The news in the financial markets continues to be quite grim. Over the past few business days, Washington Mutual was seized by its regulators and quickly sold to JPMorgan Chase bank. Today the regulators assisted in the forced sale of Wachovia to Citigroup. Then this afternoon the United States House of Representatives rejected the Troubled Asset Relief Program ("TARP") program that would have enabled the Federal government to purchase up to $700 billion in "toxic" mortgage assets. Once the news of the no vote spread, the equity markets quickly turned even further south, ending up with the largest ever loss in the Dow Jones Industrial Average. Ahead of Tuesday's end of the month and the third quarter, the market for commercial paper is virtually frozen and what trading there is for very short terms, often overnight and generally a week or less.

In light of all of the above, several clients and professional contacts have reached out to Lars Toomre for his perspective on where things might go from here. In short, I am quite pessimistic. There is an old saying that the markets have a tendency to extract maximum pain for many parties before a correction can start. I fear that the sell-off witnessed this afternoon in the equity markets will continue and get worse as investors wonder which institution might be next. Also, I sense that equity investors are beginning to adjust downward their expectations for future earnings as consensus begins to build that the United States and perhaps the world is entering a major recession.

As bad as the equity markets might be, I am even more worried about the debt markets. The bankruptcy filing of Lehman Brothers has had far more repercussions than the Federal regulators originally projected. If you have not read the front-page story from the September 29th 2008 Wall Street Journal entitled Lehman's Demise Triggered Cash Crunch Around Globe, go read it now!

Lehman Brothers was one of the two largest dealers in commercial paper plus it had quite a bit of its own commercial paper outstanding. Its absence as a market maker has hurt the commercial paper market. The breaking of the proverbial buck by Reserve Primary Fund (due to the amount of Lehman Brothers commercial paper it held) caused many larger investors, primarily corporations and institutions, to question whether money market funds were money good. Hence, more than $150 billion of the $1.7 trillion money market funds were redeemed and much of the cash apparently has been parked in Treasury bills driving such holdings down to yield just a few basis points.

All markets are driven by the marginal buyer and seller. With few buyers in the commercial paper market, the rates required to roll over outstanding commercial paper have risen quite a bit and could well go even higher if the financial panic stays constant or worsens even further. The coming year-end is going to be truly horrendous as almost all financial institutions want to hold as much cash as possible and make their all-important year-end balance sheets look as pristine as possible. Hence, I suspect that there will be limited funds available for commercial paper issuers who want to take out bank loans instead of rolling their paper. Also, with such uncertainty about financial credits, it is also will be likely that issuing longer term debt in the corporate bond market will be very difficult, if not impossible for all but the safest credits.

Finally, market participants do not seem to be focusing on what is going on in the hedge fund sector. Many hedge funds are suffering net losses for the year and as a result, many hedge fund investors are submitting redemption notices. Even though most hedge funds have substantially reduced their leverage, many still employ leverage in the range of 3:1 to 5:1. The redemptions and margin calls from the decline in the equity markets will cause yet more selling from hedge funds. Hence, I would expect that many markets will be under pressure from further hedge fund deleveraging.

Toomre Capital Markets LLC ("TCM") consults with clients who are involved with structured finance securities, derivatives and other "hairy" investment opportunities like weather derivative contracts and life settlement portfolios. Many of these investment alternatives are illiquid, even in the best of times. As a result, we have a keen appreciation of what is termed "liquidity risk". Two of the clients today independently asked that I highlight a past post entitled Can Wall Street be Trusted to Value Risky CDOs?. Both found it extremely helpful and useful in thinking about the value of liquidity and what may lay ahead for the rejected TARP program.

Reader comments and thoughts are welcome.

Back in one of the items tucked into the Toomre Capital Markets LLC ("TCM") post entitled March 27, 2008 TCM Observations, TCM noted that already 20,000 financial services sector jobs had been eliminated since the start of 2008. Lars Toomre wondered what the reader's over/under number might be for the total number of Wall Street jobs that might be shed in 2008 when all of the stealth layoffs are factored in. He personally was thinking that the total reduction might be close to 100,000 this year.

