Market Commentary for September 05, 2007
A strong south bound trend moved stocks and the major indices into lower territory, from the ringing of the opening bell this morning. As the trading session moved on, the strength increased at the hands of the Bears, with the major indices hitting their lows of the session, during the late afternoon. The cause of the downdraft, apparently from word from the Fed that there is basically a slim chance of a drop in interest rates as well as, the continuing concerns over the weak housing market.
At the closing bell, here is how the major indices ended the session: the DOW (Dow Jones Industrial Average) posted a triple digit loss of 143.39 points on the day to end the session at 13,305.47; the NYSE (New York Stock Exchange) posted a triple digit loss of 115.51 points to end the session at 9,583.17; the NASDAQ posted a loss of 24.29 points for a close at 2,605.95; the S&P 500 moved lower by 17.13 points to end at 1,472.29 and the RUSSELL 2000 moved lower by 10.21 points to close at 790.46. The FTSE All-World Index ex-US (top Large/Mid Cap aggregate from over 2,700 stocks from the FTSE Global Equity Index Series (GEIS) which covers 90% of the world’s investable market capitalization) posted a loss of 2.26 points to close at 254.36 and the FTSE RAFI 1000 posted a loss of 71.93 points to close at 6,079.80.
Testimony of Robert K. Steel Under Secretary for Domestic Finance U.S. Department of the Treasury Before the House Committee on Financial Services: Washington- Chairman Frank, Ranking Member Bachus, Members of the Committee, good morning. I very much appreciate the opportunity to appear before you today to present the Treasury Department's perspective on the recent events in the credit and mortgage markets and their impact upon consumers and the economy. The Treasury Department and Secretary Paulson know that these events are of considerable interest to the American people, this Committee, and other Members of Congress. To give context to the current market situation, I would like to begin my remarks today with a description of both domestic and global economic conditions. In the United States, the unemployment rate is at 4.6%, close to its lowest reading in 6 years. Real GDP growth was 4.0 percent in the second quarter, supported by strong gains in business investment and exports. Core inflation is under control. Since August 2003, 8.3 million jobs have been created, more jobs than all the major industrialized countries combined; over the past 12 months, nearly 2 million jobs have been created. Real wages have increased 1.7% over the past 12 months. In the corporate sector, earnings continue to outperform expectations and default rates on corporate credits of all kinds are at historically low levels. On the government side, the U.S. fiscal deficit is declining and well below long-term averages as a share of the economy, reflecting strong revenue growth and the continued strength of the U.S. economy. The global economy continues to grow at around 5% annually, with many emerging market economies growing even more rapidly than the global average. The advanced economies also continue to perform well, with unemployment down sharply in Europe, helping to make growth of the last several years the strongest since the early 1970s. The Treasury Department, as the steward of economic and financial systems in the United States, is committed to ensuring these strong U.S. and global economic fundamentals. At the same time, the Treasury Department's mission includes the promotion of economic stability. It is important to appreciate that the core fundamental economic environment is strong globally, and it is against this backdrop that I turn to the current credit and market challenges.
General Trends in the Mortgage Industry
As just discussed, over the past several years the United States has enjoyed favorable economic conditions: low unemployment, low inflation, and low interest rates. These positive conditions served to fuel a demand for credit and investment and the marketplace responded with a vast supply of both to satisfy consumers and sophisticated market participants. At the consumer level, this demand was very noticeable in the mortgage industry, and in recent years particularly, the sub-prime arena. For the first time, in the early 1990s, consumers with lower incomes and challenged credit history, typical sub-prime borrowers, were able to gain access to mortgage credit at interest rates a few percentage points higher than prime borrower rates. Homeownership became more widely available in the United States, growing from 64% in 1994 to 69% today, some of that due to sub-prime mortgage origination volume, which increased from less than 5%, or $35 billion, of total mortgage origination volume in 1994 to nearly 20%, or $625 billion, in 2005. Mortgage securitization has fundamentally changed the mortgage industry and has played a significant role in the growth of the mortgage market. Typically in a private label mortgage securitization, the mortgage originator transfers loans to a securitization sponsor, who pools together mortgages into mortgage-backed securities, and sells pieces, or tranches, of these securities to investors. Thus, the mortgage originator, instead of holding the mortgage loan on its balance sheet, distributes the loan and its attendant risks to a securitization sponsor in return for capital. The credit rating agencies work closely with the sponsor to rate the credit risk of each tranche. These innovative securities offered sophisticated investors a diversification tool and the ability to better target their risk/return profile. The demand for mortgage-backed securities has been global in nature and has helped to provide mortgage originators with a steady stream of capital. Over 55% of total mortgage origination volume and over 70% of sub-prime mortgage origination volume were securitized in 2006. Further fueling this growth has been the development of another structured product, the collateralized debt obligation, which purchases asset-backed securities, such as mortgage-backed securities. Mortgage-backed CDO’s, nearly 40% of the entire $500 billion CDO market in 2006, have been one of the major purchasers of mortgage-backed securities, in particular the lower rated tranches.
