How the Friday “Bernanke Put” Slammed Holders of “Put Options” Betting on a Market Fall

Nouriel Roubini | Aug 20, 2007

Whether the surprise discount rate cut and FOMC easing bias last Friday is the first example of a moral-hazard related “Bernanke Put” is being widely discussed. But it was certainly the case that the Fed action sharply hurt those who had bought “put” options on the S&P that were expiring last Friday almost immediately after the opening bell. Given the spike in the S&P at the start of the day those put options that were in the money before the Fed Statement lost their value right after the opening bell.  So quite paradoxically the “Bernanke Put” slammed holders of “put options”. Market Beat reported this by citing a report by Scott Peterson:

While the Fed’s move helped many investors last Friday, it slammed a handful who’d wagered that the market would continue to decline. It was especially painful to those who had purchased certain monthly “put” options tied to the Standard & Poor’s 500-stock index, which are contracts that pay off if the index declines below a certain level. Those options expired almost immediately after the opening bell Friday.

Holders of many of these August puts — which are often purchased as a form of insurance against a declining market — went to sleep Thursday evening expecting to cash in Friday morning. Instead, since the Fed’s announcement came before the opening bell, sending stock futures sharply higher, they were left empty-pocketed. Investors holding S&P puts that would pay off if the index opened Friday below 1450, for instance, would have made money without the Fed’s action, since the index closed at 1411 Thursday and was moving lower in overnight trading. Instead, the index shot up at the open, pushing the exercise settlement value of the contract above 1450 (1450.11, to be exact — see chart of S&P futures at right).

On Thursday, when stocks were in free-fall, S&P August puts that would have paid off if the contract opened at or below 1450 were at times changing hands for nearly $80 a piece, according to OptionMonster.com. Since roughly 110,000 of those contracts were still open at the start of trading Friday, that represents a theoretical loss of about $800 million for that single contract.

Far more investors had been purchasing S&P puts than normal due to the recent jump in volatility. Roughly $4 billion in S&P puts changed hands Thursday, about four times the daily average during the last three month, according to Hamzei Analytics, a Los Angeles derivatives trading firm. “A lot of people were hurt,” said Fari Hamzei of Hamzei Analytics. “We just zoomed to a new level, there was nothing that anyone could do.”

On the flip side, holders of S&P “calls,” which pay off in a rising market, hit the jackpot. Far fewer investors had been purchasing calls than puts, however, since the market appeared to be heading lower.

The fact that the Fed’s move came on an option-expiration day raised some eyebrows on Wall Street. Not only did the discount-rate cut hurt holders of S&P puts, it also forced them to scramble to purchase index futures in order to balance out their losses — further fueling the market’s surge. “If you ask me, if you want to get bang for your buck, I’d say [the Fed had] excellent timing,” said financial author Michael Panzner.

And today another finance blogger - Adam Warner of Daily Options Report – explains how Bernanke &Co. implictly used their Friday actions to the maximum effect by short squeezing option sellers (hat tip to Market Beat again):

The Bernanke Short Options Squeeze

So how does putting a market-moving Fed action as close to expiration as humanly possible have the maximal turbo effect? One word: Gamma.

Throw in a similar dynamic on all other index/ETF options that expire at the end of the day, and Big Ben literally found the perfect minute to cause the most pain to options sellers.

So now holders of put options and other participants in the options markets will have to start to worry about another surprise “Bernanke Put” Fed actions in the next few weeks. Indeed, since credit markets do not seem to have stabilized after the Friday Fed actions, investors are considering whether the Fed may be forced to cut the Fed Funds rate target before the next formal FOMC meeting on September 18th. I will not rule out such a surprise emergency Fed Funds rate cut since I expect (see my forthcoming blog) that the Fed actions last Friday will not succeed to reliquify markets seized by a severe credit and liquidity crunch.

http://www.rgemonitor.com/blog/roubini/211386/ 

Say hello to the ‘market dislocation vehicle’

Aug 30 16:29
by Paul Murphy
Comment
(1 comment)

Blindingly obvious, really - Wall Street’s having a sale of returned/shop-soiled stock.

Or, more precisely, investment banks are following the lead of some private equity funds in launching fresh funds to buy leveraged loans that are trading at depressed prices in the secondary market. More…

Who’s afraid of the big bad banks? Everyone.

Aug 30 16:26
by Sam Jones
Comment

The much whispered-about Lehman Brothers have some harsh words for their detractors: the investment bank today downgraded the outlook for four of their Wall Street stablemates.

