2007 Stock Market Synopsis

The blowup of two Bear Stearns (BSC) Hedge Funds in the second half of June was the tipping point for the stock market in 2007. Those two blowups and their announcement that there would be little or no money left to return to their investors had a direct impact on the credit crunch of 2007. That event, more than any other, triggered the drying up of LBOs, M&As, and liquidity in the credit markets. As Bill Gross put it back in September, “the commercial paper market, in terms of the asset-backed commercial paper market, is basically history.” Investors seeking low risk, high yield, predictable and stable returns simply balked and said "No Mas." This left the major central banks (primarily the ECB) on the hook as lenders of last resort to provide liquidity to the global financial system – in particular the ABCP and LIBOR markets.

By the end of 2007, we find the asset-backed credit markets are still suffering from their lack of transparency and inability to price their products. So, as we enter 2008, the credit markets are still shunned by investors, and central banks continuing their role as lenders of last resort. They have fulfilled their obligations as lenders of last resort quite well, and will of course continue to do so. As the ECB succinctly stated at their Sept 6th meeting "Given [the] high level of uncertainty…The ECB has a 'determination to act in the future whenever it is necessary.'" It is for that reason the stock markets around the world have proved resilient to date – even if faltering, as a domestic recession in the US looms large as a result of the deepening housing recession and an elevated level of home foreclosures prolongs the credit crunch well into the first half of 2008.
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2007 was a remarkable year for all the colorful commentary that accompanied the financial turmoil which began in the second half of the year. What follows is a chronicling of events as they were unfolding liberally sprinkled with quotes from the brightest of the brightest.

Primary Sources are as follows:
· Bloomberg news
· Moody’s Economy.com Chief Economist Mark Zandi
· Bill Gross and Paul McCauley from Pimco.com
· Morgan Stanley’s Global Economic Forum
· Bank Credit Analyst – BCA
· Chris Whalen of the Instititutional Risk Analyst

Credit Cycle Peaks
July 10 (Bloomberg) - ``The credit cycle is peaking. In the past two weeks, more than a dozen companies postponed or restructured debt sales, '' said John Lonski, chief economist at Moody's Investors Service..

``The incremental risk aversion now evident in the financial markets seems to us to be a sign that the financial liquidity spigot is starting to tighten. The childhood alliteration to remember how to turn a spigot is `righty-tighty, lefty-loosey.' It's now righty- tighty time for the financial markets'' said Richard Bernstein, chief investment strategist at Merrill Lynch.

Stock Market and “Animal Spirit’s” Speculative Fever Peaks on Buyout Rumor
As the market peaked in mid-July, animal spirits were high, and the speculative rumor on the street was that Vodaphone would buy Verizon (VZ) for $160 Billion.

July 16 (Bloomberg) - "I think just the idea of the number floated -- $160 billion -- gets the juices running in the market again even after this big move. It would be the biggest deal ever. I think when this might pop is where one of these big deals can't get financing. Then the game is done" said Greg Church, chief investment officer of Church Capital Management.

The stock market crested that very same day, and the Verizon acquisition never happened. What squashed the bull campaign was Bear Stearns two hedge funds that blew up announcing to its investors that there would be little if any money returned to them. Ten days later the animal spirits on Wall Street had vanished entirely.

July 26 –``You have a stampede of the animals away from the watering hole. Right now, everything that smacks of financial risk is backing out through the door'' said Scott MacDonald, director of research at Aladdin Capital.

Credit Crunch Arrives
Aug. 9 (Bloomberg) – “The European Central Bank in an unprecedented response to a sudden demand for cash from banks roiled by the subprime mortgage collapse in the U.S., loaned $130 billion to assuage a credit crunch. The ECB said it will launch an unlimited fine-tuning operation to assure orderly conditions in the euro money market. It intends to allot 100 percent of the bids it receives" reported Bloomberg.

"This is probably the most serious step of all taken since the subprime crisis started,'' said Glen Capelo, at RBS Greenwich Capital.

``There seems to be a hole in the balance sheet of World Inc. that will have to be filled by government intervention. The ECB is treating this like an emergency,”' said Peter Lynch, chairman of Prime Active Capital in Dublin.

Aug 9 (Bloomberg) - BNP Paribas halted withdrawals from funds that owned subprime loans because it can't value the holdings. ``For some of the securities there are just no prices. As there are no prices, we can't calculate the value of the funds'' said Alain Papiasse, head of BNP Paribas's asset ``

``It looks hideous out there. The fear is obviously not that BNP Paribas has a problem, but that it's much more widespread, '' said John Wilson, co- director of equity strategy at Morgan Keegan & Co.

``This is an old-fashioned credit crunch. This is not a small thing. A credit crunch, when the short-term credit markets seize up, is extraordinarily serious, almost always the precursor of a significant recession.'' Chris Low, the chief economist at FTN Financial.

Aug. 10 (Bloomberg) -- The ECB loaned $83.6 billion pumping funds into the banking system for a second day. The U.S. Federal Reserve added $35 billion in temporary funds to the banking system today and $24 billion in temporary reserves to the banking system yesterday. The Bank of Japan added 1 trillion yen ($8.5 billion) to the financial system.