Recent Mortgage Market and Credit Market Events
Through most of the 1990s, annual mortgage origination stood at approximately $1 trillion. With the historically low interest rate environment of 2001-2003, mortgage origination climbed to nearly $4 trillion in 2003. Infrastructure build-up and the entry of many new participants into the mortgage industry matched this increase. With the rise in interest rates in 2004, mortgage origination fell to just under $3 trillion. With this decline, there was significant overcapacity in the mortgage industry. Competition among mortgage originators and brokers intensified. At the same time, investor demand for securitized products remained unabated. To satisfy this demand and their excess capacity, some mortgage originators relaxed their underwriting standards, lending to individuals with a lower standard of documentation and selling mortgage products, which for some borrowers would become unaffordable. In the past few years, some of the most popular sub-prime products were adjustable rate mortgages, like the 2/28: a hybrid mortgage with a fixed rate of interest, often free of amortization payments, for the first two years, resetting at an adjustable rate for the remaining 28 years. The fixed rate of interest in the first two-year period was typically lower than the initial adjustable rate in the reset period. In the initial period of these resets, rising housing prices enabled these borrowers to refinance their original mortgages on terms more attractive and affordable. Eventually, due to both an upwards adjustment in rates and commencement of principal amortization as these mortgages began to reset in 2005, 2006, and 2007; many borrowers were faced with payment shock. These resets, combined with a decline in housing price appreciation, led to rising delinquencies and defaults among sub-prime borrowers, first widely evidenced in autumn 2006. In 2007 this trend has continued and spread to other participants in the mortgage industry: several mortgage originators and brokers have exited the industry. In turn, the mortgage-backed securities investor has felt the repercussions of the weaknesses in the mortgage assets underlying some of these securitized products: in autumn 2006 with rising defaults on the underlying assets, mortgage-backed securities spreads began to widen. Over the past several months, a small number of U.S. and foreign financial institutions and hedge funds that invested in mortgage-backed CDO’s and other mortgage-backed securities have reported large losses. Some have suspended or limited redemptions, while others have closed or received capital infusions. At the same time, credit rating agencies announced their intent to downgrade some of these securitized products and revise their ratings methodologies. The uncertainty regarding both the future prospects of these mortgage-backed securities and the methodologies the credit rating agencies used to rate these securities compelled investors to reassess the risk of these securities and subsequently reassess price. Given the uncertainty of the underlying credit and cash flows, few buyers were willing to risk their capital. Valuation became extremely difficult as a no-bid environment seized certain segments of the market. This reappraisal has spread across the credit market spectrum, first affecting residential-mortgage backed securities and then spreading to other asset classes and, particularly, securitized products. Spreads have widened and a lack of liquidity has affected these other asset classes. The financing of buy-out transactions has also been challenged as higher risk premia resurfaced after a long period of favorable conditions. Volatility has increased: from Treasury bills to the stock markets.
This reappraisal of risk is normal and typically follows periods of widely available credit when markets have undervalued risk. As in other times of reappraisal, investors, adverse to risk and protective of their capital, have fled to quality assets, demanding and driving up the prices--and in turn driving down significantly the rates, of Treasury bills. For example, during the past three weeks, the demand for Treasury securities by global investors was so enormous that rates on the safest, most liquid asset in the world dropped over 250 basis points, a decline of such magnitude not seen in the past. In early August, this uncertainty began to spread to the asset-backed commercial paper market, typically a very liquid market. The uncertainty surrounding the health of the assets underlying commercial paper (especially asset-backed commercial paper, which represents approximately 55% of the commercial paper market) compelled investors to shorten the terms to maturity that they were willing to purchase and, in some cases, even to decline to buy such paper altogether. Subsequently, banks became increasingly concerned about their own liquidity in view of the possibility that they might have to provide backup for commercial paper and take other assets onto their balance sheets. In response to such developments, the Federal Reserve took several measures to increase liquidity and promote the orderly functioning of financial markets. The Federal Reserve provided additional reserves through open market operations in order to promote trading in the Federal Funds market at rates close to the target rate. The Federal Reserve also lowered the discount rate and changed Reserve Banks' usual practices to allow the provision of term funding at the discount window. Such actions have helped stabilize the markets. The ultimate impact of these events on the economy has yet to play out. At the time of its discount rate cut, the Federal Reserve noted that "financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace…the downside risks to growth have increased appreciably." The Treasury Department respects the independent actions and leadership of the Federal Reserve. Like the Federal Reserve, the Treasury Department shares the perspective that recent market developments pose downside risks to economic growth. However, the economy was in strong condition going into the recent period of volatility, and while certain sectors like housing are undergoing a transition, overall economic fundamentals remain solid. And while recent difficulties in the sub-prime mortgage market are having and will continue to have a profound effect for many families, the underlying strength of the economy should allow for continued growth. Just last Friday, the President announced plans to help those homeowners facing mortgage delinquencies and foreclosures and I will return to these initiatives later.
Impact of Recent Market Developments on the Mortgage and Credit Markets
The financial services industry has enjoyed a period of extraordinary growth over the last several decades. Key drivers to this growth have been successful engagement with the trends of innovation, institutionalization, and internationalization. The complexity and innovation of financial products have brought great benefits to the mortgage and credit markets. In the mortgage industry, securitization allows mortgage originators to undertake better risk management as they do not have to hold loans on their balance sheets and instead have another source of capital funding. Investors purchasing a securitized product have reduced transaction costs and can purchase an array of products at targeted risk levels. Homebuyers have expanded product offerings and more lenders competing for their business.
The recent market events have revealed potential complexities in the securitization model. In some cases, risk evaluation of securitized products can be difficult. In mortgage-backed securities and mortgage-backed collateralized debt obligations, the performance of the underlying assets, particularly many of the innovative sub-prime mortgage products, may not have been properly understood, or investors may have failed to perform adequate due diligence prior to their investment decision. At the same time, mortgage originators may have possessed less incentive to perform appropriate levels of due diligence because of their distributing their loans and the attendant risks through securitization. Over the past few decades the capital markets have experienced growing institutionalization. These institutions, such as pension funds, mutual funds, and hedge funds, have provided the markets with liquidity, pricing efficiency, and risk dispersion. These institutions have also spurred on financial product innovation and complexity and possess the incentives, resources, and information to make prudent decisions. At the same time, these institutions can be highly leveraged and employ highly correlated strategies, potentially leading to more widespread market disruptions. Finally, the capital markets are becoming increasingly internationalized. Market participants, sources of capital, product offerings, and trading strategies ignore national borders. This has contributed to the significant global economic growth over the past decade, especially in the emerging market economies. At the same time, an event in one country's market may impact the rest of the world.