Lehman downgraded third and fourth quarter earnings as well as the 2008 outlook for Morgan Stanley, More…

Like chocolate soldiers - structured credit bankers can’t take the heat

Aug 30 15:23
by Helen Thomas
Comment

We worry that just as we’re getting slowly to grips with the acronym-rich world of structured credit, the people in charge of creating the stuff are all leaving their respective organisations.

The hunt is still on for the last bankers to take their P45s and exit the structured product scene. More…

Structured finance profits

FINANCIAL TIMES

http://www.ft.com/cms/s/1/ce5af26e-56d2-11dc

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77cc4-c820-11db-b0dc-000b5df10621.html

Published: August 30 2007 09:27 | Last updated: August 30 2007 12:49

Trying to work out how much exposure investment banks have on their books to the subprime market can be a frustrating business – even for the banks concerned. An easier game is guessing which investment bank will be next to cut staff in structured finance in the wake of the subprime crisis. Royal Bank of Scotland has already set the ball rolling, and there are reports that Lehman Brothers, Goldman Sachs and Bear Stearns are poised to follow suit.

This rapid shedding of staff reflects the urgent need to cut costs as revenues decline in this highly lucrative and (until recently) growth business. Lehman and RBS, for example, topped the underwriting league tables for asset-backed securities last year, according to Dealogic. Cutting back quickly is par for the course for investment banks, with their high staff costs. It will help, but won’t replace lost revenues. For the top 10 global investment banks, fixed income revenues (where most asset-backed business is booked) reached more than $27bn in the first quarter – more than double the total five years before, according to Credit Suisse. And structured finance has been particularly profitable, so margins are likely to decline too.

Is it just a blip? Writedowns may be out of the way quickly, but the loss of confidence in some high-yielding structured products is likely to be more durable. The history of structured finance, though, is that a blow-up in one area is swiftly followed by a surge of demand for ingenious new products elsewhere. And there is no reason why companies should stop hedging currency risk, or locking in energy prices. In fact, increasingly risk-averse investors may even be more inclined to buy structured products with guaranteed returns, for example.

Working out which banks will prove most vulnerable is still tricky, since they do not break down the contribution of different areas of structured finance. That explains the lack of differentiation in the market. The S&P investment banking and brokerage sector is trading at 8.3 times next year’s earnings – and Deutsche Bank, Barclays, RBS, Lehman and Goldman, for example, are all trading at between 7.5 and 8.5 times. This does not mean that they will all cope equally well.

Copyright The Financial Times Limited 2007

Moody’s President Sees Unprecedented Illiquidity

Topics:Credit | Housing | Mortgages | Subprime Lending

By Reuters | 30 Aug 2007 | 01:34 PM ET

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The credit market is experiencing an unprecedented loss of confidence due to the lack of transparency over where exposures lie rather than underlying credit quality problems, Moody’s Investors Service President Brian Clarkson said on Thursday.

“I’ve been in the marketplace for 20 years … what we’re experiencing is an extreme lack of confidence and lack of liquidity. I have never seen this before,” Clarkson told Reuters in an interview. “A lot of it has to do with transparency: it’s not clear who owns what.”

There are also questions over valuations of illiquid securities, he said, although not necessarily from a credit standpoint. Some structured vehicles — such as the Cheyne Finance fund run by British hedge fund Cheyne Capital Management — have been forced to sell assets due to losses even though the securities they hold have not been downgraded.

“It’s not that a lot of the things people are holding aren’t money good, they are. If you hold them to maturity they will pay interest and principal on a timely basis.”

Ratings agencies have come under fire for not being quick enough to react to the problems in the U.S. subprime mortgage market that have roiled equity and credit markets in July and August.

In recent months they have downgraded hundreds of securities as mortgage defaults have proved higher than expected. That has led to widespread falls in prices for asset-backed securities whether linked to subprime or not as investors have shunned risky structures.

The European Commission said in August it will review the voluntary code used by the agencies, and French President Nicolas Sarkozy said questions should be asked about the role of ratings agencies in the latest crisis.

Too Quick and Too Slow

Clarkson, who before being appointed as president early in August was responsible for overseeing global structured finance among other areas, said Moody’s had also been criticised by some investors for acting too quickly.

“If you’re a buy and hold investor, we acted way too quick. If you’re holding that thing to maturity, you don’t want a downgrade,” he said. “If you’re a mark-to-market investor, or in particular if you’ve shorted the market or shorted particular securities, we acted way too slow.”