Aug 10 – Moody’s Economy.com’s Chief economist Mark Zandi, who is usually optimistically balanced, had the following thoughts: “Pressure on financial markets is likely to remain intense as global hedge funds and other investors are forced to realize very substantial losses. Forcing this repricing are investor redemptions in the hedge funds, and margin calls by other financial institutions worried they won’t be repaid by the faltering hedge funds…there is a significant amount of repricing yet to occur, and more hedge funds and other investors will stumble.

Financial markets broadly are panicked at this prospect. Investors, not knowing where the next problem will be, are increasingly unwilling to take any risk at all. Liquidity is thus evaporating, mostly in the riskiest markets, but increasingly in nearly all markets. Issuance of subprime, alt-A, and jumbo mortgage loans has come to a standstill; high-yield corporate bond issuance is a trickle.

With investor sentiment frayed, less and less separates the current liquidity problem from a full-blown credit crunch. The economic implications would be serious, as free-flowing credit is the mother’s milk of a well-functioning economy. Policymakers must be prepared to respond more boldly unless markets quickly find their footing.

Most encouraging is that today’s events show global policymakers are working together and will not make a mistake. The current financial market turmoil should thus ultimately prove to be no more than a therapeutic cleansing of financial excesses.

(One can almost always count on Mark Zandi to find a silver lining in most anything. And his observation of global policymakers working in concert together has remained in effect as we enter 2008. The question one might entertain years down the road is how the burgeoning Sovereign Wealth Funds (with political agendas buying our distressed financial institutions) might interfere with central bankers coordinated efforts in the future.)

Aug 10 (Bloomberg) - ``The Fed has almost unlimited ability to supply liquidity if they feel that is appropriate,'' said Alice Rivlin, a former Fed vice chairman. ``The dramatic moves by many of the world's central banks could imply that we have a whole new ball game when it comes to monetary policy,'' says David Brown, chief European economist at Bear Stearns.

Panic in the Streets as Credit Markets Seize Up

Aug 10 (Bloomberg) ``The market is in panic mode. It is a full-blown unwinding of the carry trade. This is just the beginning'' said Michael Woolfolk, currency strategist at the Bank of New York.

`There's panic in the market, that's the bottom line. There are now systemic issues and risk,'' said David Ader, head of U.S. government bond strategy at RBS Greenwich.

``Data doesn't matter, This is all about the fear of the system ceasing'' to function properly,” said Thomas Roth, head of U.S. government bond trading at Dresdner Kleinwort, a primary dealer. ``

Money funds that had been buying corporate commercial paper ``have all switched to the safe side. I'm sure their managers have all given them a Treasury-only mandate, at least until the dust settles,'' said Glen Capelo, a trader at RBS Greenwich Capital.

Aug 17 (Bloomberg) - Trichet said the market tumult ``can be interpreted as a normalization of the pricing of risk.'' ``The ECB should recognize that the process of risk normalization is threatening to become disorderly. It's becoming a textbook financial meltdown now,” said Lena Komileva, an economist at Tullett Prebon.

“As a practical matter, banks both here and abroad don't want to lend for any period longer than overnight. The ``term'' market is virtually frozen,” according to a NY bank funding desk.

Aug 17 (Bloomberg) - The $1.1 trillion market for commercial paper used to buy assets from mortgages to car loans has seized up just as more than half of that amount comes due in the next 90 days, according to the Federal Reserve.

The credit crunch is ``getting uglier and uglier. This has moved beyond temporary. It's gotten beyond bailing out some hedge fund and into the broad economy,'' said Christopher Low, chief economist in New York for FTN Financial.

Aug 20 – Mark Zandi noted that “Unless these markets perform measurably better in the next few days, the economic expansion will soon be threatened. Odds that financial markets resume unraveling, forcing a funds rate cut before the mid-September FOMC meeting, remain high. Investor fears are infecting the psyches of consumers and businesses and the odds of recession are rising quickly as a crisis of confidence could undermine the economy's still good, but now weakening, fundamentals.

Aug 21 (Bloomberg) - ``Confusion and uncertainty of risk is creating this liquidity problem,'' Moody's Senior Vice President Pierre Cailleteau said.

“Should the panic exhibited over the last few days turn into revulsion, the markets may never be the same again,'' wrote HSBC economist Stephen King and strategist Richard Cookson.

Aug 23 (Bloomberg) – “Nothing within the current marketplace allows for the hedging of liquidity risk and that's the problem at the moment. The commercial paper market, in terms of the asset-backed commercial paper market, is basically history,'' said Bill Gross. Banks worldwide have $891 billion at risk because of credit agreements on asset-backed commercial paper programs, Fitch Ratings said today.

Sept 5 (Bloomberg) - The Libor rates are ``increasing because banks are anticipating a credit crunch in coming weeks. The problem is not the lack of funds in the system, which central banks can control. It's money not shifting hands. This is the problem that cannot be fixed by central banks,'' said Lena Komileva, economist at Tullett Prebon.

Sept 6 - More than 100 mortgage companies have halted operations or sought buyers since the start of last year.