On Sunday, May 25^th 2008, The New York Times focused on the psychic toll the current round of layoffs is having on the many people affected in an article written by Sarah Kershaw entitled Wall Street Exodus: Fear, Panic and Anger. The article starts "The mind wraps itself around losing a job, one of life's great traumas, in jagged and swerving fits. When the call comes in, when rumor turns to reality, when it's not the broker in the next cubicle but you who is presented with a stack of severance papers, the psyche takes over. It goes numb. It goes into survival mode. Fear quickly turns into anger. For some, there may be relief in saying goodbye to what therapists call the "psychological terror" that has haunted the corridors of troubled financial institutions since last summer. But what follows — the unknown — may be no less frightening."

Apparently by the NYT's count, "Since August, banks worldwide have announced plans to eliminate as many as 65,000 jobs. Many losing their jobs now have lived through other crises on Wall Street — the 1987 market crash, the widespread layoffs of the early 1990s and the financial upheaval of 1998. But investment bankers, recruiters and psychologists say the current economic downturn, the cascade of layoffs and the steady beat of grim financial news have exacted an especially daunting psychic price."

According to the Triangle Business Journal, Bank of America has agreed to spend as much as $25 million over the next five years in a research partnership with the Massachusetts Institute of Technology ("M.I.T."). The Charlotte North Carolina-based BofA said it will "team with MIT's Media Laboratory to create the Center for Future Banking, which will be located on MIT's campus and seek to transform the ways banking is conducted. Researchers will address issues related to information technology, financial planning and customer service."

"Bank of America is investing in the future of banking," Anne Finucane, chief marketing officer at BofA, said in a statement "Working with the MIT Media Lab provides a unique opportunity to grow banking in innovative ways that respond to evolving customer behavior, preferences, and trends."

As a graduate of MIT professionally focused on financial services and technology, Lars Toomre is always intrigued by the amazing research that results from the M.I.T. academic experience and its research labs. It certainly will be interesting over the coming months to see what results from this research effort in the Media Lab.

This morning the Federal Reserve starts one of its regular meetings. The interest rate futures markets are predicting 100 percent probability of a 75 basis point cut and a very high probability of even a 100 basis point cut. Toomre Capital Markets LLC ("TCM") hopes that these market expectations are disappointed. Hopefully, the Federal Reserve only cuts its short-term rates by 50 basis points.

The Federal Funds rate is currently 3.00%. In the last week, the Federal Reserve has taken several major steps to get the needed liquidity to the financial market community. The new funding program that starts later this month allows the Wall Street dealers to fund $200 billion of mortgage-backed securities through Federal Reserve repurchase agreements. Further, the Federal Reserve has agreed to finance $30 billion of the least liquid securities from the Bear Stearns inventory. Finally, the Federal Reserve has opened up its discount window to the twenty or so primary dealers that for the first time includes all of the major investment banks. Some of the language from the Federal Reserve also suggests that the primary dealers are encouraged to use the discount window in the event that some of their large customers (like hedge funds or mortgage REITs holding agency MBS) have funding difficulties.

A cut of only 50 basis points is sure to disappoint both the bond and stock markets today. And no doubt there will be more calls that the Federal Reserve is "behind the curve." However, market participants forget (or do not appreciate) just how simulative the 225 basis points cuts already made truly are. Nor do they fully appreciate how stimulation is coming down the pike in the third quarter with the rebate checks passed by Congress and signed into law by President Bush. However, a cut of 50 basis points will allow the Federal Reserve to keep its powder dry for the impact of further rate cuts, if needed. And such a "small" cut is also likely to be a surprise to the foreign exchange and commodity markets. I might suggest that with the Federal Reserve having addressed the liquidity concerns of its primary dealers that the next major issue is getting the dollar stabilized and reducing some of the speculation that has become concentrated into the broad commodity markets.

Toomre Capital Markets LLC ("TCM") has long been concerned about the opaqueness of the Credit Default Swap market. As this market sector has exploded in size in the past decade, TCM has feared that some losses from these credit derivative instruments may be hidden from investors, regulators and counterparties. Hence, the soundness of the global financial system might well be less sound than what international regulators, rating agencies and large financial institutions might think.