Treasury, Administration, and Federal Banking Regulator Actions
The Treasury Department closely monitors the global capital markets on a daily basis. This is especially true given the events unfolding in the credit and mortgage markets. Secretary Paulson has been communicating regularly with federal banking regulators and the members of the President's Working Group on Financial Markets, which includes Federal Reserve Chairman Bernanke, Securities and Exchange Commission Chairman Cox, and Commodity Futures Trading Commission Acting Chairman Lukken. This complements information gathering from market participants, finance ministers, and other participants in the global marketplace. Enhanced communication is vitally important for understanding where disruptions are occurring, and evaluating what actions can be considered. Under Secretary Paulson's leadership, the President's Working Group on Financial Markets will examine some of the broader market issues underlying the recent market events, including the impact of securitization and the role of rating agencies in the credit and mortgage markets. The Treasury Department will also be releasing early next year a blueprint of structural reforms to make financial services industry regulation more effective, taking into account consumer and investor protection and the need to maintain U.S. capital markets competitiveness. Most important and in addition to efforts to fully understand the current situation in the financial markets, the Treasury Department, the Department of Housing and Urban Development, and others in the Administration have carefully focused on evaluating the challenges faced by individuals in the sub-prime market. Last week, the President announced a series of market-based initiatives to help more homeowners keep their homes. The Administration, led by the Treasury Department and HUD, has undertaken several actions to provide assistance to homeowners, including the Administration's continued pursuit of legislation modernizing the Federal Housing Administration. Coordinating with HUD, the Treasury Department also will reach out to a wide variety of entities, such as Neighbor Works America, mortgage originators and servicer’s and government-sponsored entities, like Fannie Mae and Freddie Mac, to identify struggling homeowners and expand their mortgage financing options. The President has also asked Congress to temporarily change a provision of the federal tax code that currently considers cancelled mortgage debt on a primary residence as taxable income. The Treasury Department looks forward to working with Congress in the days ahead. In addition, the federal government has taken several actions to increase transparency and enhance lending standards in the mortgage industry. For example, in 2006, the banking regulators issued supervisory guidance addressing nontraditional mortgages and in June 2007 finalized sub-prime lending guidance. Separately, the Federal Reserve has undertaken a comprehensive review of the disclosure system for mortgage loans under the Truth in Lending Act and is currently addressing unfair and deceptive mortgage practices using its authority under the Home Ownership and Equity Protection Act. Later this fall, HUD will propose reforms to the Real Estate Settlement Procedures Act to promote comparative shopping for the best loan terms, provide more transparent and comprehensible disclosures, including fee disclosure, and limit settlement cost increases.
Conclusion
The recent volatility in the credit and mortgage markets reflects a reassessment of risk across a broad spectrum of securities. These events have occurred during a time of solid domestic and global growth, helping to mute some of the impact of this turbulence. I do want to caution policymakers that this process is far from over. It will take more time to play out and certain segments of the capital markets are stressed. Risk is being re-priced. This re-pricing will lead to a reevaluation of assets. This reevaluation will inevitably impact the balance sheets of financial market participants. As investors review fundamental characteristics and confidence returns, liquidity will improve. Yet, policymakers must remain vigilant as further stress could create further challenges and continued volatility. It is critical that policymakers understand these issues and their underlying causes and continue to enhance the capital markets regulatory structure to adapt to market developments. I appreciate having the opportunity to present the Treasury Department's perspectives on these important issues.
Economic Data:
MBA Purchase Applications: Compilation from the Mortgage Bankers’ Association of various mortgage loan indexes. This data is the leading indicator for single-family home sales as well as, housing construction. U.S. MBA Market Index Rises 1.3% to 622.9 from 615.2; U.S. MBA Purchase Index Rises 0.4% to 425.8 from 424 and U.S. MBA Refinancing Index Rises 2.3% to 1770.2 from 1729.6.
Challenger Job-Cut Report: Corporate layoffs comprised in a monthly, not seasonally adjusted report which indicates a trend in the labor market. Challenger U.S. August Job Cuts were 79,459, up 85.2% from July The number of job cuts announced by U.S. corporations in August jumped by 85.2% from the number reported in the prior month for a total of 79,459 according to a Challenger, Gray & Christmas survey released Wednesday. Job cuts were 21.7% higher this August than last year, when there were 65,278 job cuts. Job cut announcements so far this year totaled 515,855, 4.3% fewer than the 538,914 in the first eight months of 2006. The financial industry announced 35,752 job cuts last month, the most for any industry. "The story in August revolves around the dramatic collapse of the mortgage and sub-prime housing markets," noted John Challenger, CEO of Challenger, Gray & Christmas in a statement. "There were early warning signs in April as a few sub-prime lenders went under and released workers. However, what had been a relatively small number of job cuts suddenly turned into a deluge in August as financial institutions shut down operations overnight." The report is an anecdotal, non-statistical tally of job-cut announcements that are reported in major medial outlets. The report focuses only on job-cut announcements, not actual layoffs, and it doesn't take into account new hires or internal transfers at companies that have announced layoff. Challenger, Gray & Christmas, Inc. an outplacement firm, tracks layoff announcements and releases its Challenger employment survey monthly.
ICSC-UBS Store Sales: Weekly measure of comparable store sales at major retail chains which is related to the general merchandise portion of retail sales, as reported by the International Council of Shopping Centers. This date accounts for approximately 10% of total retail sales. ICSC-UBS Chain Store Sales were Up 0.2% for week of September 1st per The International Council of Shopping Centers-UBS; Retail Chain Store Sales Index rose by 0.2% in the week ended September 1st from its level in the week before on a seasonally adjusted, comparable-store basis, according to data reported today. This result followed a 0.3% increase in the prior week. "Sales improved slightly by the end of August, but the year-over-year momentum remained relatively steady and sluggish," said Mike Niemira, chief economist at ICSC who compiles the index. "We continue to expect sales will increase by about 2.0% to 2.5% for the month." On the year, chain store sales were up 2.3% in the week ended September 1st compared with a rise of 2.5% the prior week.
