HEDGE FUND NEWS
@ Tue 21 August 2007 : GMT

FINTAG COMMENT

Now we understand why the Germans have been complaining vociferously about Hedge Funds and Private Equity with their jibes about them being locusts, unwashed and the scum of the earth: it has been a huge distraction away from their Banking sector which is incompetent and useless.

First we had West LB, IKB, Sachsen LB and now the daddy of them all - Deutsche Bank whose prop desk lose a lot of money on subprime - is now in the bucket of shame along with Goldman, BNP Paribas, UBS, JP Morgan and Goldman Sachs. Not only that but their begging bowl was out in the discount market too.

Who next? Well I think Lehman still have something to tell us, along with Merrills and Wachovia.

As we said yesterday, the media may enjoy seeing hedge funds in trouble, but the real worries are the Investment Banks who will be firing thousands by the end of the year: time to short luxury goods and houses ...

Another sad day as we see Solent Capital struggle, Sentinel collapse under a cloud of SEC smoke and Odey turn to dust.

The Bulls keep their heads up high and Bernanke keeps his fingers crossed (maybe he is cleverer than we thought?) although some argue the t-bill market is taking a volatility hammering

As the inverted yield curve is tamed, are we now facing - shock, horror - a flat one?

Jana and Lansdowne buy into the Goldman cake.

Poor old 130/30 get a piece of volatility and the pseudo long only managers panic.

Capital One (0% balance transfer anyone?) sells off its Greenpoint mortgage unit: others put in big bad provisions.

The ECB says no to inflation and is expected to put rates up (take that back room boy Bernanake).

OC NEWS

Fed fails to calm money markets (ft)

Fasten Seat Belts (nypost)

Flight to safety hits Treasury bill yields (msnbc/ft)

DB Said to Have Lost $135m, But Who Cares ? (hereisthecity)

Yileding to the crisis (breakingviews)

FA 100 index posts record gain (financeasia)

Commercial Paper Roils Borrowers With $550 Billion Coming Due (bloomberg)

Odey hard hit as performance drops (telegraph)

Quote of the day
"The reductions in demand and pricing in the secondary mortgage markets make it difficult to operate our wholesale mortgage banking business profitably," said Gary Perlin, Capital One's Chief Financial Officer.

Why the OC is responsible for the Crash of 2007
This popular drama series, the OC, is not what it seems.

The first series started in 2003, just as subprime lending started to take off in California and most notably Orange County. Caleb, Kirsten, Julie and Sandy were all part of the Newport Group that built cheap residential homes and sold them off quickly to aspiring NEWPSIES who had no intention of paying off their mortgages.

The OC promoted a lifestyle that seemed unattainable. Unless you were the boy from the wrong side of the tracks who is adopted and starts driving around in a Range Rover and dating sexy debs, you could only but dream. And then the mortgage brokers began offering cheap home loans and living the dream became a reality.

The show's writer and producer, Josh Schwartz, should be investigated by the SEC for seeding the stock market credit crunch crash.

No wonder series 4 came to an abrupt end in 2007.

ISLE OF WIGHT

Solent Capital to wind down fund (marketwatch)
U.K. hedge-fund manager Solent Capital said Monday it was going to wind down one of its funds because of a downturn in value in the asset-backed securities it contains, the latest fallout from the global credit crisis.

The fund, called Mainsail II, was invested in commercial mortgage-backed, residential mortgage-backed securities, and collateralized debt obligations, according to a statement released by the company.
The fund may have a forced sale of investments or a closing out of hedging instruments at a loss that may "materially" impact principal and interest repayments, Solent said.

The fund had raised $1.5 billion in assets when it debuted last year.

Many of these securities have struggled in the aftermath of poorer U.S. borrowers failing to make timely payment on their mortgages, as well as downgrades by credit-rating agencies.
"Current market volatility and lack of market liquidity with respect to subprime lending markets have caused adverse conditions with respect to the liquidity and market risk exposures on the company's underlying portfolio of investments," Solent said.

'Current market volatility and lack of market liquidity with respect to subprime lending markets have caused adverse conditions with respect to the liquidity and market risk exposures on the company's underlying portfolio of investments.'

The fund acted in a way similar to the conduits that have got German banks including IKB and Sachen into trouble.