He said it was wrong to treat all subprime mortgage deals alike, with some issuers performing in line with expectations.

“You’ll hear that subprime mortgages are a disaster, a meltdown, it’s terrible. There will be significant losses, there’s no doubt about that,” Clarkson said. “(But) the way we view our role in the market post assigning the ratings is to make sure we’re providing the market with as much information as possible on an ongoing basis. And the observation is that it’s not the entire market.”

Clarkson said that Moody’s wanted to work with regulators to avoid being put in a position of having to provide a service that it was unable to do.

“A rating is an opinion. It’s not a promise, not a guarantee. It’s also not static,” he said.

Calls to revamp the business model of the rating agencies, for instance, by making investors rather than issuers pay for ratings may not help.

“Regardless of who pays, there’s always a conflict,” he said. For instance, if an investor pays for a rating, and that rating then has to be downgraded, there is potential for conflict there. “Any time there is money involved, there is potential for conflict.”

He said that criticism suggesting that Moody’s was involved in structuring securitisations was not accurate. “We make it a point not to be structuring transactions,” Clarkson said.

“We make everything as transparent as we possibly can. Our ratings process is transparent. The ratings are not assigned by the analyst, they’re assigned by committees. Our ratings record is out there for everyone to take a look at. Historically, the ratings have held up extremely well.”

Copyright 2007 Reuters Limited. All rights reserved. Republication or redistribution of Reuters content is expressly prohibited without the prior written consent of Reuters.

http://www.cnbc.com/id/20514802

August 29, 2007

Calls Grow for Foreigners to Have a Say on U.S. Market Rules

By HEATHER TIMMONS and KATRIN BENNHOLD

Politicians, regulators and financial specialists outside the United States are seeking a role in the oversight of American markets, banks and rating agencies after recent problems related to subprime mortgages.

Their argument is simple: The United States is exporting financial products, but losses to investors in other countries suggest that American regulators are not properly monitoring the products or alerting investors to the risks.

“We need an international approach, and the United States needs to be part of it,” said Peter Bofinger, a member of the German government’s economics advisory board and a professor at the University of Würzburg.

While regulators in the United States have not been receptive to the idea in the past, analysts said that Europe and Asia had more leverage now. Washington might have to yield if it wants to succeed in imposing bilateral regulations on government-owned investment funds from emerging economies.

“America depends on the rest of the world to finance its debt,” Mr. Bofinger said. “If our institutions stopped buying their financial products, it would hurt.”

Half a dozen American banking and financial regulators — including the Securities and Exchange Commission and the Federal Reserve Board — had no comment. Several noted that they were not the sole regulators of the subprime market.

In general, Washington’s reaction has been that it wants “no form of oversight,” said Kenneth Rogoff, an economics professor at Harvard and a former chief economist of the International Monetary Fund.

Banks and investment funds from China to France suffered losses after buying mortgage-related securities and complex financial products based on them in the United States.

In many cases, investors were caught by surprise because American rating agencies had given the products top ratings, leading buyers to believe there was little risk. International investors are also asking why American lenders were allowed to give mortgages to home buyers who could not repay them.

“In a globalized economy with hedge funds, leveraged buyouts and all these investment funds, we have to ask the question about more transparency,” said Claude Bébéar, the chairman of the supervisory board of the insurance company AXA.

In Europe, the credit crisis appears to have emboldened those who have long been pushing for stricter international rules.

Washington and London rebuffed the German government earlier when it pushed for an international code of conduct for hedge funds. Now some economic advisers to the German government are going further, suggesting that rating agencies should be nationalized, that large-scale loans be registered publicly and that minimum standards be developed for complex debt securities.

The head of the Council of Economic Analysis in France, which advises the prime minister, said hedge funds should be subject to stricter disclosure rules about their risk exposure.

Christian de Boissieu, president of the group and a member of the Committee for Credit and Investment Institutions, which helps regulate French banks, is calling for a global register of hedge funds. In addition, he said, complex securities should be scrutinized before being sold to bank portfolios.

President Nicolas Sarkozy of France, who has vowed to “moralize financial capitalism,” has asked his finance minister, Christine Lagarde, to prepare a proposal for stricter disclosure rules on market participants before an October meeting of finance ministers from the Group of 7. On Monday, in a foreign policy speech, Mr. Sarkozy called again for stronger global regulations to avoid financial crises.

