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Mid-Week Analysis

Mortgage Applications
Mortgage Purchasing Index
Natural Gas Futures prices
Natural Gas Futures Prices - West Coast Spot
Mortgage Backed Yields

It is another historic week in the financial markets, with accommodative comments from Fed Chairman Greenspan helping propel NASDAQ to its largest gain ever. So far this week, the NASDAQ100, the Morgan Stanley High Tech index and the Semiconductors all gaining about 8%. The NASDAQ Telecommunications index has surged 9%. Despite today's selling, the Dow and S&P500 have gained 3%. The Morgan Stanley Cyclical index has added 4%, while the Morgan Stanley Consumer index has gained 1%. The Utilities have dropped 2%. The small cap Russell 2000 and the S&P400 Mid-Cap indices have gained 2%. Biotech stocks have increased 3%. A 7% gain (so far this week) in the S&P Bank index was quickly cut to a 1% this afternoon with bad news out of Bank of America. The Securities Broker/Dealer index, although giving up some gains, has jumped 6% so far this week.

Heightened financial instability is finally making its way to the gold market, with bullion gaining better than $5 so far this week. The dollar remains under pressure, with the dollar index dropping more than 1%. The euro ended today about 89, a strong rally since trading below 84 just eight sessions ago. Today the Canadian dollar had its best day since June of last year. It is virtually panic buying in the Treasury market, with 2-year yields dropping 19 basis points to 5.4%. The 5-year has seen its yield drop an astonishing 22 basis points this week to 5.23%. The 5-year traded at 5.90% on November 7th. 10-year yields have sunk 20 basis points to 5.30%, while long-bond yields have dropped 14 basis points to 5.51%. And while corporate securities are noteworthy for their underperformance, agency and mortgage securities experience spectacular collapse in yields.

It was another spectacular day in the energy market with the actively traded natural gas futures price surging $1.10 to almost $8.50 per million Btu. Natural gas began the year at about $2.50. It was described as "total mayhem" on the floor of the exchange (from Bloomberg). Inventories continue to shrink, only worsening what had already been exceptionally low inventories for this time of the year. And with all indications of an exceptionally cold winter, there are increasingly signs of panic. The situation out in the West has all the makings of an energy debacle. Natural gas inventories are 26% below this time last year, and increasingly nervous state officials today began power plant inspections in preparation of blackouts. Spot prices for natural gas in California shot to $36, a seven-fold increase in the past month. Bloomberg quoted an energy analyst: "Utilities in California are going to hurt big time. The problems there are chronic…" Yesterday, the American Petroleum Institute reported that the nation's heating oil inventories are 25% below last year's levels. Evidence strongly suggests that we are heading directly into a major energy crisis.

Emerging markets continue to demonstrate considerable vulnerability. Today, the Brazilian real weakened after the state government in Sao Paulo canceled it billion-dollar auction of a major utility, as international bidders withdrew. In Turkey, the IMF has moved aggressively to restore confidence with $7.5 billion of new loans. Bloomberg quoted an analyst: "The IMF coming in with an emergency loan so fast is unprecedented."

"Though lenders will be viewing new transactions with greater caution than they did a couple of years ago, both bankers and their supervisors should now guard against allowing the pendulum to swing too far the other way by adopting policy stances that cut off credit to borrowers with credible prospects." Alan Greenspan 12/5/00

"In closing, the transition of the U.S. economy to a more sustainable supply-demand relationship is posing challenges for businesses, banks, and monetary policymakers. How well banks perform under these conditions will depend on their ability to continuously reevaluate previously held assumptions and adapt to change. Fortunately, U.S. banking organizations of all sizes have the right tools to thrive in this environment, in the form of improved risk management techniques, more diverse earnings, and strong capital bases. I am confident that banking organizations will continue to monitor and respond to risks while meeting customer demands in a way that strengthens our underlying financial structure in the years to come." Alan Greenspan 12/5/00

"We're pessimistic about the economy, we're pessimistic about the capital markets and the ability of companies to refinance, and it's very easy for companies to throw in the towel. We're taking a very conservative outlook." James Hance, Chief Financial Officer, Bank of America 12/6/00

