The market ended the final trading session of the volatile week in a mixed fashion. The Dow, which helped by big rallies seen in big banks, gained more than 1%. The Nasdaq, on the other hand, was dragged by a 27-point drop in RIMM and finished the session in red. For the week as a whole, the Dow lost 2.2% while the S&P 500 gave up 3.4%. The focus of the session continued to be the $700 billion bailout plan. Congress members are going to work through the weekend and try to reach a consensus. The latest feeling on the Street is that the bill will eventually get passed but the final terms are anything but certain. In other top economic news, the second quarter GDP figure was revised down to 2.8% from 3.3% in the previous estimation. The downward revision was mostly due to a drop in consumption, which accounts for more than two thirds of the GDP. Actually, if it were not the $168 billion stimulus implemented during the quarter, we might already see negative growth. Also, exports gave the economy a big boost as weakness in the US dollar made its goods more attractive in the foreign markets. However, we should also notice that a global slowdown is more likely in the next few quarters, which could affect the US exports. The BDI index declined to 3700 points from more than 10000 points less than four months ago, indicating weakness in the emerging markets. I’m traveling in China now and after talking with various people, it should be clear that things have slowed down quite dramatically following the Olympic Games. For example, the wholesale diesel price has dropped significantly during the past two weeks and it should be noted that high diesel demand was one of the key reasons behind crude run-up earlier in the year.
With more clear signs of a global slowdown, commodities were underperforming the broad market recently and that was obviously the case in today’s trading. Basic materials declined almost 4% while energies gave up more than 2%. On the winners’ side, we had names like financials and utilities. The CRB commodity index dropped more than 1%. Gold price earlier gained as much as 3% amid uncertainties over the bailout plan. The US dollar moved higher against most major currencies. Treasury mixed with the yield curve flattened a bit. The VIX index gained 2 points and closed above 30 for the tenth consecutive session, indicating continuing nervousness in the market. The market breath was neutral while the volume was on the light side.

The market had a nice rebound on this Thursday. All three major indices finished the session higher by at least 1% as investors became optimistic once gain regarding the passing of the $700 billion bailout plan. However, things turned around after the market close. It appears that Congress cannot reach an agreement as market expected, which sent stock futures tumbling in the after hour trading. In a separate story after the bell, JP Morgan Chase came to the rescue of WaMu after the latter was seized by the Federal Deposit Insurance Corp in the largest failure ever of a US bank. WaMu has about $310 billion in assets, dwarfing the previous record of Continental Illinois National Bank in 1984, which had $40 billion in assets when it closed. The news came after the market closed and they will almost certainly add more volatility to tomorrow’s trading. It is almost 20 months since the recent sub-prime crisis first emerged. What originally thought to be a mild setback in the financial sector turned out to be one of the largest financial crises in the US history. Given the confusion and turmoil in the market these days, it is more critical than ever to keep a clear mind to separate facts from rumours. I spent some time digging through various data to come up with a picture of the crisis we are experiencing now and I will briefly outline them below.
First of all, the root cause of the sub-prime crisis or whatever crisis following is the falling housing price in the US from 2006 to 2008. If the housing price kept increasing like it did between 1996 and 2006 (total average gain nationwide is 124% during the period), then Wall Street will never have today’s nightmare. I will have lots of numbers below so please bear with me if it feels overwhelming. So what is the total home value at its peak back in 2006? The answer is somewhere between 18 trillion to 19 trillion. Here is how I came up with the result: The average housing price during early parts of 2006 is between $260K and $270K depending on which months you are looking at. Note here I use average price instead of median price, which is around 20% lower. Then we have the peak home ownership rate of around 69.5% and the number of household is around $1 trillion. Put them together you will get the number I listed previously. Now according to the latest S&P Case/Shiller Housing Index, the average price nationwide has dropped about 20% from its peak. In other words, total home value has lost close to $4 trillion over the period. It is not a small sum and it roughly equals 5 months’ income of a US citizen.
The next question is will banks lose that much or even more(as housing price still tries to find its bottom) before the crisis is over? Fortunately the answer is NO. Because banks only need to worry about the mortgage loans they have made to borrowers. The total mortgage loan outstanding is around $12 trillion and the majority of that is fixed rate primary loan. Things look ok until this point because among the $12 trillion, we do have some bad apples, noticeably sub-prime loans and AI loans. I’m not going to discuss how we get to the current disaster here as that’s something historians will deal with. Instead, let’s look at some hard numbers. The total outstanding amount of sub-prime loans at the end of March 2007 is $1.3 trillion. Why use March 2007 instead of today? Because little was generated after that date and a big chunk of that $1.3 trillion has already been written-off. By the way, nearly half ($600 billion to be precise) of that $1.3 trillion was generated in 2006. Now let’s turn to AI loans, which some investors are afraid to become an even bigger monster after the sub-prime crisis. By the end of 2007, the total outstanding amount of AI loans is around $1 trillion and again, little is generated since then. So now we should have some good idea of the banking industry’s exposure: $1.3 trillion sub-prime loans + $1 trillion AI loans + $9.7 trillion fixed rate prime loans.