The Chinese central bank said yesterday that it was moving to standardize disclosure of all asset-backed securities as it increases its own market for the financial instruments. Information about loans, terms and borrowers will need to be included in any new securities in China, it said.

The United States and Britain are the source of the bulk of the world’s sophisticated financial products, like the ones that broke down recently.

“At the heart of the issue is that the largest financial institutions continue to innovate and create ever more sophisticated products,” said Chris Rexworthy, director of enhanced regulatory services at IMS Consulting in London and a former regulator with the Financial Services Authority in Britain.

Regulators talk about the importance of stress-testing, Mr. Rexworthy said, but recent developments create concerns that “institutions are either not investing enough effort in this, getting it wrong, or just producing things too complex for their risk-assessment models to cope with.”

“Greater cooperation on the international stage between regulators is undoubtedly one of the things we need to see more of.”

United States regulators are aware of the problem. Regulators have found that credit standards were loosened for home loans, and that borrowers in some cases did not understand or qualify for the loans they were given.

Treasury Secretary Henry M. Paulson Jr. said in June that the department was seeking better oversight, increased efficiency and a reduction in overlap in general.

Some American regulators have been pushing for more international cooperation. The Securities and Exchange Commission has been discussing greater oversight of hedge funds, and it signed several cooperation agreements with regulators from China to Germany in the last 18 months.

The S.E.C. understands “the need for closer international cooperation,” said Andrew Larcos, the public affairs officer for the International Organization of Securities Commissions, the global regulatory body.

Still, Mr. Larcos added, because the subprime mortgage loans that started the crisis were primarily from the United States, the situation obviously raises questions about market regulation.

In the United States, much of the focus is on rating agencies, which are paid by banks for rating products, and which sometimes attached investment-grade ratings to securities that turned out to be not up to that standard.

Joseph Mason, a finance professor at Drexel University in Philadelphia, and Josh Rosner, the managing director of the research firm Graham Fisher, have pushed for more oversight of rating agencies.

“It’s not just the U.S. regulators that failed, though they did fail,” Mr. Rosner said. International regulators have “thrown the keys to the rating agencies,” which have been left in charge of the safety and soundness of bank capital, insurance and pension money.

In Australia, where investors have embraced financial products like derivatives and swaps, several hedge funds were hard hit by exposure to subprime loans, and analysts said they expected it would be months before the extent of the problem became clear.

As geographical boundaries are broken down, “a problem in one location is a problem everywhere,” said Dick Bryan, a professor of economics at the University of Sydney.

“There is the need to challenge the sovereignty of national regulators,” he said. “Why should the rules of lending in the U.S. be left to U.S. regulators when the consequences go everywhere?”

Asian nations were pushing for regional cooperation even before the latest credit problems, as cross-border investing and their equity markets have boomed.

Whether the outcry will result in changes remains to be seen. Soon after the 1997 Asian financial crisis, President Bill Clinton and a number of regulators and politicians pushed to remake the global financial system. But the impetus faded as markets stabilized.

Economists now expect an increase in international regulation, particularly because Washington has raised questions about the need to impose standards on large investment funds controlled by countries like Russia and China.

Ms. Lagarde, the French finance minister, predicted that negotiations might indeed succeed. “There are a lot of shifts happening,” she said. “Once the dust has settled we will see where the different powers stand and what will be on the bargaining table.”

http://www.nytimes.com/2007/08/29/business/worldbusiness/29regulate.html?

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News Analysis: Credit turmoil leads to better understanding of risk

By Jenny Anderson and Heather Timmons

Published: August 30, 2007

The entertainment for roughly 500 financial executives at the Deutsche Bank global derivatives conference last month in Barcelona did not come cheap: the Rolling Stones reportedly received more than $5 million.

“The best part is, it’s coming out of your bonuses,” Mick Jagger, the lead singer, joked to the crowd.

The hosts of the conference could well afford it. After all, the business of creating new finance vehicles like derivatives and structured products had exploded in recent years. And at the time of the conference just seven weeks ago, there remained a mostly rosy view of such investments, for their ability to help businesses and investors spread out risk.

But the global financial turmoil - set off by problems with subprime mortgages - has prompted a backlash in some quarters against such financial engineering.

More broadly, it has led to a better understanding of the downside of spreading risk so well - it can be felt in all corners of the world, roiling hedge funds, banks and stock markets as far as away as Australia and Germany. In effect, reducing risk on a global scale appears to have increased it for some players.

