Debt Rattle, February 13 2008

Updated: noon


Ilargi: ”Legal changes would be needed to give the Federal Reserve and the U.S. government the authority to buy stocks.”
Uh-oh..... Better check your wallets and start storing your assets someplace safe, like a deep hole in the ground.

Depression risk might force U.S. to buy assets

Fear that a hobbled banking sector may set off another Great Depression could force the U.S. government and Federal Reserve to take the unprecedented step of buying a broad range of assets, including stocks, according to one of the most bearish market analysts. That extreme scenario, which would aim to stave off deflation and stabilize the economy, is evolving as the base case for Bernard Connolly, global strategist at Banque AIG in London.

In the late 1980s and early 1990's Connolly worked for the European Commission analyzing the European monetary system in the run up to the introduction of the euro currency. "Avoiding a depression is, unfortunately, going to have to involve either a large, quasi-permanent increase in the budget deficit -- preferably tax cuts -- or restoring overvaluation of equity prices," Connolly said on Monday.

"If conventional monetary policy is not enough to produce that result, the government may have to buy equities, financed by the Fed," Connolly said. Legal changes would be needed to give the Federal Reserve and the U.S. government the authority to buy stocks. Currently the Federal Reserve can buy only debt issued by the Treasury, as well as U.S. agency debentures and mortgage-backed securities.[..]

He expects that a depression may be averted, but only by the state and the Fed reinflating the price of such assets. Beleaguered housing, non-government fixed-income securities and even the now overvalued Treasury market have little hope of generating substantial returns for investors over the next few years, he said.

"If we don't avoid depression, the only thing worth holding is cash," he added.

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Ilargi: Attempts in Germany to save IKB look increasingly desperate as they unfold. The government is afraid of wide spread banking panic, probably justified, and coughs up another $1.5 billion, despite fierce protests. Meanwhile, other banks in the country stubbornly refuse to help out. After all, IKB was just another gambler at the securities table, and lost. Why should taxpayers pay for a bank's gambling debts?

Berlin leads third rescue attempt for IKB

IKB, the stricken bank, is to be bailed by the German government which plans to provide €1bn ($1.5bn) out of a €1.5bn capital injection in the third attempt to save the small-business lender from insolvency. The rescue marks the first time the German federal government has stepped in financially to salvage a casualty of the current credit crisis.

IKB was the first German casualty and was bailed out by its shareholders twice to the tune of over €6bn. So far, the state-owned development bank KfW has shouldered the bulk of the burden. The news sparked protests from government and opposition politicians, who accused chancellor Angela Merkel’s coalition of wasting taxpayers’ money in propping up what they described as a discredited public-sector financial industry.

The bailout was unveiled Wednesday night after a four-hour meeting of KfW’s supervisory board. KfW is the largest shareholder in the listed IKB with a 38 per cent stake. In addition to the government’s €1bn participation, unnamed shareholders will provide €500m. The total, however, falls short of IKB’s reported need for a capital injection of close to €3bn to mop up its latest losses.

Peer Steinbrück, finance minister, called on the country’s private sector banks to take part in the rescue, which they have so far refused to do.The banks, however, stand to lose a total of €24bn – according to the finance ministry – from a collapse of IKB, which would trigger a guarantee mechanism designed to spread the burden of a bank failure across the sector. Also unclear Wednesday night was how the government would finance its share of the rescue package. Mr Steinbrück said the money would not be taken out of this year’s budget. A government official said a plan to sell some of the state’s shares in the privatised post office had been dropped in favour of issuing a bond.

Mr Steinbrück is thought to have contemplated letting the bank go under but feared for confidence in the banking system.

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Ilargi: A little reminder for Valentine’s:

Bernanke to testify Feb 14 before Senate panel

Federal Reserve Chairman Ben Bernanke is scheduled to testify on February 14 before the Senate Banking Committee on the U.S. economy and the state of the U.S. financial markets, a source familiar with the matter said on Tuesday.

Treasury Secretary Henry Paulson and Securities and Exchange Commission Christopher Cox also are slated to testify, the source said.

