The Fed Meeting Fallout, US$ Strength / Smaller than Expected Debt Limit Increase, Shadow Home Inventory on the Rise, State Budget Problems

The Fed chose not to change rates or comments during the Wednesday meeting. While we anticipated this outcome in our Monday post, the market reaction has been anything but expected. In months past the type of Fed commentary exhibited this week led to a lower US$ and inverse strength in commodity and equity markets. This week the results have been anything but ordinary. The US$ gained strength, some commodities have rallied with the US$ (e.g. Oil) but precious metals have suffered. Meanwhile the Treasury markets have rallied and equity markets seem to have stalled.

The Fed's commitment to a lenient stance is not a surprise. The following two stories are just a couple of the driving forces applying pressure to the economy and in turn the Fed...

More homes are poised to hit the market - LA Times
LA Times reports a supply of 1.7 million homes headed for sale because of foreclosure or delinquency looms over the nation's housing market, which could dampen progress toward recovery should the Obama administration fail in its efforts to aid struggling homeowners, researchers said. A variety of measures to keep discounted bank-owned properties off the market -- including moratoriums on foreclosures by major lenders and federal initiatives aimed at keeping people in their homes with mortgage payments they can afford -- has helped increase a backlog of so-called shadow inventory 55% in the year ended Sept. 30, according to a report released Thursday by First American CoreLogic, a Santa Ana-based real estate research firm.

States scramble to close new budget gaps - WSJ
WSJ reports the patches used by states on their ailing budgets just months ago are now failing. Ohio lawmakers were expected late Thursday to vote on a compromise reached with Gov. Ted Strickland to avoid cutting education budgets an average of 10% on Jan. 1. In Arizona, lawmakers met in a special session Thursday -- their fourth on the budget this year -- to grapple with a new deficit. And in New York, Democratic Gov. David Paterson said Sunday he would postpone paying $750 million of state bills to avert a cash crunch. Many states eliminated expected deficits earlier this year with budget cuts, tax increases, short-term borrowing, accounting moves and planned gambling expansions. But despite a slight improvement in the U.S. economy, states are now finding those measures didn't go far enough. Tax collections continue to trail projections in some states, and court rulings and political battles have blocked some gap-filling moves. Plus, some legislatures didn't fully deal with the deficits, leaving the toughest decisions to governors... Only a few states now have cash-flow problems. But if revenues continue to fall below expectations, the list could grow, said Scott Pattison, executive director of the National Association of State Budget Officers.

...the US$'s strength as well as the strength in the Treasury bond market does however, provide some consternation. Apparently, other factors have overshadowed the Fed meeting this week and driven the direction of markets. Many attribute the strength of the US$ to troubles developing in Europe. The fears of a debt default in Greece have led some to believe the viability of the EU is in question. We believe this fear is unfounded and would instead direct your attention to the following story...

House narrowly passes $290 billion increase in debt limit - WSJ
WSJ reports the House approved a short-term $290 billion extension in the nation's debt ceiling, delaying a decision until February about a larger increase in the borrowing cap. The vote comes less than a week after House Majority Leader Steny Hoyer (D., Md.) said he intended to seek a $1.8 trillion increase in the ceiling to support federal government borrowing through 2010. A decision was made to seek the more modest increase after it became clear the larger increase may have failed to win support in the Senate. The Senate must still take up the two-month increase, which it is expected to do next week.

...The decision to delay the "larger increase in the borrowing cap" in our opinion added fuel to a short covering rally already underway in the US$. I will note that the vote has only been delayed and will no doubt be passed in the not to distant future.

In short, year-long trends remain in place although severely tested this week. Seasonality would suggest equity market strength during the last two weeks of the year. Volatility as judged by the VIX index has remained subdued during this week's shenanigans and would add credence to the idea of a resumption in seasonal trends.

Credit Thaw, LIBOR Trend, Commercial Paper,M Hanson Real Estate, CA Home Sales Report, Earning of Interest ABX, NETL

We have been following the LIBOR story since the beginning of the credit crisis. Conventional wisdom suggests that if the LIBOR rate is going up then there are problems with the credit markets and if rates are going down then credit is flowing freely. This story highlights a possible wrinkle in this theory. Rates are clearly going down but the positive effects associated with the ease may not be felt in the economy which may cause some consternation for policy makers.