ADP Employment: This report is a national employment report computed from a subset of ADP records that cover roughly 225,000 business establishments and approximately 14 million employees. Macroeconomic Advisors was contracted by ADP to compute a monthly report to assist in predicting monthly non-farm payrolls from the Bureau of Labor Statistics employment situation covering private payrolls. ADP-Macroeconomic Advisers see August Payrolls increase by 38,000.
Redbook: General merchandise portion of retail sales covering only approximately 10% of total retail sales, this data is a weekly measure of sales at department stores, chain stores and discounters. Redbook U.S. Retail Sales fell by 0.5% for first four weeks in August versus July. National chain store sales fell 0.5% in the four weeks of August versus the previous month, according to Redbook Research's latest indicator of national retail sales released Wednesday. The fall in the index compared with a targeted 0.9% drop. The Johnson Redbook Index also showed seasonally adjusted sales in the four-week period rose 2.4% compared with August 2006 and relative to a target of a 2.1% gain. Redbook said on an unadjusted basis, sales in the week ended September 1st were up 2.7% from the same week in 2006, following a 2.4% gain the previous week. "Most companies in Redbook's sample are on or ahead of their monthly sales plans during the week," Redbook said. "Last minute back-to-school shoppers and bargain hunters boosted sales." Retailers reported strength in back-to-school categories such as school supplies, and children's and junior apparel, Redbook said, with higher-end women's clothing also considered by many to be a good performer.
Pending Home Sales Index: Reported by the National Association of Realtors, leading indicator of housing activity. U.S. Pending Home Sales Index fell by 12.2% in July and U.S. July Pending Home Sales fell by 16.1% from July 2006.
Beige Book: The Beige Book is a compilation of anecdotal evidence on economic conditions from each of the 12 Federal Reserve districts. Notes from the Beige Book released today: Fed Beige Book Survey Period Ended August 27th; market Turmoil Effect On Economy 'Limited' Ex-Housing; market stress led to tightening lending standards; housing slump 'deepened' in most Fed districts; commercial real estate stable or expanding; moderate gains seen in consumer spending; little change seen in overall price pressures and most districts saw modest job gains.
Commodities Markets
The trend was higher across the board again today for the Energy Sector: Light crude moved higher today by $0.65 to close at $75.73 a barrel; Heating Oil ended the session higher by $0.02 again today at $2.10 a gallon; Natural Gas moved higher today by $0.18 to close at $5.81 per million BTU and Unleaded Gas closed higher by $0.01 at $2.00 a gallon.
Metals Market ended the session lower across the board today: Gold moved lower today by $0.80 to close at $690.70 an ounce; Silver moved lower by $0.09 to close at $12.36 per ounce; Platinum moved lower today by $0.70 to close at $1,273.00 an ounce and Copper closed lower by $0.04 at $3.26 per pound.
On the Livestock and Meat Markets, the trend was lower across the board today: Lean Hogs ended the day lower by 1.18 to close at 65.90; Pork Bellies ended the day lower by 1.65 at 88.78; Live Cattle moved lower by 0.58 to close at 97.05 and Feeder Cattle ended the day lower by 0.15 at 118.90.
Other Commodities: Corn moved sharply lower on the day with a loss of 7.50 at 345.75 and Soybeans moved lower today for a loss of 4.50 points to end the session at 903.00.
The e-mini Dow ended the session today at 13,343 with a triple digit loss of 113 points on the trading session. The total Dow Exchange Volume for the day came in at 143,795 which are comprised of Electronic, Open Auction and Cash Exchange. Traders should review workshops available at the CBOT (Chicago Board of Trade) Educational in-person seminars schedules available on CBOT (Chicago Board of Trade) website.
Bonds were higher across the board today: 2 year bond closed higher by 7/32 at 99 31/32; 5 year bond closed higher by 15/32 at 99 28/32; 10 year bond moved higher by 21/32 today to close at 102 21/32 and the 30 year bond moved higher by 29/32 to close at 103 17/32 for the day.
The end of day results for the CBOT (Chicago Board of Trade) which is comprised of the total Exchange Volume for Futures and Options (EVFO) including Electronic, Open Auction and Cash Exchange ended the day at 3,712,737; Open Interest for Futures moved lower by 26,491 points to close at 9,081,517; the Open Interest for Options moved higher by 31,364 points to close at 7,060,809 and the Cleared Only closed higher by 95 points at 8,284 for a total Open Interest on the day of 16,150,610 with a total Change on the day of a gain of 4,968 points.
On the NYSE today, advancers came in at 906; decliners totaled 2,333; unchanged came in at 77; new highs came in at 38 and new lows came in at 44. Gainers and losers for the day as well as active day trading stocks on the NYSE: Aluminum Corporation of China Limited (ACH) moved lower on the Big Board today for a loss of 4.07 points with a final trading price on the trading day of $64.48; The Bear Stearns Companies Incorporated (BSC) shed 5.18 points on the trading day with a final trading price of $108.95; Allegheny Technologies Incorporated (ATI) fell by 3.16 points on the session for a closing price on the day of $97.17; PetroChina Company Limited (PTR) moved lower by 4.02 points on the session to end the trading day at $142.49 and Forest Laboratories Incorporated (FRX) posted a gain on the day of 3.75 points with a high on the session of $43.38, a low of $36.95 for a final trading price of $41.63.
On the NASDAQ today, advanced totaled 995; decliners totaled 1,995; unchanged came in at 126; new highs came in at 49 and new lows came in at 45. Gainers and losers for the day as well as, active day trading stocks on the NASDAQ: Apple Incorporated (AAPL) fell sharply on the trading session to post a loss of 7.76 points with a high on the trading day of $145.84, a low of $136.10 to close the session at $136.40; Applix Incorporated (APLX) posted a sharp gain on the trading day of 22.34% to tack on 3.21 points for a closing price on the session of $17.58; OSI Systems Incorporated (OSIS) moved sharply lower on the session with a loss of 19.56% to shed 5.00 points on the day for a final trading price of $20.56 and SanDisk Corporation (SNDK) shed 2.49 points on the session to close at $55.61.
