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Five Things You Need to Know: Why Should You Care About LIBOR?; Bull vs. Bear: The Credit Market Paradigm; $2,000,000,000,000 = Two Million Fewer Millionaires; Risk Aversion Leads to Risk Aversion; Fuzzie Mae?


What you need to know (and what it means)!


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Why Should You Care About LIBOR?

Overnight the three-month dollar LIBOR rose 4 basis points to 4.95% today, the biggest one-day increase since Sept. 3, according to the British Bankers' Association. But what is LIBOR, and why should you care?

  • LIBOR is the London Interbank Offered Rate for dollars.
  • Simply put, it's the amount banks charge each other for loans.
  • Ok, so why do we in the U.S. care about the London Interbank Offered Rate?
  • A number of important reasons.
    1) LIBOR is the most active interest rate market in the world.
    2) It is the reference rate for many financial derivatives.
    3) It is an important benchmark for determining "real" supply and demand for credit.
  • Another way of viewing LIBOR is to consider it as a "real" indicator of supply and demand.
  • Why "real"?
  • Because LIBOR, which generally trades only a hair of a percentage point (we're talking a few hundredths) above the Federal Funds rate, is the overnight lending rate among banks set outside the U.S. Federal Reserve's control.
  • The Federal Reserve has many tools at its disposal to set the Federal Funds rate, the overnight rate charged by banks, but has no control over LIBOR.
  • The fact that LIBOR is high and rapidly rising is an indication that either demand for dollars by large banks is high, or supply is low.
  • In this case, demand is high because banks are both hoarding cash to ensure they have adequate reserves, fearful of more writedowns (See Five Things Number 3, What are Writedowns?), and supply is low because they are afraid to lend the money to other banks, fearful they won't be repaid.
  • That's why LIBOR matters to you.

2. Bull vs. Bear: The Credit Market Paradigm

There were some interesting comments made yesterday by Wells Fargo (WFC) CEO John Stumpf from the Merrill Banking and Financial Services Investor Conference. Most news services focused on the gritty headline making stuff: "Wells Fargo Chief Says Housing Market Worst Since the Great Depression." What we found interesting, however, were these comments made by Stumpf:

"As the adverse current trends emerge we tightened credit standards early in 2007 and stopped correspondent originations altogether in the third quarter. In response to the decline in housing, we have taken a number of other actions across our home equity portfolio including reducing the maximum combined loan to values for all sales channels and further tightening underwriting in weakening markets. We have also been anticipating higher credit losses in the portfolio for some time, but losses have turned out to be greater than expected because home prices have declined faster and deeper than expected. As we said in the third quarter, given the current real estate market conditions credit losses in the home equity portfolio are likely to increase in the fourth quarter and remain elevated into 2008."

Wells Fargo has minimal exposure to CDOs and asset backed commercial paper, but the company is not immune from overall credit deterioration and what is interesting here is the overall structure of how WFC handled weakening markets: they followed the typical, reasonable path toward risk aversion by tightening credit standards and in certain markets ceasing originations altogether.

This, in a nutshell, is why credit problems are so difficult to "contain." The transition from easy credit conditions to tighter credit conditions tends to induce one thing: even tighter credit conditions. In other words, risk aversion begets more risk aversion. Key to understanding this transition is understanding from where it began.

The battle between bulls and bears is over the following question: did loose underwriting standards and excessive credit creation in the subprime residential mortgage market exist in a vacuum?

If one believes that it did, and consequently that the paradigm within which loose underwriting standards and excessive credit creation came into being were isolated to that segment of the market, then overall credit conditions here are too tight and higher-quality segments of the market are being unfairly punished.

However, if one believes that the paradigm within the subprime segment is simply a weaker version of the larger credit market paradigm - that loose underwriting standards and excessive credit creation is the norm across all market segments, not just subprime - then we are still in the first inning of these credit issues. In fact, if that is the case, we may not even have seen the first out of the first inning yet.

3. $2,000,000,000,000 = Two Million Fewer Millionaires

Speaking of an expanding suprime credit paradigm expansion, Goldman Sachs (GS) says the slump in global credit markets is likely to force banks, brokerages and hedge funds to cut lending by $2 trillion, according to Bloomberg.

  • "The likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized, Jan Hatzius, Goldman's chief economist wrote in a report released yesterday.
  • Goldman's forecast reduction in lending is equivalent to 7% of total U.S. household, corporate and government debt.
  • Hatzius said this is based on a "conservative estimate'' of financial companies cutting lending by 10 times the loss to their capital.

4. Risk Aversion Leads to Risk Aversion

Risk aversion doesn't just apply to bank lending and consumer discretionary spending. It applies across many different segments of the economic landscape. Take J.C. Penney (JCP) for example.

  • J.C. Penney is an important stock in terms of consumer stress, something made clear by CFO Robert Cavanaugh in the company's conference call yesterday:
    "Our focus is the moderate consumer, a consumer who has always had to make serious choices about their discretionary spending."
  • And J.C. Penney CEO Myron Ullman touched on what the company is seeing in terms of consumer sentiment and risk aversion:
    "For the first time we really saw a change in consumer sentiment reflecting the soft housing market, the subprime market and the effect of – psychological effect, at least, of fuel prices."
  • But what struck us as interesting about the call is how risk aversion infects everything and applies across many different segments of the economic landscape.
  • Ullman noted, "[I]t's our belief that 2008 is going to continue to be a difficult selling environment and as such we are planning 2008 very conservatively on expenses. We certainly need to be able to flex the business count in terms of customer staffing and selling, but we are not going to be very aggressive in terms of spending on discretionary projects in this environment."
  • This is how risk aversion leads to yet more risk aversion, and why the Federal Reserve's battle at a point becomes a psychological battle.
  • The Federal Reserve can continue to make credit available, but what matters is how willing businesses and consumers are to take it.

5. Fuzzie Mae?

Fannie Mae (FNM) stock plunged 10% yesterday after an article in Fortune magazine questioned how the mortgage giant is measuring the impact of rising foreclosures.

  • Fannie Mae said it believes its credit losses will be between 4 basis points and 6 basis points during 2007, or between .04 and .06 of a percentage point.
  • But the ratio for the first nine months of this year would have been 7.5 basis points, or .075 of a percentage point, under Fannie Mae's alternative accounting methods, Fortune reported.
  • Last week, as part of its earnings report, Fannie Mae revealed that the company had changed the way it calculates the credit loss ratio, the article said.
  • As of Sept. 30, Fannie Mae had exposure to $74 billion of loans with a FICO credit score below 620, the level below which loans are typically considered "subprime."
  • Fannie Mae also has exposure to $196 billion of Alt-A mortgages, the level between prim and subprime.
  • Fortune notes that Fannie Mae has only $40 billion of capital, however.
  • That's not a lot of margin for error if losses exceed Fannie Mae's estimates.
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