Today in Business

“The market appears to be finding it harder to truly understand the inherent and underlying risks involved,” said Chris Rexworthy, who was a regulator with Britain’s Financial Services Authority for 10 years before moving recently to the private sector.

In the United States, regulators and lawmakers appear to think that the new and often unregulated investment vehicles - which have shrunk the world and speeded up business in much the same way as the Internet did - are not all inherently flawed. Rather, it is up to investors to scrutinize more closely what they are buying.

This opinion is captured in an analogy offered by Peter Douglas, the founder of GFIA, a hedge fund research firm in Singapore. He likens using derivatives to power tools. If you know how to use them, he said, they are exponentially better and faster for building a house, compared to using hammers, screwdrivers and handsaws.

If you don’t, “you could drill a hole in your head,” he said.

Funds and banks around the world have taken hits because they purchased bonds, or securities related to bonds, backed by bad home loans, often bundled into financial instruments called collateralized debt obligations, or CDOs.

The losses have often surprised their investors, and in same cases the funds and banks’ own executives, who were unaware of the extent of their risks.

The crisis extended as far as the $2.2 trillion money market that finances the day-to-day operations of businesses, as investors wondered whether the underlying assets were sound. “It’s amazing how much ignorance and fear are out there,” said Kevin Davis, a professor of finance at the University of Melbourne.

The confusion about these products lies in part because they are so complex.

Structured products are pooled assets that have been sliced and diced into ever more smaller, more specialized pieces.

They offered investors higher returns at a time when traditional fixed-income, or debt-related products, were producing low returns. As low interest rates fueled a lending boom to borrowers with weak credit, banks looked for new ways to package those loans, so they could sell more. A central building block to offset the risk was asset-backed securities, which are bonds backed by pools of mortgages or other income-producing assets, such as student loans, auto loans, and credit card receivables.

Banks and other financial institutions pooled those asset-backed securities into new pools, dividing them up again and issuing securities against them, creating collateralized debt obligations.

The idea took off, with new combinations that were further removed from the original asset. New creations included CDOs of CDOs, called CDO-squared. There is even a CDO-cubed.

According to JPMorgan, there are about $1.5 trillion in collateralized debt obligations, and about $500 billion to $600 billion in structured finance CDOs, referring to those made up of bonds backed by subprime mortgages, slightly safer mortgages and commercial mortgage backed securities.

Many of the products have proven to be highly problematic as the underlying assets - the subprime mortgages - have gone bust, revealing dangerous levels of leverage in the securities and very few people who know how to figure out their value. As a result, they have become like a potent computer virus, leaving many people fearful that they too will be affected.

“A lot of risk in the subprime asset-backed market is embedded in, and amplified by, CDOs,” said Rod Dubitsky, head of asset-backed research at Credit Suisse.

When defaults in subprime loans started to rise, the impact was felt faster and further than if all the complex asset-backed products did not exist.

Weaknesses in the system were laid bare, including ratings that did not accurately reflect risk and faulty assumptions on how diversified pools would act and multiple layers of leverage.

That in turn unsettled investors in other markets as well who started selling anything they thought might be risky at all, from stocks to loans, and in some cases putting their money into cash.

The advent of radically more complex structured products coincided with another trend in finance: the explosion of credit derivatives, financial tools that enabled institutions like banks and hedge funds to try and hedge exposure to the vast credit market, like loans to corporations, or ownership of corporate bonds.

“Credit derivatives are the fastest growing part of any bank,” said Derek Smith, head of flow credit trading at Deutsche Bank. He cited growth in 2007 of 80 percent for his company and average annual growth of about 40 percent for the industry.

Today in Business

Blythe Masters, a veteran of the credit derivatives revolution and the head of global derivatives at JPMorgan Chase, added, “There has been a wall of money coming at the credit markets in the past five years.”

Credit default swaps (what are widely known as a credit derivatives) allow two parties to exchange the credit risk of an issuer, like a company. For example, if an investor buys a credit default swap on General Motors, called buying protection, he or she makes money when the credit weakens and makes a lot of money if GM goes bankrupt.

In the meantime, the seller of protection makes a fee from the buyer and profits if the company’s credit improves.

Credit derivatives radically shifted the financial landscape for two reasons: they allowed banks to hedge some of their exposure to the huge loans they gave corporations, and they have allowed investors to bet against, or short credit, as a hedge and to speculate.