Credit thaw is spurring appetite for bank IOUs -

WSJ reports investors have developed a voracious demand for short-term debt issued by U.S. and European banks, and an important global lending benchmark has fallen to an all-time low -- welcome signs that bank credit markets have improved.

But beneath the demand for short-term bank debt, known as commercial paper, and a drop in the London interbank offered rate, or Libor, significant kinks remain lodged in the bank markets: Banks are using the fresh cash to repay existing debt, or simply hoarding it. That cash buildup is potentially stymieing efforts by regulators to circulate funds to borrowers and the most needy banks.

In contrast to the panicked days early this year, bank commercial paper "flies off the screen," said one New York trader. The market for this short-term bank debt runs from 7 a.m. to about 2 p.m. in New York. But investor demand has been so strong that some banks are turning away buyers by late morning... There is the possibility that three-month dollar Libor could fall yet further. The most healthy U.S. and European banks are selling three-month commercial paper at a range of 0.3 percentage point, or nearly 0.2 percentage point below the three-month Libor, according to one New York desk that trades commercial paper. That suggests Libor might fall further if it tracked the cost of selling the short-term IOUs.

In Thursday's post I made reference to the dire condition of the real estate market. The following piece by Hanson Advisors lays credence to that claim. Please read the red highlights closely as they will protect you from the positive spin chicanery evangelized by government.

M Hanson Advisers – Real Estate & Finance:

Late last week, DataQuick released their monthly CA home sales report. June saw more sales and higher prices than May. More sales are better for the market than less, no doubt. But opening a bottle of Dom and slapping a high-five to your real estate investment partner -- or proclaiming a bottom to the CA market on national tv -- would be misguided and ultimately detrimental to your career.

This is especially true given that loan defaults and foreclosures are surging faster than sales, foreclosure-related resales are at a point of maximum demand, and all-important organic sales are off 65% from levels seen just a few years ago. In addition, the primary reason for the recent house price appreciation is due to mid-to-high end price slashing and short sales, which has led to an up-tick in sales, and a subsequent rise in the median due to the mix-shift. (Very important to understand and yet rarely discussed by traditional media sources.)

While lower prices are needed to ultimately put an end to the housing crisis, price dumping leads to increased negative equity across the homeowner population significantly increasing the likelihood of loan default. As you witnessed at the low-to-mid end of the market beginning in 2007, a lot of pain is experienced while a market finds its bottom.

This up-tick in mid-to-high end sales is the leading indicator I have been waiting for that signals the rest of the housing market is finally beginning its mark-to-market. This time around, however, the mid-to-high end earners and consumers are the ones most affected.

The bottom line is that foreclosure-related resales have peaked and organic sales are off 65% from their peak levels. In the foreclosure resale half of the market, supply is once again outpacing demand. The mid-to-high end is being swiftly re-priced lower. This cannot be viewed as a ‘market getting better’.

Earnings of Interest

(Please click on the link above to review previous EPS posts)

Periodically I will post the EPS news of companies we find interesting. This is not a recommendation to purchase or sell the shares. I will not engage in the hackneyed approach of other bloggers and give advice about when to buy or sell. The purpose of these posts is to give you, the reader, an idea of what companies our research department deems worthy of review.

Of course, if you are an investor in any of the Fortune's Favor Family of Funds or a client of RCM our door is always open. Feel free to call or email questions at any time.

Barrick Gold beats by $0.11, beats on revs (32.86 ) : Reports Q2 (Jun) earnings of $0.49 per share, excluding non-recurring items, $0.11 better than the First Call consensus of $0.38; revenues rose 3.2% year/year to $2.03 bln vs the $1.9 bln consensus. Barrick remains on track with its full year 2009 production guidance of 7.2-7.6 million ounces of gold at net cash costs of $360-$385 per ounce or total cash costs of $450-$475 per ounce. "Our portfolio of operations performed strongly in Q2, exceeding plan, and positioning us well to meet our production and cost targets for the year. The go-ahead decision on Pascua-Lama during the quarter marks an important milestone for Barrick and our strategy of developing long life, low cost mines. Pascua-Lama is expected to be one of the industry's lowest cost gold operations and joins the world-class Cortez Hills and Pueblo Viejo projects in construction. Execution on this new generation of projects, combined with a favorable gold price outlook and our focus on cost management provides the foundation from which Barrick will continue to deliver shareholder value."