Conduits issue commercial paper that typically have maturities of under a year, and use the cash from those sales to buy longer-term bonds paying higher interest rates. With low- to no investment demand for the commercial paper they issue, the conduits effectively seize up.

The Mainsail II fund was part of an asset class called "SIV-Lite," which have even less credit line back-up than the conduits had.

Mainsail II, as well as other SIV-Lite investments, were underwritten by the Barclays Capital unit of Barclays

According to Moody's Investors Service, Barclays provided a $566 million line of liquidity that expired in July. It's unclear if that line was still available.

A spokesman for the bank couldn't immediately answer those questions.

As recently as June 30, the Columbia Acorn Select fund had $15.7 million invested in Mainsail II, or 0.49% of overall assets, according to a filing from the Bank of America fund-management division

CAPITAL ONE

Downtime for Subprime (portfolio)
Capital One to close mortgage unit; other companies take steps to shore up credit.

On a day when the markets were relatively quiet, following the Federal Reserve's move to calm credit fears on Friday, a number of companies hit by the subprime implosion sought to cut back their exposure or bolster their liquidity.

Capital One said it would shut down its GreenPoint Mortgage unit and take a charge of $860 million. Capital One acquired GreenPoint when it acquired North Fork Bancorp for more than $13 billion last year.

K.K.R. Financial, an affiliate of the private equity giant Kohlberg Kravis Roberts & Co., plans to sell $500 million in stock to seven institutional investors, including funds managed by Morgan Stanley, Farallon Capital Management, and Oak Hill Advisors. The move comes days after K.K.R. Financial warned of investment losses of as much as $290 million because of “unprecedented disruptions” in the residential-mortgage market.

Countrywide Financial, which tapped a $15 billion credit line last week, has begun laying off workers involved in originating loans, the Wall Street Journal reported, citing an internal email.

Another lender, Thornburg Mortgage, said it had sold $20.5 billion of mortgage-backed securities at a discount and terminated $41.1 billion of interest-rate hedging instruments.

“The company took these actions to address challenges in meeting its liquidity and financing needs caused by rapidly declining mortgage securities prices and simultaneous declines in the value of its hedging instruments,” Thornburg Mortgage said.

A mortgage investor, Luminent Mortgage Capital, meanwhile, has agreed to sell a majority of itself to Arco Capital.

FRAUD IN THE USA

SEC picks up Sentinel ball (nakedshorts)
Selected lowlights from yesterday's US Securities and Exchange Commission complaint against Sentinel Management Group Inc, filed in federal court in Chicago:

Among its improper activities, Sentinel transferred at least $460 million...from client investment accounts to Sentinel's proprietary 'house' account. Sentinel also used securities from client accounts as collateral to obtain a $321 million line of credit as well as additional leveraged financing. The bank that extended the $321 million line of credit to Sentinel...intends to sell securities pledged as collateral for the loan...as soon as Aug. 22 2007.

Sentinel did not disclose to its clients its practices of commingling, transferring and misappropriating their assets, or inform them that their investment portfolios were highly leveraged...To the contrary, Sentinel provided its clients with daily account statements that did not reflect the improper activities.

Sentinel's explanation of its redemption suspension was false and misleading.

Undisclosed Misappropriation and Commingling of Client Assets

...Sentinel e-mailed customer account statements to its clients that were materially false and misleading...Customer statements...represented that the face value of the securities...was, in the aggregate, more than $670 million. Contrary to these representations, the Bank of New York custodial statement showed only approximately $93 million of securities...

...Sentinel placed at least $460 million of clients' securities...in Sentinel's house account...and, significantly, was available to be pledged as collateral. When SEC examiners asked Sentinel representatives which securities in the 'house' account were owned by clients...Sentinel representatives responded that it could not identify who owned those securities.

Undisclosed Leveraging of Client Assets

Sentinel pledged securities belonging to clients order to obtain a line of credit from the Bank of New York for its own benefit. The credit...reached as high as $500 million in Jun. 2007 and is now $321 million...clients had no way of knowing that their assets had been used by Sentinel to obtain financing for its own purposes.

...Sentinel had used $1.5 billion in securities owned by the clients to obtain financing three times the value of those securities....the financing was used to purchase additional securities. However the client statements prepared and distributed by Sentinel did not reflect any of this activity.