Sept. 6-7 (Bloomberg) -- The European Central Bank pumped $57.7 billion into money markets to lower borrowing costs and said there's more to come. ``Financial-market volatility and reappraisal of risks over recent weeks have led to an increase in uncertainty…Given this high level of uncertainty…The ECB has a ``determination to act in the future whenever it is necessary,'' ECB President Jean-Claude Trichet said.

``There's a lack of liquidity and a lack of trust. We're not looking at weeks. We're looking at months before the market normalizes” said Padhraic Garvey at ING.

Sept 10 - ``Here's saying a prayer that 100 basis points of Fed funds cuts by the end of 2007 will not be too late,'' McCulley wrote after attending the Jackson Hole symposium..

Sept. 11 (Bloomberg) Defaults by U.S. companies will more than double in the coming year as investors shun riskier debt, Moody's Investors Service said.

Economy.com - Homeowners with adjustable rate mortgages facing their first payment reset will crest this fall, but remain elevated well into next year (see chart).





Axel Weber at Jackson Hole Symposium

Axel Weber president of the Bundesbank in Jackson Hole, Wyoming said “The current turmoil in the financial markets has all the characteristics of a classic banking crisis, but one that is taking place outside the traditional banking sector… What we are seeing is basically what we see underlying all banking crises.

The comments mark the first time that a top central banker has endorsed the notion that the non-bank financial system is seeing an old-style bank run. Mr. Weber told fellow central bankers and economists at the Federal Reserve's Jackson Hole symposium that the only difference between a classic banking crisis and the turmoil underway in the markets is that the institutions most affected at the moment are conduits and investment vehicles raising funds in the commercial bond market, rather than regulated banks.

"Most of the conduits are owned by the banks," he said. In many cases, sponsoring banks are being forced to take risky assets back onto their balance sheets, in turn causing banks to keep hold of their own cash, putting pressure on short-term money markets, he argued.

Paul McCauley and the Run on the Shadow Banking System

There was a "run on the shadow banking system," McCauley said. The shadow banking system held $1,300 billion of assets that now had to be put back onto the balance sheets of the banks. The issue is "how it is done and at what price."

“Unlike regulated real banks backstopped by access to the Fed’s discount window, unregulated shadow banks fund themselves with un-insured commercial paper, which may or may not be backstopped by liquidity lines from real banks. Thus, the shadow banking system is particularly vulnerable to runs – commercial paper investors refusing to re-up when their paper matures, leaving the shadow banks with a liquidity crisis – a need to tap their back-up lines of credit with real banks and/or to liquidate assets at fire sale prices.

And make no mistake: that is precisely what has been happening in recent weeks, as evidenced both by a near $200 billion plunge in asset-backed commercial paper (see Chart 1) and soaring spreads between the Fed’s Fed funds policy rate and LIBOR. Indeed, LIBOR itself has widened sharply relative to the Fed’s Fed funds policy rate, further straining the financial health of all borrowers – not just shadow banks – that borrow at a spread to LIBOR.




This problem was frequently referred to at Jackson Hole as the Fed’s "plumbing problem," meaning that the basic plumbing of the financial system is clogged up, despite very hefty Fed injections of excess reserves, as those injections get stopped up in the real banking system, which is reluctant to lend them on to the shadow banking system. This plumbing problem was precisely the rationale for the Fed’s 50 basis point cut in the discount rate on August 17.

A (So Far) Impotent Roto Rooter
I certainly applauded the Fed’s actions that day thinking they might help unclog the plumbing and at worst do no harm, but the fact of the matter is that these actions are not effectively roto rootering the plumbing – getting Fed-created liquidity from its discount window to the shadow banking system.

Bill Gross on Transparency and Trust: “Where’s Waldo”

While market analysts can guesstimate how many Waldos might actually show their face over the next few years – 100 to 200 billion dollars worth is a reasonable estimate – no one really knows where they are hidden. First believed to be confined to Bear Stearns hedge funds, Waldos have been popping up with regularity in seemingly staid institutions such as German and French Banks that have necessitated state-sanctioned bailouts reminiscent of the LTCM Crisis.

Regulators have been absent from the game, and information release has been left in the hands of individual institutions, some of whom have compounded the uncertainty with comments about volatile market conditions unequaled during the lifetime of their careers. And too, many institutions including pension funds and insurance companies, argue that accounting rules allow them to mark subprime derivatives at cost. Defaulting exposure therefore, can hibernate for many months before its true value is revealed to investors and importantly, to other lenders.

The significance of proper disclosure is, in effect, the key to the current crisis. Financial institutions lend trillions of dollars, euros, pounds, and yen to and amongst each other. In the U.S., for instance, the Fed lends to banks, which lend to prime brokers such as Goldman Sachs (GS) and Morgan Stanley (MS) which lend to hedge funds, and so on. The food chain in this case is a symbiotic credit extension, always for profit, but never without trust and belief that their money will be repaid upon contractual demand.

When no one really knows where and how many Waldos there are, the trust breaks down, and money is figuratively stuffed in Wall Street and London mattresses as opposed to extended into the increasingly desperate hands of hedge funds and similarly levered financial conduits.