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At the closing bell, here is how the major indices ended the session: the DOW (Dow Jones Industrial Average) posted a triple digit loss of 143.39 points on the day to end the session at 13,305.47; the NYSE (New York Stock Exchange) posted a triple digit loss of 115.51 points to end the session at 9,583.17; the NASDAQ posted a loss of 24.29 points for a close at 2,605.95; the S&P 500 moved lower by 17.13 points to end at 1,472.29 and the RUSSELL 2000 moved lower by 10.21 points to close at 790.46. The FTSE All-World Index ex-US (top Large/Mid Cap aggregate from over 2,700 stocks from the FTSE Global Equity Index Series (GEIS) which covers 90% of the world’s investable market capitalization) posted a loss of 2.26 points to close at 254.36 and the FTSE RAFI 1000 posted a loss of 71.93 points to close at 6,079.80.
Testimony of Robert K. Steel Under Secretary for Domestic Finance U.S. Department of the Treasury Before the House Committee on Financial Services: Washington- Chairman Frank, Ranking Member Bachus, Members of the Committee, good morning. I very much appreciate the opportunity to appear before you today to present the Treasury Department's perspective on the recent events in the credit and mortgage markets and their impact upon consumers and the economy. The Treasury Department and Secretary Paulson know that these events are of considerable interest to the American people, this Committee, and other Members of Congress. To give context to the current market situation, I would like to begin my remarks today with a description of both domestic and global economic conditions. In the United States, the unemployment rate is at 4.6%, close to its lowest reading in 6 years. Real GDP growth was 4.0 percent in the second quarter, supported by strong gains in business investment and exports. Core inflation is under control. Since August 2003, 8.3 million jobs have been created, more jobs than all the major industrialized countries combined; over the past 12 months, nearly 2 million jobs have been created. Real wages have increased 1.7% over the past 12 months. In the corporate sector, earnings continue to outperform expectations and default rates on corporate credits of all kinds are at historically low levels. On the government side, the U.S. fiscal deficit is declining and well below long-term averages as a share of the economy, reflecting strong revenue growth and the continued strength of the U.S. economy. The global economy continues to grow at around 5% annually, with many emerging market economies growing even more rapidly than the global average. The advanced economies also continue to perform well, with unemployment down sharply in Europe, helping to make growth of the last several years the strongest since the early 1970s. The Treasury Department, as the steward of economic and financial systems in the United States, is committed to ensuring these strong U.S. and global economic fundamentals. At the same time, the Treasury Department's mission includes the promotion of economic stability. It is important to appreciate that the core fundamental economic environment is strong globally, and it is against this backdrop that I turn to the current credit and market challenges.
General Trends in the Mortgage Industry
As just discussed, over the past several years the United States has enjoyed favorable economic conditions: low unemployment, low inflation, and low interest rates. These positive conditions served to fuel a demand for credit and investment and the marketplace responded with a vast supply of both to satisfy consumers and sophisticated market participants. At the consumer level, this demand was very noticeable in the mortgage industry, and in recent years particularly, the sub-prime arena. For the first time, in the early 1990s, consumers with lower incomes and challenged credit history, typical sub-prime borrowers, were able to gain access to mortgage credit at interest rates a few percentage points higher than prime borrower rates. Homeownership became more widely available in the United States, growing from 64% in 1994 to 69% today, some of that due to sub-prime mortgage origination volume, which increased from less than 5%, or $35 billion, of total mortgage origination volume in 1994 to nearly 20%, or $625 billion, in 2005. Mortgage securitization has fundamentally changed the mortgage industry and has played a significant role in the growth of the mortgage market. Typically in a private label mortgage securitization, the mortgage originator transfers loans to a securitization sponsor, who pools together mortgages into mortgage-backed securities, and sells pieces, or tranches, of these securities to investors. Thus, the mortgage originator, instead of holding the mortgage loan on its balance sheet, distributes the loan and its attendant risks to a securitization sponsor in return for capital. The credit rating agencies work closely with the sponsor to rate the credit risk of each tranche. These innovative securities offered sophisticated investors a diversification tool and the ability to better target their risk/return profile. The demand for mortgage-backed securities has been global in nature and has helped to provide mortgage originators with a steady stream of capital. Over 55% of total mortgage origination volume and over 70% of sub-prime mortgage origination volume were securitized in 2006. Further fueling this growth has been the development of another structured product, the collateralized debt obligation, which purchases asset-backed securities, such as mortgage-backed securities. Mortgage-backed CDO’s, nearly 40% of the entire $500 billion CDO market in 2006, have been one of the major purchasers of mortgage-backed securities, in particular the lower rated tranches.