Perhaps Fed Chairman Greenspan is working diligently to perpetuate what we see as one enormous "confidence game," or maybe he is just out of touch with the reality of escalating problems throughout the U.S. financial sector. This afternoon, Bank of America, one of the largest U.S. banks with $670 billion in assets, announced that they would be taking charge of up to $1.2 billion for bad loans during the fourth quarter. This compares estimates last month of $870 million, and charge offs of $435 million during the third quarter. And indicative of a rapid decline in credit quality, nonperforming assets are expected to rise 20% from the previous quarter. Earnings per share are expected at between 85 and 90 cents, much below current estimates of $1.17 and the $1.40 estimated early in the year. Bank America has exposure to Armstrong World that recently defaulted on its commercial paper, and according to Bloomberg is the largest unsecured creditor to Owens Corning. Bank America has also experienced problems with loans to Sunbeam, ICG Communications, Pillowtex, and Regal Cinemas. Not surprisingly, surging credit losses and faltering corporate debt markets are also causing a slowdown in its investment banking business. "Trading" is also "not as robust." We certainly see BofA as one of a group of "New Economy" banks that will suffer mightily from previous reckless lending.

"To be sure, our current circumstances are in no way comparable to those of 1998. Financial markets have continued to function reasonably well, and credit continues to flow, although admittedly with reduced availability to less-than-investment-grade borrowers and at interest spreads sufficiently elevated to press on profit margins of those lower-rated borrowers. Both lenders and borrowers are reassessing their positions in light of an apparent uptick in domestic risks, but the palpable fear that dominated financial markets at the height of the crisis two years ago is not now in evidence." Alan Greenspan 12/5/00

And while Greenspan is content to view the world through very rose-colored glasses, his "fuzzy" vision is not going to change reality. Actually, it should be recognized that his comments yesterday only created greater financial instability, with historic volatility in the stock market and increasingly dislocated conditions in the credit market. Let there be no doubt, this environment takes on more of the appearance of a 1998-style financial system dislocation by the week, especially with the dollar sinking and a buyers' panic erupting in Treasuries, agency securities and mortgage-backs. Yields on Fannie Mae benchmark mortgage-backed securities sunk 13 basis points point today to 7.04 %, the lowest yield since May of 1999. Mortgage yields have now declined a stunning 26 basis points in just two sessions and 42 basis points during the past 15 sessions. Agency yield collapsed as well, with the implied yield on the 10-year agencies futures contract sinking 24 basis points in two days to 6.21%. Agency yields have declined 55 basis points during the past 19 sessions. Such dramatic moves are generally indicative of aggressive derivative-related trading, often from accounts caught on the wrong side of trades.

As was certainly the case in 1998, growing financial instability incites investors and, importantly, the leveraged speculating community away from corporate debt securities and into the relative safety of Treasuries and Agencies. These lower interest rates then fuel a surge in mortgage refinancings that abruptly shortens the average life of mortgage-back securities. To hedge against this growing prepayment risk, investors and speculators in the mortgage area purchase Treasuries and, often, call options or other derivatives on Treasuries (or agencies) for protection. This aggressive hedging only exacerbates the decline in Treasury and agency yields, which incites larger numbers of homeowners to refinance.

And, importantly, as yields collapse throughout the Treasury, agency and mortgage areas, derivative players that provided derivative insurance against lower rates must then purchase the underlying bonds (Treasuries, agencies, mortgages) to hedge their exposure. This creates a self-feeding market dislocation, and major losses for players caught on the wrong side of trades. Think, for example, of the losses to speculators that earlier in the year bet on what appeared a reasonable trade, shorting agency securities to take leveraged positions in higher-yielding corporate debt instruments. After all, the spreads have generally been highly correlated, that is, until the past few months.

Certainly, collapsing mortgage rates have absolutely nothing to do with borrowing demands, as real estate markets remain very robust. This morning, the Mortgage Bankers Association reported that their weekly application index jumped 10% for the week. Mortgage purchase applications jumped 9% from the previous week, to the highest level since June and the second highest level of the past two years. Current purchase applications are running 16% above this time last year. The week's mortgage refinancing applications index jumped 15%, and is 72% above this time last year. Homebuilding remains ranked first out of 87 S&P industry groups for the past six months, gaining 69%.