Others have been concerned too. The Australian has started off the 2008 New Year with a rather ominously entitled article Forget CDOs, Is is Time for CDSs. The article starts with "If 2007 was the year of the CDO, the latest acronym to loom dark and large on the financial markets' horizon for 2008 is the CDS. And the CDS (credit default swap) is shaping up to be far more noxious than its little derivative brother, the CDO - a spliced and diced bundle of mortgages known as a collateralized debt obligation that sent Wall Street into a tailspin last August when the market for low-grade US mortgages froze over. At least Warren Buffett seems to think so. After the world's top two bond insurers were scolded with [the threat of] a ratings downgrade last month and told to go and raise some capital, the visionary Buffett revealed last Friday that he was to set up a bond insurance business." [emphasis added]

The key point of this article is that "the murmur among the cognoscenti is that an implosion in the CDS market could do serious damage to the international banking system." They have slightly misquoted Warren Buffett who did say "We felt that, in many cases, the prices that people were charging were inappropriate." What Mr. Buffett was referring to was the cost of credit enhancement insurance to ensure that a municipality's debt was paid on a timely and ultimate basis that is part and parcel of a AAA/Aaa rating. He was not referring to the prices of CDS transactions. However, the article authors were correct that the crux of the problem is that there is not only price transparency but there also are problems about reserving and regulation.

Back on March 1st 2007, Toomre Capital Markets LLC ("TCM") created a post entitled Where is Value in Sub-Prime Mortgage Market? In recent days, UBS has announced a further write-down of $10 billion in sub-prime mortgages and CDO securities; London-based HSBC, Paris-based Societe Generale and Germany's WestLB have all rescued their sponsored SIVs either by taking them on to the balance sheet or providing credit lines that ensure that all of the outstanding senior commercial paper will be repaid; and MBIA has announced a $1 billion investment by Warburg Pincus LLC that for at least for a few weeks will help ensured that MBIA maintains its AAA credit enhancement rating. Late on Monday December 10th 2007, Washington Mutual, the United States' largest savings and loan by market value, declared that it was exiting the subprime mortgage business, eliminating another 3,150 jobs and raising some $2.5 billion dollars in additional capital through the issuance of convertible shares.

Based on the recent TCM posts about the perils of reaching for yield and some the enormous losses various financial institutions are taking from their subprime and CDO security activities, a couple of investors have asked Lars Toomre to go back and update his thoughts on that Where is Value in Sub-Prime Mortgage Market? post. Hence, a few hours ahead of the release of Lehman Brothers 4th quarter 2007 earnings release, here goes:

Clearly, Lehman Brothers was wrong back in late February arguing that the sell-off in the ABX index was way overdone. From their historically very tight levels around the start of 2007, the risk premiums for all types of credit investments have dramatically increased. For all practical purposes, the mortgage sector has virtually stopped trading and those risk premiums are now more of a "pick 'em" variety.

So where is value from here? As Lars has preached in many different conversations and written comments, the trade-off from going from a liquid to an illiquid position requires a very significant yield pick-up and recognition that one must be able to live with the illiquid investment for five years or more. Given that criteria, most, if not all, mortgage investments are still not trading cheaply enough to justify going illiquid. Hence, Lars Toomre would recommend that interested institutions remain more in a seller mode than an acquisition mode when considering structured mortgage investments.

As The Wall Street Journal reminded investors, home prices will need to fall about 30 percent to restore their historic relationship to inflation, rents and incomes. Hence, Toomre Capital Markets LLC would urge that investors avoid the mortgage sector for at least another six months as housing prices continue to decline. Whether the popping of the housing bubble will take five or six years as Jim Rogers has argued remains to be seen.

However, clearly the full effects of cheap and easy mortgage credit are not fully reflected in mortgage security valuations. Make a point of following just how badly home equity loans, Pay Option ARMs, other intermediate and hybrid ARMs and the Alt-A security sector will decline in the coming months. While there no doubt will be periodic spikes as people perceive the housing market is bottoming, remember that a 30% price decline is going to turn almost all of these mortgage types into "upside down" positions with borrowers having negative equity in their homes.

An interesting question is just how prevalent the "jingle mail" phenomena will become. Also, remember that the housing price bubble is beginning to deflate during a period of relatively healthy employment. Just imagine how bad the delinquency and default statistics would be if the United States economy were to enter a "normal" recession.

As before, thoughts and comments are most welcome.

Deanne Landress is another individual who was very instrumental in the development of the Lehman Brothers mortgage trading business and who strongly praised the relative value of investing in structured mortgage products. Deanne also was Lars Toomre's predecessor as the head of the Lehman CMO Trading Desk and taught Lars tremendous amounts about relative value, risk/reward and that funny relationship between price and yield on mortgage-backed securities, especially as general market rates plunged from more than 14% in 1984 to less than 7% some two years later. Some people call this latter phenomena "negative convexity"; others who have lived through a market experience where an illiquid market turns "all sellers" refer to this phenomena as "Oh, shit!!"

