Evening Update

Anxiety Mounts on Treasury Debt Issuance

Stocks took their cue from the bond market today, and a renewed sell-off in Treasuries that saw the 10-year note yield rise to a fresh 2009 high at 3.71% erased any hope of a gain in the averages for the day. While the government debt auction for the day was positive, concerns about record issuance to come continues to weigh on investor sentiment, and even assurance from Moody’s that the U.S. government Aaa rating is not at risk did not diffuse the negative attitude toward Treasuries. Crude oil hit a new high for the year, and rising gasoline prices and interest rates could forestall a recovery in the economy. While widely previewed, a further move toward a bankruptcy filing for General Motors added to the gloom. On the positive side of the ledger, Chrysler is reported to be closer to exiting bankruptcy than previously thought. The FDIC reported that the number of problem banks rose and stress-tested banks announced further plans to fill the capital needs required by the test. In other equity news, Monsanto lowered its full year guidance, while retailers Staples, Autozone, American Eagle Outfitters and Chicos FAS all announced positive earnings surprises. Existing home sales rose amid sharply falling prices.

The Dow Jones Industrial Average lost 173 points (2.0%) to close at 8,300, the S&P 500 Index fell 17 points (1.9%) to 893, and the Nasdaq Composite declined 19 points (1.1%) to 1,731. In moderate volume, 1.3 billion shares were traded on the NYSE, and 2.1 billion shares were traded on the Nasdaq. Crude oil rose $1.00 to $63.45 per barrel, wholesale gasoline increased $0.04 to $1.89 per gallon, and gold declined $1.00 to $951.00 per ounce.

Shares of Dow member General Motors(GM $1) fell 20% after the company announced that it failed to attain the necessary approval of its bondholders by a deadline that expired at midnight last night, setting the stage for bankruptcy unless a new agreement can be found before the June 1 deadline being enforced by the government. GM had been seeking to convince its creditors to accept an equity stake of 10% in exchange for the $27 billion in unsecured bonds they hold but received “substantially less” than the 90% approval that was needed. An ad hoc committee of large GM bondholders has referred to GM’s offer as “neither reasonable nor adequate” and proposed a 58% stake in the reorganized firm, in contrast to the 10% stake that GM offered them. Meanwhile, the Washington Post reported that the US and Canadian governments are preparing a proposal that would effectively nationalize General Motors – with the two governments together holding over 70% of the firm. The US government will reportedly inject an additional $30 billion, on top of the $19 billion already lent, while Canada is preparing to contribute about $9 billion for a smaller interest, according to a source that stipulated the amounts currently being discussed are still fluctuating. GM did not comment on the report, stating that it will hold a meeting of its Board of Directors before the end of the week to plan its next move.

In related news, several media outlets reported that privately-held Chrysler is much closer to exiting bankruptcy than originally thought, possibly as early as next week, according to a person familiar with the matter. Although investors will see this as a positive sign for GM should it also be forced into bankruptcy, the source said that GM’s bankruptcy would take longer than Chrysler’s because it is more complex. When it emerges from bankruptcy, Chrysler will be 20% owned by the Italian company Fiat (FIADF $11) with Fiat CEO Sergio Marchionne as the new CEO of Chrysler.

The FDIC reported that the number of problem banks rose to 305 in 1Q from 252 in 4Q and 21 FDIC-insured institutions failed during the quarter. While citing some positives such as higher net interest income and noninterest revenue, as well as improved realized gains on securities and other assets, these positive factors were outweighed by higher expenses for bad loans and goodwill impairment. The amount of non-current loans (90 days or more past due or in nonaccrual status) rose by $59.2 billion in the quarter, and are $154.3 billion higher than a year ago.

Despite the deteriorating environment for banks, the largest 19 U.S. banks that were subject to the government stress test continue to repair their Tier 1 common equity ratios by raising capital and converting preferred shares to common stock, with Bank of America (BAC $11 ¹), PNC Financial Services (PNC $43), and KeyCorp (KEY $5) making moves today.

Bank of America announced that it has raised an additional $5.9 billion by converting privately-held preferred shares into common stock. According to Dow Jones, the preferred shareholders will receive about 82 cents in BAC shares for every dollar held in preferred shares, higher than the 40-70 cents on the dollar that the shares currently trade. Bank of America noted that none of these conversions involved the preferred shares held by the government as part of the Troubled Asset Relief Program (TARP). Combined with last week’s common stock offering and proceeds from selling holdings in China Construction Bank (CICHF $1), BAC has now raised almost $26 billion in new capital, putting it approximately 76% of the way to filling the $34 billion capital shortfall identified by its regulators. Shares erased early gains, following the broader market lower..

PNC Financial Services announced that it raised more than $600 million through a common stock offering. PNC said it plans to repay the $8 billion in government funding it has accepted “as soon as appropriate.” KeyCorp said it plans to exchange up to $1.7 billion of preferred stock for common stock. KEY had previously announced intentions to sell $750 million in common stock as the bank tries to fill the $1.8 billion capital shortfall mandated by the government. Shares of both banks fell

Monsanto (MON $80) announced that its full-year earnings will be at the low-end of its previously announced guidance due to stronger-than-expected competition in its herbicide business. Chinese competitors are selling low priced herbicides, cutting into sales of MON’s flagship Roundup brand. Full year profits are now forecast to be $4.40 per share, compared to a prior forecast of $4.40-4.50, and the average analyst estimate of $4.59. Shares were lower.