APPLE PIE

More U.S. hedge funds likely to crumble (reuters)
This is shaping up to be a record year for hedge fund industry road kill.

Every year, hundreds of funds and fund managers have quietly left the industry, which now manages $1.75 trillion (880 billion pounds). But this year, their exits will be more numerous after a meltdown in subprime mortgage investments spread to other sectors and caught some of the most seasoned managers off guard, investors, analysts and fund managers said this week.

Two prominent Bear Stearns funds and Sowood Capital, run by a former Harvard Management stock picker, collapsed recently, while an ailing fund run by Goldman Sachs got a $3 billion cash injection this week.

Dozens of funds are said to be nursing heavy losses and investors and managers say they expect more suffering funds will pop up in the weeks ahead.

"This year is going to be the worst we've ever seen in terms of numbers of funds having problems, worse than 1998," when hedge fund Long Term Capital Management collapsed and the private sector banks engineered a bailout, said John Mauldin, who invests in hedge funds at Millennium Wave Advisors.

By early 2008 the industry's annual 8 percent failure rate could be nearly double, experts said, and within five years perhaps only two-thirds of the estimated 9,800 funds now operating worldwide will exist.

"There has been such unabated growth in this industry that there is bound to be some consolidation and the more marginal funds will be washed out to the side," said Randy Lampert, managing director at investment bank Morgan Joseph & Co.

The blow-ups are prompting investors, in the short-term at least, to reassess and reduce risk in their portfolios and, because hedge funds are considered secretive, they're withdrawing funds.

Fund manager Tom Brown, who concentrates on financial stocks, has told investors his Second Curve Opportunity International hedge fund fell 27 percent in the first seven months of the year, according to someone familiar with the numbers. And James Simons' Renaissance Institutional Equities Fund was off "in the order of 7 percent," through the end of last week, he told investors.

"This is going to be like a line of dominoes falling," said Jaeson Dubrovay, who heads the hedge fund practice at New England Pension Consultants. "Sometimes the dominoes hit something that isn't even in their line. There is going to be a lot of collateral damage this year," he said.

Some big losses occurred as funds had to sell stocks to meet margin calls, investors and managers said. Also funds are being forced to sell as investors want their money back and redemption notices pile up.

"The headlines will get significantly worse and that will prompt further redemptions," said Lawrence Glazer, managing partner at Mayflower Advisors, an advisory firm for corporate clients and individuals.

"We would expect to see the worst redemptions since 2001 with the more exotic strategies like the black box traders who rely solely on computers being affected most," he added.

Indeed analysts expect pension funds, whose appetite for hedge fund investments grew by 69 percent last year to $50.5 billion, to back off now amid growing concern about heightened volatility and risk. Pressure from federal and local politicians about the lack of hedge fund regulation will also act as a brake on investments.

Small hedge funds that manage less than $1 billion and are suffering heavy losses may be among the first forced out of business, investors and managers agreed. Hedge fund managers traditionally earn the bulk of their fees from performance or incentive fees, which they can't collect if they are in the red
"When you are not collecting an incentive fee from investors and you have to pay employees out of your pocket, that hurts," NEPC's Dubrovay said.

The expected failure rate among smaller hedge funds may not sound like a calamity especially since data from Morgan Stanley shows that the world's top 100 hedge funds managed 68 percent of hedge fund assets.

But investors like John Mauldin said losing the small and newer managers may be problematic because research shows that they, not the industry giants, deliver the best returns.

Despite the turbulence, investors still believe new hedge funds will form, albeit not in the numbers that have been seen in recent years. "There is a lot of opportunity to buy distressed securities," said one hedge fund manager who is mulling starting a new fund.

LONG TOOTHERS

Volatility shakes 130/30 funds (financialnews-us)
Investors learn true risks of short-extension strategies

The billions of dollars that were hurtling towards 130/30 funds are slowing to a halt after this month's experiences of fund managers that rely on computer models to make investment decisions.

Quantitative equity managers, which experienced unprecedented volatility in their funds in the first week of the month, saw 130/30 funds make losses that investors would normally associate with higher risk funds.

