MarketView for July 7

It was a volatile day on Wall Street with the Dow Jones industrial index oscillating back and forth between positive and negative territory as Wall Street tried to decide whether the glass was half full or half empty. In particular, the Street is concerned that Fannie Mae and Freddie Mac are still short on capital, meaning that they will have to raise additional capital at the expense of devaluing their current shareholders.

 

Lehman Brothers estimated that a proposed accounting rule would force Fannie Mae and Freddie Mac to raise as much as $75 billion between them. Analysts at Lehman wrote in a note to clients that a pending accounting change could force Freddie Mac and Fannie Mae to boost capital by an additional $29 billion and $46 billion, respectively.

 

As a result the shares of the two mortgage companies fell to their lowest level since 1992. Fannie Mae ended the day down $3.04, or 16.19 percent to close at $15.74, while Freddie Mac was down $2.59, or 17.86 percent, to close at $11.91.

 

In addition, research firm CreditSights said mortgage insurer Radian could face more downgrades, forcing it to wind down its existing business. That increases risks for Freddie Mac, which had $63 billion of loans or pools of loans backed by Radian as of March 31.

 

SunTrust saw its shares fall to their lowest level in more than 12 years after a Street analyst wrote on Monday that the southeastern regional bank may suffer significant losses from residential construction lending. SunTrust's stock ended the day down $3.18, or 9.11 percent, to close at $31.74.

 

A warning from regional bank Marshall & Ilsley only added to the day’s mounting stress on financial stocks. Several Wall Street brokers reversed their 2008 forecast on Wisconsin's largest bank to a loss after the bank said it expects a huge second-quarter loss due to increased provision for bad loans. Marshall & Ilsley's ended the day down $1.64, or 11.60 percent, to close at $12.50.

 

The day’s mood was not helped by comments from San Francisco Federal Reserve President Janet Yellen who sounded a cautious note on the economy, stating that the risk of inflation is beginning to outweigh the risk of a deteriorating economy. That indicates the Fed could be leaning toward raising rates.

 

Exxon Mobil and other big energy companies fell after crude prices fell nearly $4 per barrel to settle at $141.37 a barrel on news that the dollar reached a 1-1/2-week high against other major currencies. 

 

Lehman Brothers fell $2.01, or 8.80 percent, to close at $20.84 after word on the Street was that Platts, an energy pricing agency, put Lehman under a temporary review that in effect excluded the company from trading certain oil contracts.

 

On a more positive note for Yahoo shareholders, although not necessarily Yahoo’s executive management, Yahoo's shares ended the day up $2.56, or 11.99 percent, to close at $23.91 as hopes for renewed talks with Microsoft stirred enthusiasm for Yahoo in particular and tech stocks in general.

 

Microsoft said it is interested in resuming deal talks with Yahoo if the company elects a new board at its August 1 shareholders' meeting. The news is seen as a major boost to activist shareholder Carl Icahn's board slate for Yahoo.

 

Teva Pharmaceutical Industries was the top drag on the Nasdaq 100 after data from a late-stage trial showed an increased dose of its multiple sclerosis drug was not more efficient than an approved lower-dose version. Teva ended the day down $4.02, or 8.52 percent, to close at $43.18.

 

Price of Crude Gives Way

 

The price of crude was down over $4 per barrel on Monday as both profit taking and signals that Iran will be more flexible in negotiations over its nuclear program took a welcome toll on prices. There was additional pressure to lower prices brought by news that Hurricane Bertha will likely miss Gulf of Mexico energy facilities. As a result, domestic sweet crude for August delivery settled down $3.92 per barrel at $141.37. Brent crude settled at down $2.55 at $141.87 per barrel.

 

The New York Mercantile Exchange did not issue an official Friday closing price due to the July 4 holiday.

 

Tehran's foreign minister Sunday expressed optimism about what he said was a "new environment" for talks. However, Iranian President Mahmoud Ahmadinejad said Monday Iran would not abandon its right to enrich uranium and rejected a major powers' demand to do so as "illegitimate," the official IRNA news agency reported.

 

Earlier Monday, oil prices were pressured by a gain in the dollar, which reached a one-week high against a basket of major currencies, benefiting from a European Central Bank tone that has reduced expectations of further interest rate rises.

 

A strengthening dollar can reduce the appeal of oil and other commodities to investors as a hedge against inflation. Oil has gained over 40 percent this year, driven partly by tension over Iran's nuclear program and expectations that global supply will fail to keep pace with demand from fast growing Asian economies such as China.

 

The rally has led to fuel protests worldwide and begun to dampen demand in some consumer nations, including the United States. World leaders are concerned prices could move even higher. Leaders of the Group of Eight nations gathering for a summit in Japan fear further rises, Italian Prime Minister Silvio Berlusconi said.

 

Yellen Says Times May Get Worse Before They Get Better

 

Janet Yellen, president of the San Francisco Fed, indicated on Monday that the risk of inflation is beginning to outweigh the risk of a deteriorating economy, indicating that the Fed could be leaning toward raising interest rates.

 

Yellen said that with worst-case scenarios having been skirted and inflation risks on the rise, interest rate policy is tilting in a "slightly tighter" direction.

 

"On a continuum I would say things are shifting to somewhat more inflation risk," Yellen said.

 

At the same time, Yellne was "agnostic" on the timing of a potential rate hike by the Federal Open Market Committee, saying only that "readiness is all" and that the central bank was "prepared to act as needed."