Hopefully you are still with me at this point. Now let’s take a look at the financial health of the banking sector entering into this crisis. In 2006, banks earned record amount of profits, which equaled $145 billion, or roughly 1% of their $14 trillion total assets on balance sheet. The profits they made during 2007 dropped 31% from 2006 and were around $100 billion. Of course, no one will doubt that number should drop further in 2008. So what is the total write-offs so far related to the sub-prime loans? According to Bloomberg, the number is around $525 billion and is expected to reach $700 billion by the end of 2008. Then we shouldn’t forget a key player behind the banking industry, the Federal Reserve. Through its 325 bps rate cut, the yield curve is at least 150 bps steepened compared to 2006. In other words, if you simply time that 150 bps with banks’ $14 trillion total assets. Banks will earn an extra $200 billion pre-tax income every single year. Assuming the crisis will take one more year to finish. That equals $400 billion extra supports to the banking industry. So now we have some numbers on the banking side: $700 billion write-offs(estimated) + $400 billion extra profits + $200 billion normal profits(in 2 years assuming 2007’s number is an average), which equals $1.3 trillion in total.
By now we have some interesting numbers: $1.3 trillion sub-prime loans, $1 trillion AI loans, $9.7 trillion prime loans and $1.3 trillion banking write-offs/profits. The $1.3 trillion banking figure can be considered as weapons to offset losses incurring in loans listed above. So now let’s make some further assumptions: Assume half of the sub-prime loans and AI loans need to be written-off and 10%(note this is a very conservative estimation by historical standards) of the fixed rate prime loans need to be written-off, the total written off should be around $2.1 trillion. Clearly, the $1.3 trillion is not enough to offset that $2.1 trillion conservatively estimated losses. But if you add the $700 billion bailout plan proposed by Paulson, you will see two sides roughly offset each other. In other words, the $700 billion is essential in solving the current banking crisis.
Some final thoughts I would like to discuss here. All the assumptions listed above regarding the losses and write-offs are based on the fact that the housing price is declining right now. Let’s say that in several years housing price reverses its trend and starts to move up(which is more likely than not based on history), then those written-offs can be reversed and today’s losses will become tomorrow’s gains and that’s why Paulson mentioned in his testimony before Congress that the $700 billion bailout plan is to buy assets, which may eventually turn out to be profitable. Also, the CDSs, CDOs, MBSs are all derivatives. The underlying value is still based on mortgage loans. So those spreading rumors that $600 trillion CDS market will fail any rescue plan are either naïve or trying to use it to scare off other investors. The root problem of the recent financial problem is still declining housing price. But if the financial problem deepens and becomes a real-economy problem, then that’s a totally different story for another discussion.
Turn back to today’s market. All 10 major sectors finished the session in green. Financials and energies were among the best performers. Crude ceased to decline and gained more than 2% in the session. The CRB commodity index gained less than 1% and closed just below 370. The US dollar was mixed against most major currencies. Treasuries declined with yields climbing throughout the curve. The VIX index dropped more than 2 points to 32.82 and closed above 30 for the ninth consecutive session, indicating continuing nervousness in the market. The market breath was positive while the volume was heavier compared to yesterday.

The market finally had a relatively quiet day on this Wednesday. Throughout today’s trading, the Dow was hovering around the unchanged level. The difference between today’s highs and lows was only around 150 points, compared to 400 or even 600 points in each of the past few sessions. Credit market, however, was anything but quiet. Concerns and confusion over the $700 billion bailout plan incurred great stress among trading desks. The so-called TED spread, which is the difference between the Treasury bill and the LIBOR rate, again soared to multi-decade high, indicating continuing stress in the credit market. The latest financial crisis even affects the presidential election, which is scheduled to start in just 6 weeks. Republican candidate McCain threatened to delay its campaign and cancel a scheduled debate on Friday unless Congress can pass the bill by that time. President Bush declared that “our entire economy is in danger” in a live televised address if the $700 billion bailout plan is not passed in time. The latest news from Congress indicated that both parties are close to agreement on legislation. I think the bill will likely be finalized by the end of this week and could be as early as this Friday. The credit market will ease after the bill is passed. But the 6-trillion dollar question now is how much damage is already done to the real economy due to the recent credit market turmoil? Many banks have dramatically cut back their credit lines to small businesses because of their own shrinking equity bases. We will probably have a better idea during the next few months. In other economic news, existing home sales for August came at an annual pace of 4.91 million. Economists were looking for 4.93 milion.