A 130/30 fund starts with a principal worth 100% and sells stocks worth 30% of the fund short to finance an additional 30% long position. Fund managers say the benefit of allowing them to take limited short positions is they can profit from stocks they believe will fall in value, as well as those they believe will perform well.

Goldman Sachs Asset Management's US large-cap 130/30 fund lost 4.4% last month and is understood to have been down by as much as 8% for the month to August 9. A bounce on August 10, which lifted most quantitative funds, is understood to have improved returns to about -5%.

Investors said Barclays Global Investors' US equity 130/30 product was down 4% for the first seven trading days of August. The S&P 500 was down 0.9% over the same period.

The poor performance registered for quantitative fund managers, which span statistical arbitrage hedge funds that trade thousands of stocks a day, to managers with longer term investment horizons that run portfolios which target modest returns above the index, has shaken investor confidence. Many had not appreciated the risk they were running while volatility was low.

Craig Baker, head of manager research at investment consultants Watson Wyatt, said: “We have been cautious on quantitative 130/30 and market-neutral products for some time but obviously I cannot say we were expecting this market move in such a short time. One of our concerns has been many investors have been thinking about 130/30, similar to a long-only strategy because of a beta of one when, instead with leverage, the risk profile of the fund changes significantly.”

Merrill Lynch analysts said in a report last week: “Managers and their clients have to be comfortable with higher levels of risk, as tracking error will almost certainly rise when short extending a given manager's portfolio.” The research showed a 130/30 fund with a large-cap bias has a tracking error of 1.4% more than a long-only fund.

Another quantitative manager added: “I have always had a little worry that people investing in 130/30 thought they were hedged portfolios. Long-only and 130/30 funds have a beta of one.”

Although a small sub-set of quant funds, 130/30 funds have attracted large volumes of assets in the past two years, adding to money chasing the same opportunities. Merrill Lynch estimates 130/30 assets are worth as much as $100bn (€75bn) against $50bn at the end of March. State Street has added $4bn since the end of March to take its total to $10bn.

Their use of leverage, although modest, meant they incurred bigger losses than long-only funds. However, enhanced index funds, which target modest returns above the index, also suffered. A fund managed by Barclays Global Investors is understood to be down 1.4% in the first seven trading days of August.

This month's events have shown how crowded quantitative equity strategies have become. Some more aggressive hedge funds were down as much as 30% to August 9, as they had employed leverage as much as 10 to one.

One quantitative fund manager said: “Just about any quantitative strategy leads to alpha spreads of 50 to 200 basis points and that makes sense. It's asking a lot to come up with a strategy that looks at one factor out of millions and for it to go up 50%. So if I can only make 200 basis points on my typical spread trade, I need to lever that five to one to get to 10%. I think it's going to get harder to lever.”

Rick Bookstaber, author of A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, formerly at hedge fund FrontPoint Partners, said quants are trained at the same places and use the same statistical methods and data, so they reach the same conclusions.

He said: “Quant managers tend to be closed-lipped in what they do and they do not talk about their models, so it's not that ideas are spreading that way. It is about scientific inquiry and, by nature, scientific inquiry is reproducible. That's why all these quant funds look to be doing almost the same thing.”

The extent of this month's losses show how much capital was chasing the same investment opportunities. Valuation and momentum factors had produced strong returns for quantitative managers but, when companies with high cashflows that were deemed value stocks plummeted and growth stocks rose, many funds were caught off guard.

The spread of losses suggests managers had become complacent about finding new factors to trade on. Baker said: “There is a small sub-set of managers that are truly innovative. In quant, you need managers that continually challenge what they are doing, using qualitative priors and back-testing them, rather than simple data-mining, and have realistic expectations on the capacity of their strategy.”

A research paper published by Rochester University professor Bill Schwert in 2003 noted that when anomalies were analyzed and documented in academic literature, they tended to disappear.

He wrote: “This raises the question of whether profit opportunities existed in the past but have since been arbitraged away, or whether the anomalies were statistical aberrations that attracted the attention of academics and practitioners.”

Fundamental managers, facing the greatest scrutiny over their ability to identify stocks to short, have recorded the best results this month. JP Morgan Asset Management, which manages $2.5bn in 130/30 funds, is one. Its large-cap 130/30 US equity fund was flat in the first seven days of trading in August.