These structures in turn are experiencing runs from depositors and lenders exposed to asset price declines of unexpected proportions. In such an environment, markets become incredibly volatile as more and more financial institutions reach their risk limits at the same time. Waldo morphs and becomes a man with a thousand faces. All assets with the exception of U.S. Treasuries look suspiciously like every other. They’re all Waldos now.

Aug 27 (Bloomberg) - "This is one of the greatest financial panics I've seen in fifty-five years in financial services," said Angelo Mozillo CEO of Countrywide Financial Corp (CFC).

Run on Northern Rock Bank (NHRKF.PK) and Bank of England Bailout

Sept. 17 (Bloomberg) -- Bank of England Governor Mervyn King has spent the past month trying to stay above the fray as the U.S. subprime-mortgage collapse roiled credit markets. Now he's getting dragged in, whether he likes it or not.

Two days after King told lawmakers on Sept. 12 that central banks should avoid giving the impression they will help lenders that made bad decisions, the Bank of England provided emergency funds to Northern Rock in the biggest bailout of a British bank in three decades.

Northern Rock's customers have ignored assurances that their deposits are secure. While Chancellor of the Exchequer Alistair Darling said today their deposits are ``backed by the Bank of England,'' customers have removed at least $4 billion since Sept. 14.

Sept. 19 (Bloomberg) -- The Bank of England abandoned its opposition to emergency three-month money auctions and loosened lending standards, a week after Governor Mervyn King said such steps would encourage ``risky behavior.''

``This measure is being taken to alleviate the strains in longer-maturity money markets,'' the central bank said in a statement today. The bank said it will accept ``mortgage collateral'' at the auction of 10 billion pounds ($20 billion) in loans next week, which will have a penalty rate of 6.75 percent.

Q3 Financial Earnings Recession Begins

Oct. 19 (Bloomberg) -- Wachovia Corp said earnings dropped for the first time in six years after trading losses and writedowns for home loans. Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. led financial shares to their worst week since 2002 after Wachovia Corp. said loan defaults reduced profit.

More than one-third of the 92 financial companies in the S&P 500 have reported third-quarter results. Their 17 percent average profit drop is the biggest since Bloomberg began tracking quarterly earnings growth in the third quarter of 1997. Financial firms account for about 19 percent of the S&P 500's value and produced 27 percent of the index's profits last quarter, according to Bloomberg data.

``Right now financial stocks are like radioactive waste. People just do not want to touch them.,'' said Michael James at Wedbush Morgan Securities.

SIV’s – Structured Investment Vehicles

Oct 19 - Many of the 30 SIVs worldwide can't find buyers for their commercial paper -- debt that comes due in 270 days or less. The concern is that without the funding, the SIVs would have to sell their investments and might have to accept fire-sale prices. SIVs are starting to go under because they can't obtain funding once short-term loans come due.

On average, about 44 percent of SIV holdings are in mortgage-backed securities, 2 percent of which is in subprime mortgage bonds, and 11 percent is collateralized debt obligations. ``There's still a very serious problem of lack of transparency in those markets, lack of trust on the part of market participants in the value of securities and the lack of trust in their counterparties,'' Martin Feldstein, an economist at Harvard University in Cambridge

Warren Buffett on SIV’s

``One of the lessons that investors seem to have to learn over and over again, and they'll have to learn it over again in the future, is that not only can you not turn a toad into a prince by kissing it, but you also cannot turn a toad into a prince by repackaging it,'' Warren Buffett said today in South Korea.

Estimating Q4 Financial Writedowns – Sovereign Wealth Funds begin Providing Capital Raises to Distressed Financial Institutions

Nov. 2 (Bloomberg) - Merrill Lynch & Co., the world's biggest brokerage, tumbled on a report that it made deals with hedge funds that may have been intended to postpone credit-market losses.

Fourth-quarter earnings at U.S. banks and brokerages may decline by 20 percent due to charges linked to credit-market losses, Deutsche Bank analysts said. The biggest financial firms will be hurt by ``worsening trends'' in credit markets that may cause them to write down a further $10 billion. Reserves for loans are the lowest since 1983, they said.

Nov. 5 (Bloomberg) -- Citigroup has seized up. The biggest U.S. bank by assets said that subprime mortgages and related securities lost as much as $11 billion of their value in the past month, a decline that may wipe out half of the company's profit so far this year.

The company said credit-market upheaval in October impaired by as much as a fifth its $55 billion book of subprime mortgages and related bonds. The writedown costs, which will be recorded in the fourth quarter if markets don't recover, add to the almost $7 billion of costs for bad debt, bond and loan losses recorded in the third quarter. ``Significant uncertainty continues to prevail in financial markets,'' Citigroup said.

Nov. 7-- Credit-default swaps on bond of Citigroup Inc., Wachovia Corp. and Morgan Stanley are trading at the highest in at least five years on speculation the nation's biggest banks may be forced to write down more subprime assets. Analysts began revising writedowns at the banks after Citigroup this week said losses from the assets may rise to $11 billion. Credit-default swaps tied to Citigroup more than tripled in the past three weeks, indicating the risk of default is rising.