Most sectors finished the session around unchanged level. Consumer staple was among the best performers while on the losers’ list, we had names like transportation and capital goods. The CRB commodity index was little changed as crude continued to retreat following a somewhat bearish inventory report. The US dollar moved higher against most major currencies. Treasury yield curve steepened after short-term bill soared. The VIX index dropped slightly and closed above 30 for the eighth consecutive session, indicating continuing nervousness in the market. The market breath was neutral while the volume was on the light side.

The market almost repeated yesterday’s pattern albeit in a smaller scale. Similar to yesterday, the selling pressure during the last hour of trading reflected investors’ concern over passing the bill proposed by the Treasury Secretary Paulson. After the bell, Warren Buffett announced that he is going to invest at least $5 billion in Goldman Sachs. In a typical Warren’s way, the deal is structured in a way that favours greatly to the world’s richest man. For those that know me long enough, Warren is the only idol in my investment life. His investment style stays exactly same since he started his first partnership back in 1956. Through his 52-year long career, he never really changes despite various market conditions. I remember that in 2002 following Enron’s collapse and California’s utility crisis, Warren increased his holding in MidAmerican, one of the largest utilities in the States. At that time, his action was laughed by many critics but time proved once again that his famous saying “be fearful when others are greedy and greedy when others are fearful” is correct. By 2007, the earnings on MidAmerican have already covered his initial investments. Will Warren be right again this time? I think only time will tell. A quick recap of today's action: All three major indices finished the session lower by at least 1% and most of the losses happened during the last hour of the trading.
For the second day in a row, all 10 major sectors finished the session in red. But unlike yesterday when basic materials and energies fared relatively well, they grasped the last two positions in today’s trading. The CRB commodity index dropped 1.6% as crude and gold started to retreat. The US dollar rebounded somewhat from yesterday’s sharp decline. Treasuries dropped slightly despite falling equity prices. The VIX index jumped another  5% and closed above 30 for the seventh consecutive session. The market breath was decisively negative although volume was again on the light side.

The market continued the new week in an old fashion. In other words, volatility rules the market. The most recent concern on Wall Street is the weak US dollar. I have discussed this issue earlier in the JC Alerts. With the government bailout plan, the parties that would be most impacted are financials, dollar and treasury. The latter two are highly correlated, i.e., the weakness in one will almost certainly lead to the weakness in the other. Currently, the market is clearly concerned that with more debt(could be as high as $1 trillion by some estimate) on the US government, the US dollar could lose value in the long run. This view is also accepted by the commodity market, which saw crude price jump by record in today's trading. But before we turn panic ourselves, let's put things into perspective. Indeed, $1 trillion is not a small sum. Not many years ago(if I remember correctly, it should be around 1998 to 1999), China's GDP was $1 trillion. However, if we calculate the $1 trillion as a percentage of the current US GDP size of $15 trillion, it turns out to be only a little more than 6%. So what does that mean? According to World Factbook, by the end of 2007, Japan's public debt as a percentage of GDP is the second highest in the world(for those curious, Zimbabwe got the gold metal in this ranking) and it is 195%. Italy and Singapore are not far behind and both are around 100%. Canada is around 68% and US is around 60%. By the way, public debt includes government debt for all levels - Federal, Provincial and Municipal and it doesn't matter who really owns it - it could be owned by foreign institutions or domestic ones. In other words, even if US adds another $1 trillion debt, it merely catches the level as Canada and still far behind Italy and Singapore, not to mention Japan. I don't know why the currency traders don't mention this fact when they start to talk about a weak US dollar against the yen. Again, in the short run, the US dollar could be moving lower due to uncertainties and confusion. But just because it adds $1 trillion debt shouldn't be an excuse for its long-term decline. A quick recap of today's action: All three major indices finished the session lower by at least 3%, essentially erasing gains in the previous session.  
All 10 major sectors declined in the session led by financials. Basic materials and energies fared relatively well due to strengh in commodities. The CRB commodity index jumped almost 4% and closed above 370. Crude price for October delivery jumped as much as $25 dollars in today's session before ending the day by more than $16. Gold, which is usually used as a dollar hedge, gained 5% in the session. The US dollar had one of its biggest declines in weeks against most currencies, especially commodity-rich ones. Treasuries rallied as typical flight to quality. The VIX index jumped more than 5% and closed above 30 for the sixth consecutive session. The market breath was decisively negative although volume was on the light side.