Paul Quinsee, chief investment officer of core US equities, said: “We have been expecting the volatility in this market to go up for some time and we have also been pretty cautious about the decisions we take in the financial sector.

“A long period of favorable conditions in the financial sector appeared to be ending. What's helped us is our portfolio positioning and our ability to manage risk.”

It also reduced its short exposure to about 20% ahead of the volatility spike.

INFLATION OR STABLE MARKETS?

European Central Bank still on course to raise its key interest rate to 4.25% on September 6th (finfacts)
The global economy is strong and this year is the fourth year of economic growth above 5% - the best sustained period of expansion since the 1950's. Global growth has been fuelled by the spectacular expansion in the economic powerhouses of Asia-Pacific: China and India. The manufacturing companies of Germany, which accounts for 30% of the Eurozone economy, have been boosted by robust demand in emerging economies while overseas demand has prevented America from sliding into recession. Last month, Deutsche Bank Research highlighted the importance of the machine tools sector when it said that the typical German mechanical engineering company employs nearly 150 people and generates annual turnover of €26 m. In 2006, the sector's roughly 6,000 businesses with a combined workforce of some 873,000 generated revenues of €167 bn.

The Wall Street Journal reported on August 9th that foreign operations contributed to strong second-quarter results in recent weeks from a number of US companies, ranging from giants like General Motors Corp. and Citigroup Inc. to smaller manufacturers like Harley-Davidson Inc. Part of this upswing can be traced to a weaker dollar, which creates an automatic gain when a company translates overseas profits back into now-devalued greenbacks. Last week, IT giant Hewlett-Packard reported that 65% of its revenues in its fiscal fourth quarter came from outside of the United States.

The Journal says that the trend toward US companies earning more profits overseas isn't new, but it has accelerated in recent years, and has spread to more types of companies, reflecting the growing globalization of US business, says Ed Yardeni, president of Yardeni Research Inc. The share of international profits at US companies has grown steadily since the 1960s, when they accounted for about 5%, and now accounts for about a quarter of all profits, he says, citing Commerce Department data.

International earnings of US companies grew 16.4% in the first quarter compared with a year ago, while domestic earnings rose just 2.7%, says Joseph Quinlan, chief market strategist at Banc of America Capital Management, using Commerce Department data.

The US has escaped recession thus far through strong overseas earnings but today, America may need a cut in its key interest rate to assist its housing sector and avoid a recession. The question for the Eurozone is whether the European Central Bank will reverse course on its signaled plan to raise its key interest rate to 4.25% on September 6th next?

In the early part of this decade, the dot-com bust and 9/11 prompted the Fed under Alan Greenspan to aggressively cut the federal funds rate to 1%. In the Eurozone, the European Central Bank (ECB) cut its key interest rate from a high of 4.7% to 2% in mid 2003. The historically low cost of money led to a global asset boom in particular in housing. In the corporate world, private equity investments in companies, financed by cheap corporate debt, became an important financing mechanism and in the US property sector, interest-only loans became an important segment of the home-loans market. Loans were aggressively targeted to people with poor credit records, and when the problems in the US high credit risk subprime home loans market, which first surfaced last February, become more serious than expected because the system of lenders being directly responsible for the risks that they assumed in lending money, was changed with risk was sold to onward to financial companies, including foreign banks through re-packaging by Wall Street firms.

There is currently a global credit problem because the extent of the exposure to the subprime crisis is not clear. Banks have become cautious about refinancing and assuming corporate debt risk, as there is fear of exposure to the subprime crisis. Last week, ECB President Jean-Claude Trichet welcomed what her termed a “repricing” of risk following the provision of liquidty to the Eurozone banking system. His interest is not to provide a lifeline to investors but to ensure that the real economy will not be damaged by the current volatility.

The recovery in markets following the cut by the US Federal Reserve in its discount rate, on Friday, was manna from heaven for at least a day. The reduction in the interest rate that the Fed charges banks for loans to 5.75% was not a cut in its key federal funds rate and the market is looking to the meeting of the rate-setting Federal Open Market Committee on September 18th to provide another antidote for frentic traders, through a cut in the rate from 5.25%. Investors and forecasters on Friday were penciling in a cut in rates of 0.75% by the year-end.