Staples (SPLS $20), the world’s largest office supply retailer, reported 1Q EPS ex-items of $0.22, above the Reuters estimate of $0.21. Revenues increased 19% to $5.8 billion but lower profitability resulted in profits falling approximately 30% on a year-over-year basis. Same-store-sales in the firm’s North American retail operations declined 8%, while same-store-sales in Europe were 14% lower. Management reaffirmed its outlook for synergy benefits accruing from the recent Corporate Express acquisition of $300 million over three years. Shares fell after spending most of the session nearly unchanged.

Autozone (AZO $155) released 3Q results, showing EPS rose 9% to $3.13, above the average analyst forecast of $2.89. Revenues also rose 9% to $1.7 billion. AZO’s management cited “favorable trends” such as lower fuel prices compared to last year as contributing to the better-than-expected results. Same-store-sales in AZO’s US stores increased 7% during the quarter. Shares were lower.

American Eagle Outfitters(AEO $14) reported that 1Q EPS fell by approximately 60% to $0.08, above the consensus estimate of $0.07. Sales fell 4% to $612 million as same-store-sales dropped 10%. Although management noted that “there are early indications that the business is stabilizing,” AEO gave guidance for 2Q that was below expectations, guiding to EPS of $0.12-0.15, while analysts had been expecting EPS of $0.15 for the second quarter. AEO shares closed lower, erasing early gains.

Chico’s FAS (CHS $9) reported 1Q EPS ex-items of $0.11, higher than the estimate of $0.08 per share. The company said that 1Q profit rose 14% on reduced expenses and improved direct-to-consumer sales and same-store sales at its White House Black Market stores, with sales at stores open at least a year up 4% for the division, while its namesake same-store sales fell 6%. Shares rose.

Treasuries fall and existing home sales rise

Treasuries erased early gains and ended lower, despite a good auction, and the 10-year note hit a new high yield for 2009 at 3.71%. Results from the $35 billion auction of five-year notes drew the most investor demand in three months, and indirect bidders, which includes foreign banks who have been postulated would pull back from U.S. Treasuries, purchased 44% of the notes, compared to an average of 32% in the last 10 auctions. Despite the positive demand, investors are speculating that foreign governments are focusing on the short end of the curve, on the fear of higher interest rates in the future. Tomorrow brings a $26 billion seven-year note auction, and there is trepidation about the ongoing drumbeat of further government issuance, heightened by last week’s outlook downgrade of the U.K. by Standard & Poor’s. Moody’s Investor Service said today that the U.S. government’s Aaa credit rating is stable, “even with a significant deterioration” in the nation’s debt position. The yield on the 2-year note was flat at 0.95%, the yield on the 10-year note surged 16 bps to 3.71%, and the yield on the 30-year bond increased 12 bps to 4.61%.

In economic news, existing home sales for April rose 2.9% month-over-month (m/m) to an annual rate of 4.68 million units, higher than the forecast of 4.66 million and a 2.0% increase, but a downward revision to March sales to 4.55 million from 4.57 million, marking a 3.4% fall in March took some luster off the better-than-expected number. For the quarter, sales dropped 0.6% and year-over-year (y/y) sales declined.3.5%. While the sales rate is relatively benign, they are catalyzed by steep discounting, with the median existing-home price dropping 15.4% y/y to $170,200.

According to the National Association of Realtors (NAR), the $8,000 tax credit for first-time buyers continues to influence the market, but there is also a seasonal rise of repeat buyers. While most of the sales are taking place in lower price ranges, there was some pick up in mid-range home sales. However, high-end home sales remain sluggish due to high jumbo interest rates, and inventory remains severely elevated, at 40 months of supply. Distressed property sales, consisting of foreclosures and short sales, accounted for 45% of transactions.

Due to seasonal factors, inventories rose 8.8% during the month to 3.97 million existing homes available for sale from 3.74 million in March, and the supply homes for sale rose to 10.2 months from 9.8 months. However, inventories are lower relative to a year ago. The NAR believes foreclosures will be released into the market over the year, but notes that home buyers are bidding up foreclosure properties in CA, NV and FL. Banks have been saddled with souring assets, and are offering deep discounts in order to spur bidding wars in an effort to quickly rid the properties from their balance sheets.

In other economic news, the US MBA Mortgage Application Index fell 14.2% to 786 for the week ended May 22. This follows a 2.3% gain for the prior week, in an index that can be quite volatile on a week-to-week basis. The Refinance Index plummeted 19%, while the Purchase Index rose 1%. The Mortgage Bankers Association (MBA) said the average 30-year mortgage rate increased 12 basis points to 4.81% - the highest level in more than two months - although still not far off of the record low of 4.61% that was reached at the end of March. Treasuries are higher.

Housing data concludes tomorrow, along with a read on durable goods orders

New home sales will be released tomorrow, and are expected to have risen 1.1% for April m/m to an annual rate of 360,000 units, after falling 0.6% in March and rising 8.2% in February. New home sales now account for 7% of the market, down from 16% at the peak, as they have struggled to compete with the steep discounts afforded by foreclosures. In response, homebuilders have significantly cut back on new housing starts, allowing inventory levels of new homes to fall.

Durable goods orders are expected to show a rise of 0.5% m/m in April, after falling 0.8% in March, and rising 2.1% in February. Ex-transportation, orders are forecasted to decline 0.3%, following a fall of 0.6% in March. Consumers and businesses have been cutting back on large purchases, as they are highly discretionary and may require access to capital to finance. And with lending standards steadily easing, capital spending looks to bounce. Also, there is a high correlation between lending standards and spending on equipment and software (the key component of capital spending), and is one reason for an “outperform” rating on the technology sector.