Recent Mortgage Market and Credit Market Events
Through most of the 1990s, annual mortgage origination stood at approximately $1 trillion. With the historically low interest rate environment of 2001-2003, mortgage origination climbed to nearly $4 trillion in 2003. Infrastructure build-up and the entry of many new participants into the mortgage industry matched this increase. With the rise in interest rates in 2004, mortgage origination fell to just under $3 trillion. With this decline, there was significant overcapacity in the mortgage industry. Competition among mortgage originators and brokers intensified. At the same time, investor demand for securitized products remained unabated. To satisfy this demand and their excess capacity, some mortgage originators relaxed their underwriting standards, lending to individuals with a lower standard of documentation and selling mortgage products, which for some borrowers would become unaffordable. In the past few years, some of the most popular sub-prime products were adjustable rate mortgages, like the 2/28: a hybrid mortgage with a fixed rate of interest, often free of amortization payments, for the first two years, resetting at an adjustable rate for the remaining 28 years. The fixed rate of interest in the first two-year period was typically lower than the initial adjustable rate in the reset period. In the initial period of these resets, rising housing prices enabled these borrowers to refinance their original mortgages on terms more attractive and affordable. Eventually, due to both an upwards adjustment in rates and commencement of principal amortization as these mortgages began to reset in 2005, 2006, and 2007; many borrowers were faced with payment shock. These resets, combined with a decline in housing price appreciation, led to rising delinquencies and defaults among sub-prime borrowers, first widely evidenced in autumn 2006. In 2007 this trend has continued and spread to other participants in the mortgage industry: several mortgage originators and brokers have exited the industry. In turn, the mortgage-backed securities investor has felt the repercussions of the weaknesses in the mortgage assets underlying some of these securitized products: in autumn 2006 with rising defaults on the underlying assets, mortgage-backed securities spreads began to widen. Over the past several months, a small number of U.S. and foreign financial institutions and hedge funds that invested in mortgage-backed CDO’s and other mortgage-backed securities have reported large losses. Some have suspended or limited redemptions, while others have closed or received capital infusions. At the same time, credit rating agencies announced their intent to downgrade some of these securitized products and revise their ratings methodologies. The uncertainty regarding both the future prospects of these mortgage-backed securities and the methodologies the credit rating agencies used to rate these securities compelled investors to reassess the risk of these securities and subsequently reassess price. Given the uncertainty of the underlying credit and cash flows, few buyers were willing to risk their capital. Valuation became extremely difficult as a no-bid environment seized certain segments of the market. This reappraisal has spread across the credit market spectrum, first affecting residential-mortgage backed securities and then spreading to other asset classes and, particularly, securitized products. Spreads have widened and a lack of liquidity has affected these other asset classes. The financing of buy-out transactions has also been challenged as higher risk premia resurfaced after a long period of favorable conditions. Volatility has increased: from Treasury bills to the stock markets.
This reappraisal of risk is normal and typically follows periods of widely available credit when markets have undervalued risk. As in other times of reappraisal, investors, adverse to risk and protective of their capital, have fled to quality assets, demanding and driving up the prices--and in turn driving down significantly the rates, of Treasury bills. For example, during the past three weeks, the demand for Treasury securities by global investors was so enormous that rates on the safest, most liquid asset in the world dropped over 250 basis points, a decline of such magnitude not seen in the past. In early August, this uncertainty began to spread to the asset-backed commercial paper market, typically a very liquid market. The uncertainty surrounding the health of the assets underlying commercial paper (especially asset-backed commercial paper, which represents approximately 55% of the commercial paper market) compelled investors to shorten the terms to maturity that they were willing to purchase and, in some cases, even to decline to buy such paper altogether. Subsequently, banks became increasingly concerned about their own liquidity in view of the possibility that they might have to provide backup for commercial paper and take other assets onto their balance sheets. In response to such developments, the Federal Reserve took several measures to increase liquidity and promote the orderly functioning of financial markets. The Federal Reserve provided additional reserves through open market operations in order to promote trading in the Federal Funds market at rates close to the target rate. The Federal Reserve also lowered the discount rate and changed Reserve Banks' usual practices to allow the provision of term funding at the discount window. Such actions have helped stabilize the markets. The ultimate impact of these events on the economy has yet to play out. At the time of its discount rate cut, the Federal Reserve noted that "financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace…the downside risks to growth have increased appreciably." The Treasury Department respects the independent actions and leadership of the Federal Reserve. Like the Federal Reserve, the Treasury Department shares the perspective that recent market developments pose downside risks to economic growth. However, the economy was in strong condition going into the recent period of volatility, and while certain sectors like housing are undergoing a transition, overall economic fundamentals remain solid. And while recent difficulties in the sub-prime mortgage market are having and will continue to have a profound effect for many families, the underlying strength of the economy should allow for continued growth. Just last Friday, the President announced plans to help those homeowners facing mortgage delinquencies and foreclosures and I will return to these initiatives later.
Impact of Recent Market Developments on the Mortgage and Credit Markets
The financial services industry has enjoyed a period of extraordinary growth over the last several decades. Key drivers to this growth have been successful engagement with the trends of innovation, institutionalization, and internationalization. The complexity and innovation of financial products have brought great benefits to the mortgage and credit markets. In the mortgage industry, securitization allows mortgage originators to undertake better risk management as they do not have to hold loans on their balance sheets and instead have another source of capital funding. Investors purchasing a securitized product have reduced transaction costs and can purchase an array of products at targeted risk levels. Homebuyers have expanded product offerings and more lenders competing for their business.
The recent market events have revealed potential complexities in the securitization model. In some cases, risk evaluation of securitized products can be difficult. In mortgage-backed securities and mortgage-backed collateralized debt obligations, the performance of the underlying assets, particularly many of the innovative sub-prime mortgage products, may not have been properly understood, or investors may have failed to perform adequate due diligence prior to their investment decision. At the same time, mortgage originators may have possessed less incentive to perform appropriate levels of due diligence because of their distributing their loans and the attendant risks through securitization. Over the past few decades the capital markets have experienced growing institutionalization. These institutions, such as pension funds, mutual funds, and hedge funds, have provided the markets with liquidity, pricing efficiency, and risk dispersion. These institutions have also spurred on financial product innovation and complexity and possess the incentives, resources, and information to make prudent decisions. At the same time, these institutions can be highly leveraged and employ highly correlated strategies, potentially leading to more widespread market disruptions. Finally, the capital markets are becoming increasingly internationalized. Market participants, sources of capital, product offerings, and trading strategies ignore national borders. This has contributed to the significant global economic growth over the past decade, especially in the emerging market economies. At the same time, an event in one country's market may impact the rest of the world.