America's housing market is in recession and the wish that there would be no contagion to the rest of the market has not been realized, while most forecasters coupled with Fed Chairman Ben Bernanke and US Treasury Secretary Hank Paulson, who was Chairman of US investment bank Goldman Sachs until the summer of 2006, were proved wrong about the fallout. Now that fears have been raised even about the financial stability of the largest US home loans lender Countrywide and the latest reading of US consumer sentiment has been negative, the Fed has to look at the implications of the market volatility and the credit crunch, for US consumer spending, which accounts for about 70% of the economy.

In Europe, the majority of financial services' economists may well have got ahead of themselves last week in foreseeing an inevitable backtrack by the ECB on its signal that it would raise its key interest rate in September.

In the absence of an impending recession, the ECB is faced with a rise in core inflation and German trade unions seeking inflation busting pay rises. Too much may well have been read into a remark by Professor Axel Weber, President of the Bundesbank and member of the ECB's Governing Council, who said in comments to reporters on Friday that that in addition to price stability it is also important for the ECB to do its part in ensuring financial stability.

“The German and European economies are essentially healthy," Weber said in an interview with a German radio station, that was broadcast on Saturday but was originally taped on Thursday.

Professor Weber said that the slowdown in German economic growth in the second quarter showed that the government's fiscal policy -- namely its increase in value-added tax -- was having a dampening effect on growth of Germany's gross domestic product.

"Despite the market turbulence I see no point to revise macroeconomic forecasts," he said.

"The German economy can weather this storm," Weber added.

While growth in the Eurozone slowed in the second quarter, it is still strong and last week, a Eurozone index of economic sentiment remained robust.

On Thursday, detailed figures provided by the EU's statistical office Eurostat, showed that “core” inflation - which gives an indication of underlying trends and excludes volatile oil and unprocessed food prices - remained at 1.9% in July, even though the overall rate fell to 1.8%. Over the past year, “core” inflation has risen steadily from a low of 1.3 per cent at the start of 2006, and last month was above the headline rate for the first time in more than three years, the data showed.

The cost of oil has increased 41% since the middle of January and food prices are also on the rise because of drought and the increase in biofuel production. Deutsche Bank Research reported last week that German shoppers have been paying more for groceries lately, up to 50% more for butter within a few days. Spending 10 cents more for a litre of milk may be noticed by individual consumers and painful for some, but the effect on the overall economy is hardly a cause for concern. Even if yearly foodstuff inflation doubled this year, this would just add 0.15 percentage points to the overall inflation rate. Moreover, the current high world prices for many agricultural commodities are partly the result of short-term factors such as recent falls in output due to drought (e.g. for grains in Australia in 2006 and currently in Europe).

Deutsche Bank says that given the particularly fierce competition in the retail sector, German food prices are low compared to its European neighbours. But the big picture is that, relative to the past, food prices are expected to stay high or even move higher for structural reasons. A typical family in the developed world has been spending around 10% of their income on food, compared to 40%, 50 years ago. Mechanization and the Green Revolution caused a steady fall in the real price of food. At the same time, the increase in labour productivity allowed for rising wages, hence higher spending beyond the basics. Now, consumers world-wide have to get used to spending slightly more on food.

Finally, a rise in trade union militancy, which was recently highlighted with the threatened German rail strike, is also a factor for the ECB to worry about. Real incomes have stagnated over the past decade and it is resulting in frustration among workers as the economy powers ahead.

ECB President Jean-Claude Trichet always stresses that the Governing Council does not pre-commit on interest rate hikes. The expectation of a rise at the September 6th meeting will be realized unless there is a perceived serious threat to the real economy from the current credit crunch. Trichet and his colleagues will be very reluctant to be seen as bailing out exuberant investors.

It is still more likely than not that the ECB will raise its key rate to 4.25% at the next meeting of the Governing Council.

The Governing Council could also indicate that monetary policy has moved from accommodative to neutral, signalling to the market that the current tightening phase is over.

It in effect will have the opportunity to kill two birds with the same stone!

THE BIG FREEZE

Markets wary of further Fed cuts as US bond yields dive to 1987 levels (telegraph)
A flight to safety on Wall Street caused yields on 3-month US treasury notes to plummet at the steepest pace since modern records began, eclipsing moves at the height of the 1987 stock market crash.

