and rising revelations in the financial sector it appears we are setting up for another Sunday morning breakfast meeting with Hank Paulson on TV spelling out the terms of another bank takeover. Rumors were flying on Friday of a sale of Lehman to be completed by Sunday. Another rumor had Washington Mutual also being taken over by JP Morgan this weekend. AIG lost another 32% and is rumored to be in trouble as well with a major announcement only days away. Even GE was not immune to speculation over financial weakness from consumer credit transactions and its inability to sell the credit card business. All in all the markets took the news rather well with the Dow the only casualty with a $6 drop in AIG knocking nearly 50 points of the Dow and GE accounting for another -12 points.

Market Stats [Image 1]

On the economic front the Producer Price Index headline number fell -0.9% and nearly erasing the +1.2% rise in July. The sharp drop was almost entirely due to the fall in the price of oil and gas prices. Prices for finished energy goods fell -4.6% for the month. Core finished goods rose only +0.2% and right inline with the prior trend. If energy prices remain weak we could see a sharp drop in inflation pressures and that would be very Fed positive.

The University of Michigan Consumer Sentiment initial release for September soared to 73.1 and a +10 point gain over the August reading. This is the highest level since January. It was also the biggest monthly increase since Jan-2004. The spike was led by a +13 point surge in the expectations component. It was the biggest increase in that component since 1991 as that recession ended. Inflation expectations also fell sharply due to declining oil prices. The current condition component also rose sharply with a +5.5 point gain. The Michigan Sentiment survey emphasizes consumer finances and therefore the sharp drop in gasoline prices was quickly reflected. However, even at the present headline number of 73.1 it is still below any level seen between 1992 and early 2008. The spike also suggests consumers are expecting the election process to produce change regardless of who is elected and recent events in the news gave them hope on home prices and mortgage rates.

Consumer Sentiment Chart [Image 2]

Retail sales for August did not reflect that rise in consumer sentiment. Sales fell -0.3% and the July number was revised down to -0.5%. Auto sales actually provided a boost in August or the headline number would have been down -0.7%. Other decliners included electronics -1.3%, building material dealers -2.2%, clothing -0.3%, service stations -2.5% and nonstore retailers -2.3%. The drop in sales at service stations was expected given the drop in gasoline prices. Motor vehicles and parts dealers saw a +1.9% gain. The drop in overall sales came from the expiring tax rebates. The money has been mailed and spent leaving consumers with little excess cash for shopping.

The economic calendar for next week is headlined by the Consumer Price Index or CPI on Tuesday along with the Fed meeting on interest rates. The CPI will tell us how much inflation is filtering down to the consumer level and tell the Fed how concerned they should be about raising rates. There is actually some talk about a potential rate cut in the future given the continued weakness in the banking and housing sectors. Nobody expects that at this meeting but it will be interesting to see what the Fed says in their statement. The Fed Funds Futures are showing a 40% chance of a 25-point cut by December. The next meeting is Oct-28th.

Economic Calendar [Image 3]

The big news for Friday and for next week will continue to be the big names in the financial sector and impending takeovers. Lehman announced on Friday it had put itself up for sale and a deal could be concluded by Sunday afternoon. The two main suitors appear to be Bank of America and Barclay's. According to analysts BAC would be a perfect fit. BAC is seen as a commercial bank but has a huge retail base. Gaining access to the top-notch bond trading division and the Neuberger Berman asset management division would be a perfect fit. BAC would also provide a migration path for employees in Lehman to spread their wings inside the banking giant. A Barclay's deal would be more subdued and is seen as less likely. HSBC was also mentioned but sources feel BAC has the lead.

The problem with a Lehman takeover is the potential portfolio risk. Nobody wants to take on tens of billions in high-risk exposure to the real estate and mortgage sector and then be forced to take billions in write-downs every quarter as the problems surface. Nobody, including Lehman, knows exactly what the current portfolio is worth. This suggests any buyer is going to be paying pennies on the dollar in hopes the good loans eventually overcome the losses from problem loans. On Friday the Fed and Treasury said they were aware of the negotiations but there would be no government money or guarantees involved. Saturday morning the WSJ reported that the Fed held an emergency meeting late Friday night on the Lehman problem. In attendance were Paulson, NY Fed President Timothy Geithner, SEC Chairman Christopher Cox, Morgan Stanley CEO John Mack and Merrill CEO John Thain. Identities of everyone else were not disclosed other than "senior representatives of major institutions."

Saturday Update: Late Saturday the NYT reported that the heads of the other major banks in the meeting were warned if they did not work together to resolve this crisis with Lehman their banks could be the next victims of the credit crunch. In the Long-Term Capital crisis major banks each contributed to a $3.65 billion bailout of the hedge fund, allowing it to be unwound in an orderly way. The current banking crisis is far worse than the LTCM meltdown. The meeting of all the major bank heads reconvened on Saturday at the offices of the New York Fed. The CEOs from Citigroup, Goldman Sachs, Morgan Stanley, Merrill and JP Morgan were in attendance along with the heads of the SEC, FED, FRB-NY and Treasury but there were no representatives from Lehman.

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