``Until there is much greater disclosure of what people have on their books, and off balance sheets as well, it just feeds into uncertainty,'' said Scott MacDonald, head of research at Aladdin Capital Management

Dollar’s Confidence Crisis grows as China Signals Further Foreign Reserves Diversification

The U.S. currency reached a new low today after Chinese officials signaled plans to diversify the nation's $1.43 trillion of foreign exchange reserves after Cheng Siwei, vice chairman of China's National People's Congress, said the nation ``will favor stronger currencies over weaker ones and will readjust accordingly.''

``The dollar is suffering a confidence crisis. The dollar is on the ropes. Comments from China about diversification and surging oil prices pushed the dollar to new lows'' '' said Michael Woolfolk.

``The big issue on any currency is if its rate of depreciation is so fast that it scares off capital, and the announcement that we heard from China feeds those fears,'' said Larry Smith at Third Wave Global Investors.

Nov. 7 (Bloomberg) -- General Motors Corp. reported a record $39 billion quarterly loss after three money-losing years forced the company to write down the value of future tax benefits.

The $2.80 a share loss, excluding the tax writedown, was more than 12 times analysts' estimates. Mortgage-related losses at GM's partly owned finance unit overwhelmed third-quarter auto sales that were the highest ever. The automaker signaled that it won't generate enough earnings to use the benefits, citing defaults on subprime mortgage loans at GMAC LLC..

``This all suggests that GM thinks that things are so ugly out there that they can't see the possibility of profitability for many quarters, maybe even years,'' said Bradley Rubin at BNP Paribas.

Level One, Level Two, Level Three

Banks Face $100 Billion of Writedowns on Level 3 Rule, RBS Says

Nov. 7 (Bloomberg) -- U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 FASB accounting rules, in addition to the losses caused by the subprime credit slump, according to RBS.

The FASB's rule 157 will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, Royal Bank's Chief Credit Strategist Bob Janjuah wrote. The new rule is effective Nov. 15, he said.

``This credit crisis, when all is out, will see $250 billion to $500 billion of losses,'' London-based Janjuah said. ``It is inevitable that more players will have to revalue at least a decent portion'' of assets they currently value using ``mark-to-make believe.''

Under FASB terminology, Level 1 means mark-to-market, where an asset's worth is based on a real price. Level 2 is mark-to- model, an estimate based on observable inputs and used when there aren't any quoted prices available. Level 3 values are based on ``unobservable'' inputs reflecting companies' ``own assumptions'' about the way assets would be priced.

Nov 7 - Washington Mutual declined the most in 20 years after New York Attorney General Andrew Cuomo said there's a ``pattern of collusion'' in the bank's home-loan appraisals. Fannie and Freddie Mac sank to a seven-year low after Cuomo subpoenaed the two biggest U.S. providers of mortgage financing

Nov 7 – SIV’s Roll-Over Challenge

Most money market funds are ``still reluctant to roll over ABCP and SIV paper. Given the lack of public disclosure by SIVs, it is exceedingly difficult'' to address concerns that SIVs will be forced to dump their assets in a fire-sale,” Hans Vrensen, director of European mortgage-backed securities at Barclays Capital.

Nov 8 - Commercial paper outstanding fell $15.6 billion in the week ending November 6. At $1.87 trillion, commercial paper outstanding sits 16.1% below the high set in the week ending July 25.

ABCP outstanding fell $29.5 billion, over three times the decrease reported in the prior week… the fact that the decline is reaccelerating starting from a much lower base makes this week's data equally troubling, notes Bloomberg.

Nov 15 - ``Anything sensitive to the consumer is struggling…`we had fooled ourselves a little bit thinking that the third-quarter was going to be the proverbial `kitchen sink' quarter where you got all the loan losses. I don't think we really had our arms around what they were,'' said Benjamin Pace chief investment officer at Deutsche Bank ``We have an almost perfect storm for the steepening trade,'' said Christopher Sullivan chief investment officer at the United Nations Federal Credit Union.

Dollar Woes and Foreign Diversification Revisited

Nov. 14 (Bloomberg) -- ``It may be our currency, but it's your problem'' was Treasury Secretary John Connally's taunt when the U.S. unhooked the dollar from the gold standard in 1971, unilaterally rewriting the rules of world business in America's favor.

Now the world is taunting back. Almost four decades after the U.S. tore up the monetary arrangements that governed the post-World War II international economy, the dollar's fall from grace amounts to a tectonic shift in the global hierarchy. This time, the U.S. currency is on the losing side.

``What we're seeing is a very broad rebalancing of economic and political power in the world. The scales are moving, and they're moving quite fast'' said Yale Professor Jeffrey Garten.

The Fed's trade-weighted major currency index bottomed at 71.11 on Nov. 7, the lowest since the era of free-floating currencies started in 1971. Against the yen and European currencies, the dollar is now worth about a third of what it was in the days of fixed rates.

One of the main U.S. exports since then has been the dollar itself, in exchange for foreign capital to finance trade deficits and a national debt of more than $9 trillion. While the current- account deficit is narrowing from last year's record $811.5 billion, the U.S. still requires $2.1 billion a day of other people's money.