For banks, shedding exposure to the credit risk of companies, or governments or individuals means not having to reserve as much capital for potential losses. That frees up capital to make even more loans - to homeowners, institutional investors, corporations or hedge funds.

“In the early 1990s, the bank made loans to a company,” recalled Masters of JPMorgan. “But how much was too much? When you reached the limit of capacity, you were shut down with doing business. Now you could buy credit protection and free up capacity for more business.”

The banks found a perfect partner in hedge funds, lightly regulated pools of capital with high fees that were looking for better returns. Insurance companies and pension funds also sought the higher returns, called yield, as interest rates hit historically low rates.

Conceptually, the advent of credit derivatives meant spreading out risk and minimizing the potential D-Day effect of a big bank blow-up. “Fundamentally, having 100 or 1,000 people with a slice of the risk is better than a bank holding 100 percent of the risk,” said Robert Pickel, chief executive of the International Swaps and Derivatives Association.

As the market for CDOs backed by structured products choked in recent weeks, the credit derivatives market has performed well, say participants.

“Credit derivatives have done a good job at doing exactly what they should do: They have accurately and immediately reflected the markets’ pricing of risk throughout this crisis,” Masters said. “That’s a good thing. They have also offered liquidity.”

But there has been a lot of pain as well. Investors purchasing derivatives are making a bet that the underlying stock or bond or loan is going to rise or fall, but they don’t own it. Because buying a derivative requires much less capital than buying the loan or bond it is derived from, banks and traders can buy more of them than they could loans or bonds. That can translate into huge gains - or, in times of stress, outsized losses.

Some institutions are not parsing what products are riskier than others, but rather they are rushing for the door. First State Investments, based in Singapore, has cut its holdings in all Asian financial firms in recent weeks.

At this point “it doesn’t really matter what their exposure is” to subprime products through derivatives, said Alistair Thompson, the deputy head of Asia-Pacific equities at First State. “What concerns us is the sentiment” in the market, he said.

(Page 3 of 3)

Predicting where the next subprime related blowup could come from, or even the size of the problem in Asia, has proven difficult for analysts and rating agents.

Goldman Sachs, for example, in an Aug. 16 report, downgraded its outlook on Asian financial stocks from “attractive” to “neutral,” estimating that there was as much as $172 billion in worldwide losses from mortgage loans that have gone bad, nearly double the estimate from the Federal Reserve.

Moody’s, on the other hand, said earlier in August that Asian banks exposure to the problem would be “limited” and “manageable” without being more specific.

The surprises are certainly not over: there were whispers among investors in Australia this week that some local funds are still turning up unexpected subprime exposure because of credit derivatives, weeks after the problems first surfaced.

Goldman Sachs analysts estimate that it will be another three to six months before all of Asian banks exposure to subprime losses turns up.

While that happens, markets are sure to remain skittish. “Liquidity can just be turned off, and essentially it is a confidence game,” said Thompson.

Jenny Anderson reported from New York and Heather Timmons from New Delhi.

http://www.iht.com/articles/2007/08/30/business/derivatives.php?page=3

  Help-wanted advertising in American newspapers fell in July to the lowest level since 1958, and online job postings also declined. The Conference Board’s index dropped to 25 last month, matching analysts’ forecasts, from 26 in June. The trend in the help-wanted measure has fallen since 2000 as print media have been losing advertising to the Internet.

U.S. Economy: Expansion Was Faster Than Estimated (Update3)
By Courtney Schlisserman

Aug. 30 (Bloomberg) — Surging exports and business spending propelled U.S. growth to the fastest pace in more than a year before turmoil in the credit markets forced the Federal Reserve to warn of a bleaker outlook.

Gross domestic product rose at a 4 percent annual rate in the second quarter, the Commerce Department said in Washington, up from an initial estimate of 3.4 percent. The median forecast of economists polled by Bloomberg News was 4.1 percent.

The figures may be the peak of the expansion for this year as the cost of borrowing increased in August and the Fed said that risks to growth “increased appreciably.” In a sign the job market is weakening, the Labor Department said today claims for unemployment benefits climbed to the highest level since April. A further report showed house prices in the second quarter rose at the slowest pace in a decade.

“The underlying economy was growing in the first half,” said Peter Kretzmer, a senior economist at Banc of America Securities LLC in New York. “We expect it to slow modestly, but not in such a pronounced way. It will slow enough, though, that the Fed will find an excuse” to reduce interest rates, he said.