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A triple-A screw up
We’ve gone too easy on the ratings firms

The watchdogs of investment, Standard & Poor's and Moody's Investors Service are tweaking the way they scrutinize securities. At S&P, for instance, no longer will they hand out triple-A's to issuers who pay them boatloads of fees. They now will employ an ombudsman to listen to complaints about the agencies handing out triple-A's to issuers who pay them boatloads of fees.

What if General Motors built cars that didn't run, or your local dairy produced sour milk? What if your bank said it didn't deposit your paycheck because it lost it, or the electric company just quit supplying your neighborhood? Then, in response to it all, those companies said: good news, we're hiring an ombudsman. The ratings agencies in the same fashion have failed on their intrinsic purpose: to judge the likelihood that a debt will default. As of Tuesday they're about 0 for a few billion.

When political mannequin Andrew Cuomo, New York State Attorney General, calls it "window dressing," you know it's not a good plan. "The supposed reforms...are too little too late," Cuomo said in a statement. "Both S&P and Moody's are attempting to make piece-meal change that seem more like public relations." Cuomo's right when he suggests that Moody's, S&P and Fitch Ratings are taking actions that don't go to the heart of the matter. It's a pattern with these guys. Last summer, S&P cast off its chief executive, Kathleen Corbet, after lawmakers criticized the company for its ratings methods.

The big two, S&P and Moody's, have knowingly operated with deep conflicts in how they are paid. Nowhere was this more obvious than its structured-products group, the place where collateralized-debt obligations and mortgage-backed securities were evaluated.Nearly half of Moody's revenue in 2006 came from this side of the business. During the most recent quarter, revenue from structured securities fell by nearly half.

Part of the problem is that ratings -- the three-letter system with pluses and minuses -- just don't fit with structured products. Values of these securities move too fast for ratings firms, which are notoriously slow to react to market changes, to make useful determinations, according to Richard Portes, a professor of economics at London Business School.

A more serious part of the problem was S&P and Moody's didn't just rate the final product. They sold advice on how to structure these securities - the kind that are now responsible for eviscerating the debt markets and nearly pushing U.S. banks into the arms of foreign ownership. That's why the industry can't be counted on to reform itself and why investors need to be willing to foot the bill for independent analysis: profit from the issuer needs to be taken out of the equation.

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MGIC Loses $1.47 Billion in Quarter, Seeking Capital

MGIC Investment Corp., the largest U.S. mortgage insurer, fell the most in a month in New York trading after posting a record quarterly loss of $1.47 billion and saying it hired an adviser to raise capital. MGIC's fourth-quarter net loss was $18.17 a share, compared with a profit of $122 million, or $1.47, a year earlier, the Milwaukee-based company said in a statement today. Excluding investment losses, the insurer lost $18.09 a share, worse than the $8.13 average loss estimate of seven analysts compiled by Bloomberg.

Claims costs, including additions to reserves, surged sevenfold to $1.35 billion, compared with a Jan. 22 company forecast of as much as $1.3 billion. MGIC set aside money for losses on loans that served as collateral for Wall Street securitizations, whose performance "deteriorated materially." "Obviously these financial results are unacceptable," Curt Culver, MGIC's chief executive officer, said during a conference call today. The company has tightened underwriting standards, raised pricing, and by shunning Wall Street deals, expects to avoid "business better lost than insured," he said. Culver, 55, said MGIC has adequate capital to meet its claim obligations.

MGIC said last week it is scaling back coverage in California, Florida, Arizona and Nevada to reduce losses on loans. The insurer is also tightening lending standards in parts of 14 other states. MGIC is reducing coverage in parts of New York including Long Island and White Plains. In Michigan, which had the third- highest foreclosure rate, the company is reducing business in the Detroit area. Other cities affected by the changes include Chicago, Boston, Washington, Denver, Atlanta and Newark, New Jersey, and some of their suburbs.