 

Financial markets imply the FOMC will start raising rates by October, having cut the benchmark federal funds rate to 2 percent by late April from 5.25 percent in September 2007.

 

"I am somewhat reassured by the recent data, which suggest that my biggest fears on the downside have, so far, been avoided," Yellen said. Growth is likely to be "reasonably weak" for the rest of 2008 before picking up.

 

By contrast, "inflation has become an increasing concern," she said, adding that headline inflation is likely to run "much higher" than desired for the next few quarters. Core prices, which exclude volatile food and energy prices, are also set to rise as businesses pass on their higher costs.

 

Both price measures should moderate in 2009 on the heels of greater slack developing in the labor market and a probable leveling off in oil and food prices, she said, adding that she did not envision commodity prices continuing to spiral upward.

 

Yellen said there is no sign so far of generalized wage pressure in the United States, and inflation expectations are "reasonably well anchored" as well, but that the Fed was on alert.

 

"The risks to inflation are likely not symmetric and they have definitely increased. We cannot and will not allow a wage-price spiral to develop," she said.

 

Second-round inflation, in which higher costs are used as leverage to drive up wages, is more apparent in Europe right now than in the United States, Yellen said.

 

Yellen is not a voting member this year of the U.S. central bank's Federal Open Market Committee, which sets monetary policy. She will vote on the FOMC in 2009.

 

The economy was likely to grow "only modestly" for the balance of 2008 before picking up in the New Year, helped by the lagged effect of the Fed's spate of interest rate cuts, Yellen said.

 

She said the federal fiscal stimulus package had been helpful in shoring up consumer spending recently and said she did not see a need for a second package.

 

Some economists have warned of a potential "double-dip" slowdown if U.S. growth stagnates again in late 2008 and into 2009 as the fiscal help fades away.

 

However, Yellen said the "three ghastly witches brewing up trouble" in the United States economy, the housing market, financial markets, and commodity prices, were likely to be less of a factor by late this year.

 

Yellen said she was surprised the jobless rate did not dip in June, when it held steady at 5.5 percent, but that the peak unemployment level in the current cycle would likely be below 6 percent.

 

Despite the Fed's series of rate cuts, credit conditions are still tighter than they were before the worst of the global credit crunch descended in August 2007, Yellen said.

 

The level of the fed funds rate is not a good indicator of the overall availability of lending, she said, but without the Fed's sharp rate cuts lending would be "incredibly tight."

 

A months-long shakeout in financial institutions -- characterized by less reliance on debt and more on equity financing -- is likely to continue, she said.

 

"Progress toward sturdier and more efficient financial markets is going to take some time, and that means the flow of credit is likely to remain impeded," Yellen said.

 

She said that the supply shocks hitting the U.S. economy in the form of higher gasoline and food prices, and the subsequent stagnation or decline in real wages, are outside of what the Fed can control through monetary policy.

 

"It's sobering. It's depressing, you bet," she said.

 

Microsoft Willing To Restart Talks

 

Microsoft told Wall Street on Monday that it is willing to restart talks with Yahoo to buy all or part of Yahoo but only on the condition that a new Yahoo board is elected. Microsoft said it would resume talks immediately if a new board were elected at Yahoo's August 1 stockholder meeting.

 

The Microsoft statement came after Icahn, a billionaire who owns more than 4 percent of Yahoo, issued an open letter saying he had "spoken frequently" to Microsoft CEO Steve Ballmer over the past week.

 

Ballmer told Icahn that a big impediment to any Yahoo deal was his concern that the current board could "mismanage" the company while the deal awaits regulatory approval, a process that could take nine months or more, according to Icahn.

 

In an interview, Icahn argued that his proposed dissident board slate would make Microsoft feel more secure in risking a large sum of capital to complete the deal during the regulatory approval process.

 

"You don't have to be Sherlock Holmes to realize there is no great comfort zone between the current Yahoo board and Microsoft," Icahn said. "During this waiting period for regulatory approval, any acquirer, not just Microsoft, would want a steward they would feel comfortable with."

 

In response, Yahoo issued a statement saying it continues to be willing to reopen talks with Microsoft, but "we feel strongly" that any deal negotiated between Icahn and Microsoft "would not lead to an outcome that would be in the best interests of Yahoo stockholders."

 

"If Microsoft and Mr. Ballmer really want to purchase Yahoo, we again invite them to make a proposal immediately," Yahoo said.

 

Icahn also said he was actively interviewing replacements for Yahoo CEO Jerry Yang and its management team. "I am moving towards getting a potential new management team for Yahoo, including a new CEO," he said in a phone interview.

 

Sanford C. Bernstein senior Internet analyst Jeffrey Lindsay wrote to clients that if Microsoft is serious about resuming talks, "there is rationale for voting for the Icahn slate and essentially ousting the current Yahoo board and probably the management too.

 

Talks between Yahoo and Microsoft broke down in early May. Microsoft originally offered $31 per share and raised it to $33, but Yahoo demanded $37 per share. After talks collapsed, Icahn amassed a stake in Yahoo and launched a proxy war to replace the Yahoo board and management, claiming they "botched" the Microsoft talks.

 

In his letter, Icahn said: "Steve made it clear to me that if a new board were elected, he would be interested in discussing a major transaction with Yahoo," including purchasing either its "search" function with large financial guarantees, or an outright purchase of Yahoo.

 

Microsoft said it would be premature to discuss details, such as the price it might offer for Yahoo. Icahn said he would immediately move to replace Yang if his board slate were elected at the August meeting.