Deanne left the securities business some years ago and now runs an Internet café business in suburban New Jersey where so to speak "she now sits at the point where the rubber meets the road." In the past week, she wrote Lars Toomre to comment about how bad this mortgage crisis truly is and to voice her frustration at the current state of the mortgage securities market, especially "having spent so many years and so many hours convincing investors of the veracity" of the structured mortgage market. She relates that the local economy is not particularly strong and has not been for a while. Apparently, local pizza parlors are howling since both of their two main ingredients, flour and cheese, have DOUBLED from where prices were about six months ago. People are paying at her internet café in coin as a regular occurrence. The local restaurants apparently are terrified because the number of customers is so low. Her argument is that much of the weakness in current economic activity was masked by cheap easy credit.

Deanne suggests that after its substantial run-up since the start of the decade, the residential real estate market is now looking at drops between 30 and 50 percent. She suggests that "we're moving towards the point where homeowners don't feel particularly obligated to pay off their mortgages if they are 'upside down'." She asks quite seriously what happens when the broad market figures out that the entire mortgage market for the last few years was one big strategy to keep everyone refinancing every couple of years and raking in the associated refinance fees. The FICO disaster, the home equity nightmare and the droves of stories about fraud might just lead a very scary state affairs. What happens if the regular guy who CAN make his first, second and/or home equity loan payments just decides not to – and in droves?

Apparently there already is another new word in the ether: "jingle mail". It is not defined in wikipedia yet, but mortgage brokers are already using it to describe the case when the borrower just mails in the keys and walks away. How frequent this might occur is anyone's guess at this point. However, Toomre Capital Markets LLC ("TCM") would suggest that interested parties keep an keen eye out for on-going developments in the home equity loan, "Pay-Option ARMs", 2/28 and 3/27 hybrid mortgage and Alt-A mortgage security sectors.

With the relative relaxation in mortgage underwriting standards starting in 2002, lesser equity was required to purchase a residential property and little, if any, documentation was required to demonstrate the borrower's capability to service that debt throughout an economic cycle. TCM is unsure whether the residential mortgage markets will decline by the more than 30 percent that Deanne Landress suggests. However, clearly they have declined already and will decline yet further. Many recently originated loans, whether for the purchase of a home or for a cash-out refinancing, will be "upside down". A key question will be how prevalent will "jingle mail" become? Reader comments and thoughs are most welcome.

As frequent readers of this Insight section are keenly aware, Toomre Capital Markets LLC ("TCM") has long been worried by the irrationality of the United States and European fixed-income markets. (See, for example, the February 5th 2007 post It's All Fun and Games Until Someone Gets Hurt.) In recent days, more news has emerged of some of the perils from irrationally stretching for yield and return.

For instance, the Ahead of the Tape column written by Tom Lauricella in the December 3rd 2007 edition of The Wall Street Journal details some of the problems now facing one of the Florida state-run investment pools called Florida's Local Government Pool. This relatively short-term "safe" investment fund was the largest state sponsored co-mingled pool until recently. For instance, during 2006, it produced a yield of about 5.4% whereas the average money-market fund yielded 4.8%. Part of their success in delivering a higher yield was investments in the commercial paper issued by several Structured Investment Vehicles ("SIVs") including those issued by KKR Atlantic Funding Trust, KKR Pacific Funding Trust, Ottimo Funding and Axon Financial Funding. Apparently, the majority, if not all, of these SIV commercial paper positions were sold to the State of Florida State Board of Administration by Lehman Brothers.

The problem is that these SIV commercial paper investments have now gone into default. When this information was reported to the state administration officials in mid-November, certain municipalities withdrew large amounts of funds from the pool. As a result, the pool which was approximately $27 billion as of September 30th 2007, has shrunk to about $14 billion when redemptions were suspended on November 29th to prevent a further run on the fund. Last week, the state hired Blackrock to provide an independent financial review of the local government investment pool for the State Board of Administration.

According the Orlando Sentinel, "BlackRock executives flew into Tallahassee Monday morning and were scheduled to meet with the chiefs of staff for Gov. Charlie Crist, Attorney General Bill McCollum and CFO Alex Sink today. The firm will make its final recommendations at the SBA's regular meeting Tuesday."