``We're getting into a very unstable situation,'' says Richard Duncan, a partner at Blackhorse Asset Management in Singapore and author of the 2005 book ``The Dollar Crisis: Causes, Consequences, Cures.''

Foreign Sovereign Wealth Funds buying distressed US Financial Institutions

Nov 16 (Bloomberg) - Middle Eastern funds such as Mubadala are snapping up stocks around the globe as governments in the region invest in the windfall revenue from surging oil prices. So-called sovereign wealth funds, through which governments buy equities and other assets, will grow to $7.9 trillion by 2011 from $1.9 trillion now, Merrill Lynch & Co. economists wrote in a report last month.

Rising Corporate Bond Spread to be a Stock Market Problem in 2008 – BCA Research

“Wider credit spreads are a road block to the stock market because it raises the cost of capital and keeps a lid on expansion plans. Expansion plans will stay dormant until businesses regain confidence the housing debacle will not continue spreading….If there is no further Fed action, recession risks will mushroom and the resolution of equity market trading range will be on the negative side. We are more optimistic, but the struggle between deflation and reflation could take months to play out.”

BCA and Fed both acknowledge Growth Scare

“Market signals are consistent with a growth scare. Global bond yields are moving lower. Until global central banks acknowledge the squeeze on their economies from strengthening currencies, (the BOE has already blinked) then the deflation scare we have been worried about since late summer will continue to dominate equity market trends…”

Nov. 20 (Bloomberg) ``Most members saw substantial downside risks to the economic outlook and judged that a rate reduction at this meeting would provide valuable additional insurance against an unexpectedly severe weakening in economic activity,'' according to minutes of the Federal Open Market Committee's Oct. 30-31 meeting.

Records of the gathering were accompanied by estimates and phrases that highlighted risks to growth. The language contrasted with the October statement, which said the dangers of a slower expansion and faster inflation were ``roughly'' equal.

Knightian Uncertainty Persists

Nov 21(Bloomberg) ``It's a very panicky market. There's a growing feeling that the problems are unknowable and unquantifiable, and that there's no way of dealing with it except through the passage of time,” said John Kattar chief investment officer at Eastern Investment Advisors.

Year End Funding Needs Heightens Tensions in Money Markets - Another Run on Shadow Banking

Nov. 23 (Bloomberg) -- The U.S. asset-backed commercial paper market fell for a 15th week as rising losses from mortgage-related securities prompted investors to avoid buying the short-term debt. Debt maturing in 270 days or less and backed by mortgages, credit-card loans and other assets fell $17.5 billion to a seasonally adjusted $835.8 billion for the week ended Nov. 21, the Federal Reserve said.

The ABCP market has shrunk 29% since its peak on Aug. 8 of $1.18 trillion, as record defaults on subprime mortgages caused buyers to shun new ASCP from structured investment vehicles (SIV’s) including Cheyne Finance and Rhinebridge Plc.

Nov 26 Nov. 26 (Bloomberg) - HSBC (HBC) will bail out two structured investment vehicles, taking on $45 billion of assets to avoid a fire sale of bond holdings. ``HSBC believes there is not likely to be a near-term resolution of the funding problems faced by the SIV sector,'' the bank said.

Nov. 26 (Bloomberg) -- The Federal Reserve sought to ease concern that banks will be short of cash next month by planning its first long-term injection of year-end funds in two years.

The Fed's New York branch said in a statement that it plans a series of repurchase agreements, starting with an $8 billion injection on Nov. 28, extending into next year. The New York Fed said it planned the steps ``in response to heightened pressures in money markets for funding through the year-end.'' The move follows the European Central Bank's commitment last week to make extra cash available to ``counter the re-emerging risk of volatility'' in money markets.

``The Fed is pulling out all stops to try to alleviate funding pressures in the money and financing markets as the markets lurch into year-end,'' said Chris Rupkey, senior financial economist at Bank of Tokyo.

Sovereign Wealth Funds Help US Financial Companies Raise Badly Needed Capital

One of the drags on the stock market through Tuesday November 27 2007 was investor perception Citigroup and many other large financial institutions like Freddie Mac to be short of capital. Indeed, many observers noted that dividend suspensions would soon be required by these two institutions to offset capital deficits. And if dividend cuts were not sufficient, these institutions would have to raise more capital. That is where the Sovereign Wealth Funds stepped up to the plate.

November 27 (Bloomberg) In order to shore up its depleted capital, Freddie Mac cut its dividend in half and announced plans to sell $6 billion in preferred stock with an 8.25% dividend attached to it. Citigroup also raised $7.5 billion from Abu Dhabi in a preferred stock offering carrying an 11% dividend to replenish its “tangible capital levels.”

“It’s going to be expensive capital for [these companies], but they just don’t have a choice. Sometimes the rate isn’t as important as getting the loan itself” noted Allegiant Asset mgmt CIO Andrew Harding.

Even though cash infusions have been secured for many financial institutions like Citigroup and Freddie Mac via Sovereign Wealth Funds, Chris Whalen of Institutional Risk Analytics warns that “bank equity valuations are likely to move even lower as the imbedded losses on the banking book of most institutions become increasingly visible and painful in 2008.”