Treasury, Administration, and Federal Banking Regulator Actions
The Treasury Department closely monitors the global capital markets on a daily basis. This is especially true given the events unfolding in the credit and mortgage markets. Secretary Paulson has been communicating regularly with federal banking regulators and the members of the President's Working Group on Financial Markets, which includes Federal Reserve Chairman Bernanke, Securities and Exchange Commission Chairman Cox, and Commodity Futures Trading Commission Acting Chairman Lukken. This complements information gathering from market participants, finance ministers, and other participants in the global marketplace. Enhanced communication is vitally important for understanding where disruptions are occurring, and evaluating what actions can be considered. Under Secretary Paulson's leadership, the President's Working Group on Financial Markets will examine some of the broader market issues underlying the recent market events, including the impact of securitization and the role of rating agencies in the credit and mortgage markets. The Treasury Department will also be releasing early next year a blueprint of structural reforms to make financial services industry regulation more effective, taking into account consumer and investor protection and the need to maintain U.S. capital markets competitiveness. Most important and in addition to efforts to fully understand the current situation in the financial markets, the Treasury Department, the Department of Housing and Urban Development, and others in the Administration have carefully focused on evaluating the challenges faced by individuals in the sub-prime market. Last week, the President announced a series of market-based initiatives to help more homeowners keep their homes. The Administration, led by the Treasury Department and HUD, has undertaken several actions to provide assistance to homeowners, including the Administration's continued pursuit of legislation modernizing the Federal Housing Administration. Coordinating with HUD, the Treasury Department also will reach out to a wide variety of entities, such as Neighbor Works America, mortgage originators and servicer’s and government-sponsored entities, like Fannie Mae and Freddie Mac, to identify struggling homeowners and expand their mortgage financing options. The President has also asked Congress to temporarily change a provision of the federal tax code that currently considers cancelled mortgage debt on a primary residence as taxable income. The Treasury Department looks forward to working with Congress in the days ahead. In addition, the federal government has taken several actions to increase transparency and enhance lending standards in the mortgage industry. For example, in 2006, the banking regulators issued supervisory guidance addressing nontraditional mortgages and in June 2007 finalized sub-prime lending guidance. Separately, the Federal Reserve has undertaken a comprehensive review of the disclosure system for mortgage loans under the Truth in Lending Act and is currently addressing unfair and deceptive mortgage practices using its authority under the Home Ownership and Equity Protection Act. Later this fall, HUD will propose reforms to the Real Estate Settlement Procedures Act to promote comparative shopping for the best loan terms, provide more transparent and comprehensible disclosures, including fee disclosure, and limit settlement cost increases.
Conclusion
The recent volatility in the credit and mortgage markets reflects a reassessment of risk across a broad spectrum of securities. These events have occurred during a time of solid domestic and global growth, helping to mute some of the impact of this turbulence. I do want to caution policymakers that this process is far from over. It will take more time to play out and certain segments of the capital markets are stressed. Risk is being re-priced. This re-pricing will lead to a reevaluation of assets. This reevaluation will inevitably impact the balance sheets of financial market participants. As investors review fundamental characteristics and confidence returns, liquidity will improve. Yet, policymakers must remain vigilant as further stress could create further challenges and continued volatility. It is critical that policymakers understand these issues and their underlying causes and continue to enhance the capital markets regulatory structure to adapt to market developments. I appreciate having the opportunity to present the Treasury Department's perspectives on these important issues.
Economic Data:
MBA Purchase Applications: Compilation from the Mortgage Bankers’ Association of various mortgage loan indexes. This data is the leading indicator for single-family home sales as well as, housing construction. U.S. MBA Market Index Rises 1.3% to 622.9 from 615.2; U.S. MBA Purchase Index Rises 0.4% to 425.8 from 424 and U.S. MBA Refinancing Index Rises 2.3% to 1770.2 from 1729.6.
Challenger Job-Cut Report: Corporate layoffs comprised in a monthly, not seasonally adjusted report which indicates a trend in the labor market. Challenger U.S. August Job Cuts were 79,459, up 85.2% from July The number of job cuts announced by U.S. corporations in August jumped by 85.2% from the number reported in the prior month for a total of 79,459 according to a Challenger, Gray & Christmas survey released Wednesday. Job cuts were 21.7% higher this August than last year, when there were 65,278 job cuts. Job cut announcements so far this year totaled 515,855, 4.3% fewer than the 538,914 in the first eight months of 2006. The financial industry announced 35,752 job cuts last month, the most for any industry. "The story in August revolves around the dramatic collapse of the mortgage and sub-prime housing markets," noted John Challenger, CEO of Challenger, Gray & Christmas in a statement. "There were early warning signs in April as a few sub-prime lenders went under and released workers. However, what had been a relatively small number of job cuts suddenly turned into a deluge in August as financial institutions shut down operations overnight." The report is an anecdotal, non-statistical tally of job-cut announcements that are reported in major medial outlets. The report focuses only on job-cut announcements, not actual layoffs, and it doesn't take into account new hires or internal transfers at companies that have announced layoff. Challenger, Gray & Christmas, Inc. an outplacement firm, tracks layoff announcements and releases its Challenger employment survey monthly.
ICSC-UBS Store Sales: Weekly measure of comparable store sales at major retail chains which is related to the general merchandise portion of retail sales, as reported by the International Council of Shopping Centers. This date accounts for approximately 10% of total retail sales. ICSC-UBS Chain Store Sales were Up 0.2% for week of September 1st per The International Council of Shopping Centers-UBS; Retail Chain Store Sales Index rose by 0.2% in the week ended September 1st from its level in the week before on a seasonally adjusted, comparable-store basis, according to data reported today. This result followed a 0.3% increase in the prior week. "Sales improved slightly by the end of August, but the year-over-year momentum remained relatively steady and sluggish," said Mike Niemira, chief economist at ICSC who compiles the index. "We continue to expect sales will increase by about 2.0% to 2.5% for the month." On the year, chain store sales were up 2.3% in the week ended September 1st compared with a rise of 2.5% the prior week.