USA Today's Thomas A. Fogarty penned an interesting article today, "Million-dollar homes selling at record pace but buyers getting less for their money." "Across the USA, and especially in California, young, two-income couples and well-heeled older buyers with enormous home equity built over decades are finding seven-figure home prices within reach. But the kind of home that $1 million will fetch isn't what it used to be. Laments San Francisco real estate agent Henry Jeger: "A million dollars just isn't a lot of money around here anymore."

"Nationally, a record 15,595 homes are projected to sell for $ 1 million or more, up 51% from 1999… Million-dollar homes aren't necessarily luxury homes anymore. As recently as 1995, the typical $ 1 million-plus house in California included 4,500 square feet, or nearly the floor space of an NBA court. This year, that average will dip below 3,000 square feet, or roughly the area between the free throw lines."

It is not, however, just the million dollar homes that are seeing rampant price inflation. Today, a press release came from the California Association of Realtors (CAR) titled, "Affordability Concerns Pushing Buyers Into Condominiums." Quoting Gary Thomas, present of the California Real Estate Association, "higher home prices and affordability concerns increased the sales of smaller single-family detached homes and pushed some homebuyers, especially at the lower and moderate end of the market, into lower-priced condominium alternatives. Overall, sellers have reaped the rewards of the robust real estate market, pocketing a median net cash gain of $80,000 -- up 23.1 percent compared to 1999."

The CAR reported "the typical California home sold in 2000 was on the market for four weeks, half the eight-week period of three years ago and the shortest time on the market since 1989. In 1995, the median time on the market was 11.5 weeks." CAR's Leslie Appleton Young stated, "throughout 2000, demand for residential real estate remained high, driving prices skyward and keeping inventory low. One indicator of the underlying strength of the residential real estate market is the historically low median price discount on California homes. The price discount, representing the percentage difference between the initial asking price and the final sales price, was only 0.5 percent in 2000, down from 1.7 percent a year ago."

Within the key technology sector, things are quickly going from bad to worse. With Apple issuing a profit warning today on the heels of Gateway's similar announcement, it appears the end to the lengthy tech boom grows nearer. The first chinks in the PC armor came from weakness in corporate American and Europe, precipitating a profit warning from Dell after its September quarter. Then, during the Thanksgiving shopping weekend, Apple and Gateway indicated that there was weakness in the consumer sector. Falling prices have been the bane of PC companies all year, and now it appears that unit growth might dramatically slow. Gateway is actually forecasting a decline in PC sales next year.

The problems leading up to the recent debacle should come as no surprise. There has long been a glut of computers being spit out by too many companies competing in the same space. Gateway expanded its presence with its "Country Store" concept. In 1997 Sony began making computers. eMachines followed in 1998 tying to carve out a niche selling low-end computers. At the same time, established companies began to ramp up capital spending to meet forecasted demand. Gateway kicked off its binge by increasing capital expenditures by 88% in 1997. Investments continued to grow into 1998 and 1999 by 45% and 42% respectively. Dell started its huge ramp-up in calendar 1998, increasing capital expenditures by 64%, 58% and 34% for 1998, 1999, and 2000.

The biggest spender associated with the PC market is Intel. After a record setting 1997, which saw capital expenditures increase 49%, Intel has actually reduced its capital expenditures in 1998 and 1999. However in 2000 spending has gone through the roof. Already Intel has spent over $4 billion, a 25% increase over all of 1999. Intel has seven fabrication plants currently under construction. These plants along with other investments, capital expenditures are expected to top $6 billion for 2000 and 2001.

The Mid-Week Analysis "Chips and Dips" discusses the semiconductor industry in more detail.

If one looks at various key markets in their entirety, it should be obvious that "something just ain't right." An historic real estate bubble runs unabated. Energy prices are out of control, and energy markets increasingly dislocated. Extraordinary price moves in the credit market are also indicative of dislocation, while stock prices continue to move with historic volatility. In short, markets could not be more unstable, the unfortunate but inevitable consequence of years of reckless credit and speculative excess. We have spoken often of growing distortions and imbalances within the U.S. financial system and economy. The problematic ramifications are now becoming much more conspicuous.

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