Kretzmer accurately predicted the pace of expansion.

The Fed’s preferred inflation measure, which is tied to consumer spending and strips out food and energy costs, rose at a 1.3 percent annual rate. The pace of increase was the slowest in four years.

Treasury notes remained higher after the reports. The yield on the benchmark 10-year note declined 5 basis points to 4.51 percent at 5:07 p.m. in New York. A basis point is 0.01 percentage point. The Dow Jones Industrial Average fell.

Trade Deficit

A bigger jump in exports and smaller gain in imports contributed to a reduction in the trade deficit, the report on gross domestic product showed. Trade contributed 1.4 percentage points to growth, the most since 1996.

Spending on corporate construction projects and new equipment also boosted growth. Commercial construction jumped 28 percent, the most since 1981. Investment in equipment increased at a 4.3 percent pace, almost double the previous estimate.

Inventories, which were forecast to play a role in the projected increase in growth, were little changed from the initial GDP estimate published in July.

Jobless Claims

Initial unemployment claims climbed by 9,000 to 334,000 in the week that ended Aug. 25, the Labor Department said today in Washington. The four-week moving average, a less volatile measure, increased to 324,500 from 318,250.

Help-wanted advertising in American newspapers fell in July to the lowest level since 1958, and online job postings also declined. The Conference Board’s index dropped to 25 last month, matching analysts’ forecasts, from 26 in June. The trend in the help-wanted measure has fallen since 2000 as print media have been losing advertising to the Internet.

The deepest housing slump in 16 years is prompting builders and mortgage-lending companies such as American Home Mortgage Investment Corp. to fire workers. That may weigh on consumer spending, which accounts for more than two-thirds of the economy.

“Business psyche is being more and more affected by what’s been going on in the credit markets,” said Zoltan Pozsar, a senior economist at Moody’s Economy.com in West Chester, Pennsylvania. “If this continues for the next few weeks, it’ll definitely be a sign that hiring is being affected by the credit- market problems.”

Home Prices

Prices for previously owned single-family homes rose an average of 3.2 percent from a year earlier, the smallest gain since 1997, the Office of Federal Housing Enterprise, said today in Washington. Prices gained 0.08 percent from the first quarter, the slowest since a decline in the final three months of 1994.

About 14 percent of banks raised standards for mortgages to their most creditworthy borrowers and 56 percent made it more difficult for people with limited or tainted records to get loans, according to a Fed survey of senior loan officers in mid- July.

In highlighting risks to growth, policy makers reversed their stance from their last meeting on Aug. 7 that inflation was the biggest risk to the economic expansion.

Traders and economists expect the Fed to lower its benchmark overnight lending rate between banks at or before policy makers next meet on Sept. 18. Chairman Ben S. Bernanke will discuss housing and monetary policy tomorrow, when he addresses the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming.

Residential Construction

Declines in residential construction subtracted 0.6 percentage point from growth in the second quarter, more than previously estimated.

Housing will probably deduct about a percentage point from GDP at least through early 2008, according to economists at JPMorgan Chase & Co.

As a result, growth will average 2.25 percent in the six months starting in October, a percentage point less than previously projected, Bruce Kasman, JPMorgan’s chief economist, said in a note to clients last week.

Lehman Lowers Forecast

Lehman Brothers Holdings Inc. lowered its forecast last week for the period covering October through June 2008 to 1.8 percent, almost a half percentage point less than previously thought.

In one of the earliest economic readings to cover August, consumer confidence dropped by the most in two years, the Conference Board said this week. The measure retreated to 105 this month and the share of people who said jobs are plentiful declined.

In today’s report, consumer spending was revised up to an annual rate of 1.4 percent from an initial estimate of 1.3 percent. The gain was still the smallest in a year.

“Our consumer is impacted obviously because they see the value of their homes go down, there’s a sort of wealth effect,” Farooq Kathwari, chief executive officer of Ethan Allen Interiors Inc., said in an interview on Aug. 28. “Yet they’re still interested in furnishing their homes, they’re still buying.”

Today’s GDP report included a first look at corporate profits for the quarter. Earnings adjusted for the value of inventories and depreciation of capital expenditures, known as profits from current production, rose 6.4 percent, the most in more than a year, to an annual rate of $1.65 trillion. Compared with a year earlier, profits were up 4.5 percent.