ADP Employment: This report is a national employment report computed from a subset of ADP records that cover roughly 225,000 business establishments and approximately 14 million employees. Macroeconomic Advisors was contracted by ADP to compute a monthly report to assist in predicting monthly non-farm payrolls from the Bureau of Labor Statistics employment situation covering private payrolls. ADP-Macroeconomic Advisers see August Payrolls increase by 38,000.
Redbook: General merchandise portion of retail sales covering only approximately 10% of total retail sales, this data is a weekly measure of sales at department stores, chain stores and discounters. Redbook U.S. Retail Sales fell by 0.5% for first four weeks in August versus July. National chain store sales fell 0.5% in the four weeks of August versus the previous month, according to Redbook Research's latest indicator of national retail sales released Wednesday. The fall in the index compared with a targeted 0.9% drop. The Johnson Redbook Index also showed seasonally adjusted sales in the four-week period rose 2.4% compared with August 2006 and relative to a target of a 2.1% gain. Redbook said on an unadjusted basis, sales in the week ended September 1st were up 2.7% from the same week in 2006, following a 2.4% gain the previous week. "Most companies in Redbook's sample are on or ahead of their monthly sales plans during the week," Redbook said. "Last minute back-to-school shoppers and bargain hunters boosted sales." Retailers reported strength in back-to-school categories such as school supplies, and children's and junior apparel, Redbook said, with higher-end women's clothing also considered by many to be a good performer.
Pending Home Sales Index: Reported by the National Association of Realtors, leading indicator of housing activity. U.S. Pending Home Sales Index fell by 12.2% in July and U.S. July Pending Home Sales fell by 16.1% from July 2006.
Beige Book: The Beige Book is a compilation of anecdotal evidence on economic conditions from each of the 12 Federal Reserve districts. Notes from the Beige Book released today: Fed Beige Book Survey Period Ended August 27th; market Turmoil Effect On Economy 'Limited' Ex-Housing; market stress led to tightening lending standards; housing slump 'deepened' in most Fed districts; commercial real estate stable or expanding; moderate gains seen in consumer spending; little change seen in overall price pressures and most districts saw modest job gains.
Commodities Markets
The trend was higher across the board again today for the Energy Sector: Light crude moved higher today by $0.65 to close at $75.73 a barrel; Heating Oil ended the session higher by $0.02 again today at $2.10 a gallon; Natural Gas moved higher today by $0.18 to close at $5.81 per million BTU and Unleaded Gas closed higher by $0.01 at $2.00 a gallon.
Metals Market ended the session lower across the board today: Gold moved lower today by $0.80 to close at $690.70 an ounce; Silver moved lower by $0.09 to close at $12.36 per ounce; Platinum moved lower today by $0.70 to close at $1,273.00 an ounce and Copper closed lower by $0.04 at $3.26 per pound.
On the Livestock and Meat Markets, the trend was lower across the board today: Lean Hogs ended the day lower by 1.18 to close at 65.90; Pork Bellies ended the day lower by 1.65 at 88.78; Live Cattle moved lower by 0.58 to close at 97.05 and Feeder Cattle ended the day lower by 0.15 at 118.90.
Other Commodities: Corn moved sharply lower on the day with a loss of 7.50 at 345.75 and Soybeans moved lower today for a loss of 4.50 points to end the session at 903.00.
The e-mini Dow ended the session today at 13,343 with a triple digit loss of 113 points on the trading session. The total Dow Exchange Volume for the day came in at 143,795 which are comprised of Electronic, Open Auction and Cash Exchange. Traders should review workshops available at the CBOT (Chicago Board of Trade) Educational in-person seminars schedules available on CBOT (Chicago Board of Trade) website.
Bonds were higher across the board today: 2 year bond closed higher by 7/32 at 99 31/32; 5 year bond closed higher by 15/32 at 99 28/32; 10 year bond moved higher by 21/32 today to close at 102 21/32 and the 30 year bond moved higher by 29/32 to close at 103 17/32 for the day.
The end of day results for the CBOT (Chicago Board of Trade) which is comprised of the total Exchange Volume for Futures and Options (EVFO) including Electronic, Open Auction and Cash Exchange ended the day at 3,712,737; Open Interest for Futures moved lower by 26,491 points to close at 9,081,517; the Open Interest for Options moved higher by 31,364 points to close at 7,060,809 and the Cleared Only closed higher by 95 points at 8,284 for a total Open Interest on the day of 16,150,610 with a total Change on the day of a gain of 4,968 points.
On the NYSE today, advancers came in at 906; decliners totaled 2,333; unchanged came in at 77; new highs came in at 38 and new lows came in at 44. Gainers and losers for the day as well as active day trading stocks on the NYSE: Aluminum Corporation of China Limited (ACH) moved lower on the Big Board today for a loss of 4.07 points with a final trading price on the trading day of $64.48; The Bear Stearns Companies Incorporated (BSC) shed 5.18 points on the trading day with a final trading price of $108.95; Allegheny Technologies Incorporated (ATI) fell by 3.16 points on the session for a closing price on the day of $97.17; PetroChina Company Limited (PTR) moved lower by 4.02 points on the session to end the trading day at $142.49 and Forest Laboratories Incorporated (FRX) posted a gain on the day of 3.75 points with a high on the session of $43.38, a low of $36.95 for a final trading price of $41.63.
On the NASDAQ today, advanced totaled 995; decliners totaled 1,995; unchanged came in at 126; new highs came in at 49 and new lows came in at 45. Gainers and losers for the day as well as, active day trading stocks on the NASDAQ: Apple Incorporated (AAPL) fell sharply on the trading session to post a loss of 7.76 points with a high on the trading day of $145.84, a low of $136.10 to close the session at $136.40; Applix Incorporated (APLX) posted a sharp gain on the trading day of 22.34% to tack on 3.21 points for a closing price on the session of $17.58; OSI Systems Incorporated (OSIS) moved sharply lower on the session with a loss of 19.56% to shed 5.00 points on the day for a final trading price of $20.56 and SanDisk Corporation (SNDK) shed 2.49 points on the session to close at $55.61.
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