Commercial Real Estate as a Full Blown Bubble at Bursting Point

Nov. 28 (Bloomberg) -- In the bond market, commercial property investors are about as creditworthy as U.S. homeowners with subprime mortgages. ``Commercial real estate is a full-blown bubble that feels very much at a bursting point. There's a fairly toxic mix of factors at work,'' said Christian Stracke, an analyst at CreditSights Inc.

The seven-year rally in offices and retail properties ended in September when prices fell an average of 1.2 percent, according to Moody's Investors Service. More losses are likely because banks are holding $54 billion of commercial mortgages they can't sell.

Shrinking SIV Tumor

Dec. 11 (Bloomberg) -- The tumor in the financial markets known as structured investment vehicles is shrinking, reducing the urgency for a bailout sponsored by the U.S. Treasury. ``Every day that goes by we are seeing more SIVs being reorganized to avoid a fire sale. The longer the SuperSIV takes, the less of a need there will be for it”, said Priya Shah, a credit analyst at Dresdner Kleinwort.

Government Mandate Freezing ARM Resets is Problematic Throughout

Dec 11 (Bloomberg) - The problem with the ARMS’s freeze is two-fold. First, investors “may completely shun” mortgage debt contracts “if contracts governing changes to the underlying loans are negated by the US government. If you are an investor, are you ever going to purchase a US mortgage backed security again,” asks John Robbins 37 yr industry veteran who headed the Mortgage Bankers Association through October 07. The sanctity of these securities contracts will have been made null and void.

Mandate Places Sanctity of Mortgage Contracts at Risk

Deutsche Bank AG analysts Karen Weaver, Katie Reeves, and Ying Shen said to their clients “We do not think it is hyperbolic to say that the sanctity of such contracts, entered into in good faith, is at the cornerstone of capitalism. And if we are to in any way devalue that sanctity, we face a far greater liquidity crunch than the one in which we currently find ourselves."

Credit Suisse Group notes that more than 30% of subprime borrowers are already behind on their payments even before their loans are due to reset higher and estimates 775,000 homes will still go into foreclosure over the next two years. As US Treasury Secretary Henry Paulson noted last week, “the current system for working out problem loans would not be sufficient to handle the anticipated 1.8 million owner-occupied [ARM] resets that will occur in 2008-2009.”

At Best, Mandate will only help 14% of the 1.8 million Borrowers at Risk of Default

In theory, notes Economy.com’s chief economist Mark Zandi, the plan to freeze interest rates on those problem loans could help “up to 750,000 homeovers avoid foreclose. [But] in practice, the plan faces significant hurdles, so that at best some 250,000 borrowers will actually benefit” – approximately only 14% of the problem would it help.

The reasons the Plan will only help so few homeowners are myriad. Loan servicing companies are already highly distressed companies. Even if they were not “nervous about being sued” by investors whose loan contracts are being modified, there is still the legitimate question if these distressed loan companies could beef up their staffs enough to “quickly modify loans.” Moreover, more than half the subprime loans in 2006 were stated income (no doc) loans that did not require proof of income. For the loan modifications to occur, these borrowers will be required to produce more financial information than before – something “they may be reluctant or unable to do” says Mark Zandi.

San Francisco Federal Reserve President Janet Yellen Favors Aggressively Easing

Dec 11 (Bloomberg) - Janet Yellen stated on December 4 that she is in favor of aggressive Fed easing so as not to fall “behind the curve”

And Bill Gross asserted on his monthly missive this week that ``To restart a near recessionary economy we may need to eventually go down to 3% or lower.” During previous recessionary periods, notes Gross, the Feds “rate has dropped to 1% on an inflation adjusted basis [so with] inflation at 2% a destination of 3% would be a reasonable target.” It’s difficult to argue the point Bill Gross is making, especially with deflating home prices.

Dec 11 - Chris Whalen stated in his weekly missive that “If Secretary Paulson and others in positions of leadership in Washington and on Wall Street want to fix the subprime crisis and restore investor confidence, then the solution must start with a comprehensive, mandatory write down of all illiquid complex structured assets held by every bank, dealer and fund. Only when investors are convinced that the rot has been cut out of the financial system and that banking institutions are honestly disclosing their full liabilities will the global capital markets start to clear and recover in terms of liquidity.”

Greenspan’s Take on the Economy and Inflationary Pressures

Dec 17 (Bloomberg) The worst U.S. housing slump in 16 years, coupled with a tightening of credit by banks, has brought the world's largest economy ``close to stall speed,'' according to former Federal Reserve Chairman Alan Greenspan. At the same time, rapid growth in China and other emerging markets is driving energy and food prices higher worldwide.

``What lies ahead is a period of stagflation -- slow or no growth combined with rising inflation -- in the advanced economies,'' says Joachim Fels, co-chief global economist at Morgan Stanley. ``This is a much tougher monetary-policy environment than anything I experienced,'' Greenspan told the Wall Street Journal on Dec. 14.

Through the first 11 months of this year, consumer prices rose at an annual rate of 4.2 percent. That's up from 2.5 percent for all of 2006 and, if maintained in December, would be the highest rate in 17 years.