[TAGINFO]

To contact the report on this story: Courtney Schlisserman in Washington cschlisserma@bloomberg.net

Last Updated: August 30, 2007 17:09 EDT

Commercial Paper Extends Slump on Asset-Backed Woes (Update5)
By Darrell Hassler

Aug. 30 (Bloomberg) — The U.S. commercial paper market shrank for a third week, extending the biggest slump in at least seven years and signaling that the Federal Reserve’s attempts to lower borrowing costs have had a limited impact so far.

Asset-backed commercial paper, which accounted for half the market, tumbled $59.4 billion to $998 billion in the week ended yesterday, the lowest since December, according to the Federal Reserve. Total short-term debt maturing in 270 days or less fell $62.8 billion to a seasonally adjusted $1.98 trillion. The yield on the highest rated asset-backed paper due tomorrow rose today 0.11 percentage point to a six-year high of 6.15 percent.

Commercial paper outstanding has fallen $244.1 billion, or 11 percent, in the past three weeks, as the Fed’s Aug. 17 reduction in the discount rate has yet to entice buyers back into the market. Yields of asset-backed commercial paper due tomorrow rose to the highest in six years as investors fled to the safety of Treasury bills.

“I don’t think the Fed understands how critical the situation is,” said Neal Neilinger, co-founder of NSM Capital Management in Greenwich, Connecticut, in an interview today. “The market is going to overshoot itself and not lend money to people who deserve it.”

NSM helps manage Abacas Investments Ltd., a $1 billion structured investment vehicle funded by commercial paper. Neilinger wouldn’t discuss Abacas’s ability to fund itself.

Three-Week Decline

The 11 percent decline over three weeks is the biggest since 2000, according to data compiled by Bloomberg. Commercial paper hasn’t fallen for three straight weeks since February. More than 20 companies and funds including Cheyne Finance and Thornburg Mortgage Co. failed to sell new paper as investors balked at buying short-term debt backed by mortgage assets.

The total fall in the commercial paper may end up at $300 billion, the amount of mortgages funded by asset-backed commercial paper, wrote Tony Crescenzi, chief bond market strategist for New York-based Miller Tabak & Co. LLC, in a note today.

Commercial paper is bought by money market funds and mutual funds that invest in short-term debt securities. In asset-backed commercial paper, the cash is used to buy mortgages, bonds, credit card and trade receivables, as well as car loans. Some of the programs are backed by subprime loans. Subprime loans are issued to borrowers with poor credit or high debt.

The fall was the slowest of the past three weeks, following the two previous declines of about $90 billion each. Outstanding paper for financial companies, not asset-backed, rose for the first time in five weeks by $3 billion to $781.5 billion.

“There’s a little better functionality and if there is any glimmer of hope, that’s where we’re finding some,” said Kevin Flanagan, fixed income strategist at Morgan Stanley in Purchase, New York, in an interview today.

Rate Cut Needed?

The Fed lowered the interest rate it charges to lend to banks to encourage buyers of commercial paper after the market seized up for Thornburg, Countrywide Financial Corp. and other mortgage lenders.

The Fed “failed to bring money markets back to normal,” John Lonski, chief economist at Moody’s Investors Service in New York, said in an interview. “Credit markets are obviously in need of a rate cut.”

In a sign that buyers are still favoring safer assets, an $18 billion auction yesterday for two-year U.S. government debt drew the most demand since 1992.

The sale drew $3.97 for every $1 sold, the most since at least 1992, according to Bloomberg data. For the past 12 sales, the bid-to-cover ratio has averaged $2.77.

Cheyne, Grampian

London-based Cheyne Capital Management Ltd., the hedge fund manager set up by former Morgan Stanley bankers Stuart Fiertz and Jonathan Lourie, said yesterday that a fund it manages has been selling investments to help repay commercial paper due through November. Cheyne Finance, a so-called structured investment vehicle, holds about $6 billion in commercial paper that is mainly tied to real estate.

Funds such as Cheyne Finance typically sell commercial paper maturing in less than 270 days and use the proceeds to purchase bonds with longer maturities. The profit typically delivered from this strategy is being cut by rising yields.

HBOS Plc, the U.K.’s largest mortgage lender, said last week that it would repay about $35 billion of commercial paper owed by its Grampian Funding LLC unit as contagion from the subprime mortgage slump drove up the cost of borrowing.

To contact the reporter on this story: Darrell Hassler in Chicago at dhassler@bloomberg.net .

Last Updated: August 30, 2007 14:48 EDT

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