The Overnight Report: NY Fed Suing Bank Of America

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By Greg Peel

The Dow closed down 165 points or 1.5% while the S&P lost 1.6% to 1165 and the Nasdaq dropped 1.8%.

It was a confluence of forces that met on Wall Street last night, culminating in the worst session since August 11. With traders having already pushed up indices close to their April peaks on potentially overblown expectations of QE2, the risk, as I have often noted recently, has been building up on the downside.

Yesterday the People's Bank of China lifted its one-year lending rate by 25 basis points to 5.56% and matched it with a similar deposit rate increase to 2.50%. While recent data emanating from China have been stronger than feared, heightening expectations of a further policy move from Beijing, the hike still came as a surprise being two days ahead of the release of China's monthly round of inflation and other data. Inflation concerns were cited as the reason for the hike.

It is a move which will only serve to intensify cross-border currency tensions given a floating currency would naturally respond to a central bank interest rate hike by appreciating. Not so in China's case, where any appreciation can only be minimal inside the range of peg against the US dollar. The question now, however, is to whether Beijing might be gearing up for at least some additional step of peg revaluation in its long, drawn out process.

As such, the interest rate move was enough to spark significant short-covering in US dollar positions. The US dollar index jumped a whopping 1.6% to 78.21. The euro had already been weak following the release of the influential ZEW investor sentiment survey which slid to a 21-month low.

The impact of the dollar bounce was immediate on Wall Street. The Dow opened down 150 points ahead of some major earnings reports. Bank of America beat expectations after adjusting for a goodwill write-off, Goldman Sachs posted a cracker, and Coca-Cola also beat The Street. By midday the Dow was only down 70-odd points.

But the sellers began to win again. Disappointing guidance from IBM (Dow) after the bell on Monday weighed on the tech sector which also impacted at the Nasdaq. Weaker than expected iPad sales had Apple shares tumbling after its very strong run-up of recent times. The indices were slipping again when at 2pm the bombshell was dropped.

A consortium of bondholders which includes investment giants Pimco and BlackRock along with the Federal Reserve of New York announced they were suing Bank of America for failing to repurchase or service dodgy mortgages within spurious CDOs issued pre-GFC. The mortgages in question were securitised by Coutrywide – the lender acquired by BofA with Fed approval around the time Bear Stearns was being rescued.

This is an issue that has actually been building for about six months and which had begun to have a noticeable impact on financial sector shares last week. The case involves the misrepresentation of the quality of mortgages and their proportions within certain CDOs, as I outlined in last week's Overnight Report The Ghosts Of Markets Past.

The expectation is that the case could end up costing BofA some US$47bn. Ironically, BofA itself is also the owner of some of these dodgy CDOs from its investment bank activities prior to its acquisition of Countrywide. It is also expected that this particular case is just the beginning of what may amount to some US$120bn of suits across the wider financial sector which will rope in other significant mortgage lenders such as JP Morgan Chase.

On the news, the Dow fell further to be down some 220 points towards the close. There it met some late buying which pushed it to be down 165 by the bell. Some commentators suggested that while this is yet another GFC fallout that needs to be worked through, such cases will take years in court before they are resolved and the banks will have ample time to earn and provision potential penalties.

Noticeably, the bank that had shorted CDOs in 2007 – Goldman Sachs – was the the only financial stock to finish higher on the day. Coke was the only Dow stock.

So just when we thought Wall Street had become frustratingly predictable along comes a session like last night's. Volume on the NYSE big board was heavy by recent standards at 1.27bn. Also driving stock indices lower was the wider impact of the significant dollar bounce. Material stocks were trashed.

Gold was thumped down US$40 or 3% to US$1333.50/oz while silver lost 4%, falling over a dollar to US$23.44/oz. The base metal spectrum consistently fell 3% in London.

Oil was thumped down US$3.83 or 4.6% to US$79.31/bbl.

And the parity-push appears to be off, at least for the moment. The Aussie was creamed by nearly two and a half cents down to US$0.9691.

The only market which didn't move significantly was the US bond market, where the overbought ten-years saw a fall in yield of only 4 basis points to 2.48%.

The SPI Overnight fell only 36 points or 0.8% compared to the S&P 500's 1.6% drop, but then the ASX 200 was lacklustre yesterday despite a solid Monday session on Wall Street. We got the Chinese news first.

After the bell on Wall Street, Yahoo posted a reasonable result and its shares are steady in the after-market.

The scene is set tonight for Morgan Stanley and Wells Fargo to report, along with eBay and Dow components Boeing and United Technologies. The Fed will also release its Beige Book, which will bring attention back to QE2 speculation.

On the local bourse, attention will fall on Ten Network ((TEN)) following the late night raid by James Packer's private investment company to net a 16% stake at $1.50. Ten shares closed yesterday at $1.41. Ironically, the move comes a day after Tabcorp's ((TAH)) demerger announcement which sparked speculation Packer may be keen on the CasinoCo spin-off. It had been assumed Packer was interested only in casinos now and no longer interested in FTA television. 

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