``Global inflation pressures emanate mainly in the emerging countries, where growth is strong and monetary policy is relatively expansionary,'' Fels of Morgan Stanley says. The same emerging-market nations have also helped stoke inflation by sheltering their consumers and companies from rising oil prices through subsidies. That's kept energy demand in China, India and other countries high because domestic prices are still low.

Dec. 18 (Bloomberg) -- Goldman Sachs Chief Financial Officer David Viniar said ``Just looking at the world's capital markets and looking at the lack of liquidity that we saw in November, it has to make us cautious.''

ECB’s $500 Billion Year End Injection

Dec. 18 (Bloomberg) -- The cost to borrow in euros plunged after the ECB added an unprecedented $500 billion to the banking system as part of a global effort to ease credit-market gridlock through year-end.

Moody’s Predicts Corporate Defaults to Quadruple in 2008

Dec. 18 (Bloomberg) -- U.S. corporate defaults probably will quadruple next year after the number of companies that lost their investment-grade credit ratings rose at the fastest pace since 2003. Moody's Investors Service predicts companies will default on 4.7 percent of their bonds in 2008.

Downgrades are accelerating across America. Moody's reduced ratings on 389 corporate issues this quarter compared with 150 upgrades, according to data compiled by Bloomberg. The gap was the biggest since the first quarter of 2003.

Another 447 borrowers in the U.S. are at risk of having their ratings reduced, according to an S&P statement today. Companies in the automotive industry lead the tally.

More Writedowns Prompt more Capital Raises Via Sovereign Wealth Funds

Dec. 19 - Morgan Stanley reported a steeper- than-forecast loss after $9.4 billion of writedowns on mortgage- related holdings and received a $5 billion cash infusion from state-controlled China Investment Corp. China Investment, the nation's sovereign wealth fund, will acquire as much as 9.9 percent of Morgan Stanley

``Our assumptions included what at the time was deemed to be a worst-case scenario,'' said Colm Kelleher, the firm's chief financial officer, in a phone interview today. ``History has proven that that worst-case scenario was not the worst case.'' Conditions in the credit markets ``clearly got worse'' after September. The credit environment remains challenged, it will take several quarters to return to more normal markets. Credit is going to be a drag on the fixed-income business going forward for the next few quarters.''

Dec 20 (Bloomberg) U.S. stocks fell after analysts forecast $8.6 billion of writedowns for Merrill Lynch

Dec. 20 (Bloomberg) -- MBIA Inc. (MBI) fell the most since 1987 in New York after the world's biggest bond insurer disclosed that it guarantees $8.1 billion of collateralized debt obligations that investors say have a greater chance of losses. ``We are shocked management withheld this information for as long as it did. MBIA simply did not disclose arguably the riskiest parts of its CDO portfolio to investors'' said Ken Zerbe at with Morgan Stanley.

``How is confidence expected to return to the capital markets when these types of surprises continue to pop up?'' said Peter Plaut hedge fund manager at Sanno Point Capital Management.

Going into 2008, Labor Conditions will Deteriorate

Dec 28 - Citigroup Inc., JPMorgan Chase & Co. and Merrill Lynch & Co. may write down an additional $34 billion in securities linked to the credit market collapse, Goldman Sachs Group Inc. estimated.

GeoPolitical Instability in the Middle East Grows as we Enter 2008

Dec 28 - Indian ADRs and ETNs fell Thursday following the assassination of Pakistani opposition leader Benazir Bhutto on fears the crime could worsen instability in Southeast Asia. "We can't think of a more scary situation in the region, and believe that the fate of Pakistan could have a much bigger impact on geopolitics than anything Iran could do right now," said Win Thin, strategist at Brown Brothers Harriman.

Dec. 31 (Bloomberg) -- Defaults on privately insured U.S. mortgages rose 35 percent in November to a record, an industry report today showed, adding to evidence the U.S. housing slump is deepening. The number of insured borrowers falling more than 60 days late on payments jumped to 61,033 last month from 45,325 in November 2006. ``This is another data point that suggests that the mortgage insurers are in for a tough slog for 2008,'' said credit analyst David Havens at UBS.

Summarizing the Overall Impact of events in 2007 on the S&P 500 going into 2008

· Up 3.6% on the year, up 2.6% above 2006 year highs.
· Fed rate cuts found lacking in Q4.
· Central Bank injections was a more appropriate response to equity markets in Q4 than were rate cuts
· Still have to face down Q4 earnings recession in Jan 08.
· Rising Unemployment will be a drag on consumer spending and Rising Corporate Bond Spreads will be a drag on the stock market.
· Technically, the stock market trend has managed to remain bullish in spite of two corrections greater than 10% in both August and November 2007. Thus far, though diminished, the odds still favor bull trend continuation, but it will be a “tough slog for 2008” to borrow an expression from David Havens.
· A failure of the November low without first breaching the October 2007 year highs would be the first indication the bull campaign of higher highs and higher lows was ending. Confirmation of an emerging ear trend would come from a failure of the August 16 2007 low. That is not the anticipated result at the moment.