Investors fled the $2,500bn (£1,260bn) money market that usually serves as a safe-haven in times of turbulence, responding to reports that funds may be exposed to sub-prime mortgage debt and asset-backed commercial paper. "This is a sign of significant fear in the financial system," said one banker.

However, the Dow, after sinking nearly 100 points in early trading, staged a late rally and ended up 42 points at 13,121, as the pile into treasury notes eased later in the day.

Traders were initially unsettled by news that Deutsche Bank had tapped the credit window of the US Federal Reserve after the emergency half-point cut in the discount rate last Friday. Banks are typically reluctant to use the facility, fearing that it could send off a distress signal.

Markets wary of further Fed cuts

German banks have unexpectedly proved to be among the hardest hit by sub-prime losses, with IKB bank and Sachsen LB requiring a state-orchestrated bail-out of EUR25.4bn between them. Deutsche Bank holds EUR15.45bn of exposure to vulnerable forms of debt through so-called conduits.

The yield on the 3-month note dropped within a period of two hours from 3.76pc to 2.55pc, a bigger shift than on the days of the 9/11 terrorist attacks or the 1987 meltdown.

"This is a mind-boggling rally in 3-month notes. There is absolutely no liquidity in the market now," said one trader. Kim Rupert, a fixed-income strategist at Action Economics, said the debt markets were still frozen. "We're not out of the woods yet in terms of more credit-market fallout, and investors are basically staying parked in shorter-dated treasuries," he said.

Demand for longer-dated 3-year treasuries tumbled as investors began to bet on a string of rate cuts by the Federal Reserve in coming months. US car sales fell to the lowest level in nine years in July, pointing to a downturn in consumer spending.

Michael Vaknin, a strategist at Goldman Sachs, expects the Fed to cut rates three times by end of the year. "The Fed's actions so far should reduce the probability of a full-blown crisis." However, he warned that the combined effect of falling house prices and the latest equity slide would hit spending more than generally realised, doubting whether there would be a sustained rally on the stock market until it was clear who held the main losses from the sub-prime crisis.

Countrywide Financial, the largest lender in the US, began laying off sales workers as it tried to weather the crunch. Meanwhile Thornburg Mortgage, which has also seen its finances ravaged, said it had sold $20.5bn of assets to boost its financial health, citing "unprecedented conditions in the mortgage financing market". The Countrywide layoffs occurred in its Full Spectrum Lending business, which handles many home loans in a category known as Alt-A, or mortgages between prime and sub-prime that often involve borrowers who don't document their income.

Capital One, a financial services group better known for its credit cards, said it was shutting down its struggling GreenPoint mortgage unit, becoming the latest casualty in the mortgage meltdown. Almost 2,000 staff will lose their jobs. Capital One bought GreenPoint in last year's $13.2bn purchase of North Fork Bancorp.

CAKE

Activist investor Jana buys into Goldman Sachs (financialnews-us)
Jana Partners, regarded as one of the most aggressive US hedge fund managers, has taken a stake in Goldman Sachs, joining UK hedge fund Lansdowne Partners on the bank's register of shareholders.

Jana has acquired 727,000 shares in the US bank, 0.2% of its equity, for $158m (€117m), according to its 13F filing published last week by the Securities and Exchange Commission. Jana had $6bn under management at the start of the year.

A Jana spokesman declined to comment on the investment.

The firm, run by founder Barry Rosenstein, has developed a reputation as an activist shareholder. It became one of the first hedge funds to launch a takeover bid for a company last year when it made a $1.8bn hostile offer for US oil group Houston Exploration Company, and worked alongside veteran investor Carl Icahn in calling for a breakup of US media company Time Warner.

The firm moved into the European market last year and took shareholdings in UK-listed companies SurfControl, an IT security company, and estate agents Countrywide when they became bid targets.

This year it has called for Canadian online broker TD Ameritrade to merge, suggesting either online broker E*Trade Financial or Charles Schwab, a US retirement fund provider as a partner.

A UK hedge fund manager focusing on European equities said: “Jana is a big boy in the activist shareholder world. Every equity manager follows its moves closely.”

Rosenstein has argued that he takes action only when he believes it is necessary to protect the value of his fund's investments.