NetLogic beats by $0.10, beats on revs (39.43 ) : Reports Q2 (Jun) earnings of $0.35 per share, $0.10 better than the First Call consensus of $0.25; revenues fell 11.0% year/year to $32.5 mln vs the $32.1 mln consensus.

NetLogic guides Q3 above consensus on earnings call (39.43 +0.15) -Update : On call mgmt guides Q3 sales to grow 8% to $46 mln vs $33.69 mln First Call consensus, EPS to $0.32 vs $0.27 First Call consensus. Guidance for Q3 will include the effects of both the acquisitions of network search engine business as well as the pending merger with RMI corporation

Japan Shifting Away From the US Dollar, Option Adjust-rate Mortgages Delinquencies, Russia Threatens to Seize ArcelorMittal's Mines

RCM Comment: I am loath to bore you with the same story over and over but the story's far reaching ramifications demand that we cover this story like the wet blanket it represents. You see, there is a fire raging in the U.S.. Our government is burning paper (US$s) at an alarming clip as it spends aggressively to avoid the inevitable. Let's not debate the simple fact that government spending plans have never in history helped drag an economy out of a recession. Even the oft-praised New Deal of the '30s didn't save the country from the depression; WWII accomplished that feat.

So, paper is burning and the only way to get more paper, short of 'cooking the books', is to issue Gov't debt and hope our trading partners continue to fund our addiction. Enter the wet blanket. The cry to dethrone the US$ as the reserve currency is building and now Japan in an 'et tu Brute' moment adds its voice to the majority....

July 13 (Bloomberg) -- Japan’s opposition party, leading in polls ahead of next month’s election, said the nation should consider shifting its $1 trillion of foreign reserves away from the dollar and buying International Monetary Fund bonds. “In the medium to long term, we need to do what we can to avoid the risk of currency losses or economic turbulence that could result if the dollar were to swing,” Masaharu Nakagawa, the shadow finance minister in the Democratic Party of Japan, said in an interview in Tokyo on July 9. “Many countries are starting to diversify their reserves.” Read more...

RCM Comment: Troubles continue to brew in the real estate arena and by extension the banking sector. The EPS announcements over the next few weeks should be very interesting. Question: Will creative accounting be condemned as it should or will it continue to be ignored as has been the case?
NEW YORK (Dow Jones)--For the third straight month, option adjustable-rate mortgages are generating proportionally more delinquencies and foreclosures than subprime mortgages, the scourge of the housing crisis. A further acceleration of troubles among the loans could mean higher-than-expected losses for Wells Fargo & Co. (WFC) and JPMorgan Chase & Co. (JPM), as well as the Federal Deposit Insurance Corp.'s own insurance fund. "The realization of the issues related to option ARMs is just beginning," says Chris Marinac, director of research at Atlanta-based FIG Partners.

Example of creative accounting: WaMu by Karl Denninger

"In March of 2006, Washington Mutual recorded net income of $985 million dollars. 4Q06 they booked $1,058 mln. This last quarter, they booked $784mln. But in those three quarters they booked $194mln, $333mln and $361 million, respectively, in PayOption ARM "Capitalized Interest." This was booked and recognized as EARNINGS.

Now here's the problem: In 1Q 06, 194 million out of $985 is 19.7%. In December, it was 31%. But this last quarter, it was FORTY SIX PERCENT, more than a DOUBLE over the year ago levels. And what's worse, not one dime of that "income" can be spent! It is entirely phantom. This is the same sort of crap that sunk Lucent and Enron - booking "income" that is not in fact spendable, as it has an impairment associated with it (the LTV is INCREASED by this negative amortization) AND it is not CASH!"

RCM Comment: This story does not bode well for emerging market investments...
MT Russia region threatens to seize ArcelorMittal mines - Reuters (29.87 )
Reuters reports Russia's Kemerovo region has notified ArcelorMittal (MT) that it will seize two of the world's largest steel maker's mines if production levels do not increase, a statement from the Siberian region said. "If your team is not able to stabilize production at these facilities, then we propose that you hand them over without compensation," Kemerovo governor Aman Tuleyev said in a telegram addressed to the multinational's chief executive, Lakshmi Mittal, and cited in the statement on the Kemerovo website. Reuters has been unable to reach ArcelorMittal's Siberian operations for immediate comment on the telegram. ArcelorMittal acquired three Siberian coal mines from Russia's Severstal in 2008, becoming one of the few foreign companies to enter the market.