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Fannie Mae Escrow Grab Exposes Shareholders to 24% Loss in Suit

Fannie Mae, the largest source of U.S. home-loan money, faces a proposed class-action lawsuit over as much as $7 billion it earned on property owners' escrow accounts starting in the 1970s.
The company violated government policy and breached its duty to about 4,000 owners of government insured moderate- and low-income housing, lawyer Mark Lanier claims in federal court in Texarkana, Texas. Fannie Mae should return gains of $3 billion to $7 billion, said Lanier, 47, with the Houston-based Lanier Law Firm. The higher figure is $7.20 a share, 24 percent of the company's market value. Fannie Mae says it acted legally.

U.S. District Judge David Folsom, 60, twice refused company requests to throw out the case. A plaintiffs' bid for class- action status has been pending since 2006, two years after three property owners sued, including Alfred Porkolab, now 93, who built a 36-unit complex in Lorain, Ohio, in 1969. "It's a significant claim against Fannie Mae, which has already been in the spotlight with respect to its fiscal policies and ability to regulate its fiscal operations," said lawyer Francis Riley with the Philadelphia-based law firm Saul Ewing.

Riley, a specialist in real estate law in the firm's Princeton, New Jersey, office, isn't involved in the case. Lanier won the biggest Vioxx jury award against Merck & Co. over the fatal heart attack of a man taking the recalled pain pill. Federal National Mortgage Association fell 45 percent in the past year. It reported a third-quarter net loss of $1.39 billion as a housing slump deepened and mortgage delinquencies increased

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Ilargi: We’ve been following the muni bonds closely, and it gets worse by the day. And I’ll say it again, take a good look: these are facilities such as hospitals, ports and bridges which can’t finance their daily opearations anymore.

Auction-Bond Failures Roil Munis, Pushing Rates Up

A wave of bonds sold by U.S. municipal borrowers with rates set through periodic auctions failed to attract enough buyers in recent days as banks including Goldman Sachs Group Inc. and Citigroup Inc. that run the bidding wouldn't commit their own capital to the debt.

Rates on $100 million of bonds sold by the Port Authority of New York and New Jersey, with bidding run by Goldman, soared to 20 percent yesterday from 4.3 percent a week ago, according to data compiled by Bloomberg. Presbyterian Healthcare in Albuquerque and New York state's Metropolitan Transportation Authority also experienced failures, officials said.

Investor demand for the securities has declined on waning confidence in the credit strength of insurers backing the debt, and on reluctance by dealers to submit bids and risk ending up with too many of the bonds. The failures in a market where local borrowers have more than $300 billion of debt outstanding follow unsuccessful auctions of student loan-backed bonds last week.

"It's the beginning of the end for the auction-rate market," said Matt Fabian, a senior analyst with Concord, Massachusetts-based Municipal Market Advisors. "Banks have stopped supporting the market."

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Ilargi: So far, it’s been relatively quiet on the hedge fund front. It’s the eery kind of silence that you hear before the storm. When they start falling, they’ll do so spectacularly; hedge funds are notorious for their levels of leverage. Losing a mere few percent can mean the end. For now, though it takes a lot of nervous scrambling, they’re mostly able to find financing. But a lot of that can be found in the 24% growth number in the derivatives trade, which indicates playing double or nothing at the casino. Hedge funds are so secretive, nobody know how much is at stake. It certainly runs into the trillions.

Bad Bets and Accounting Flaws Bring Staggering Losses

Mark S. Fishman was a modern prince of the markets — a pedigreed money manager who raised billions of dollars at the height of the hedge fund boom. But last week his dream collapsed. Hobbled by bad trades in the credit markets, Mr. Fishman began to shut the fund he helped found, Sailfish Capital Partners, which oversaw $2 billion just six months ago, investors said.

On Monday Mr. Fishman, 47, sat in the paneled Princeton Club of New York, explaining what it was like to battle the markets — and lose. “It feels like someone has died,” Mr. Fishman said, his eyes welling up. “We’ve disappointed people, and there is no one more disappointed than me.” Mr. Fishman is not the first hedge fund manager to run into trouble — and he certainly will not be the last. After years of explosive growth, this secretive, sometimes volatile corner of the financial world is entering a dangerous new era. The running turmoil in the markets is stirring fears that more of these funds will fail, some, perhaps, spectacularly.

“This will be the year with the highest number of hedge fund failures given the huge number of new and untested hedge funds,” said Bradley H. Alford, founder of the Atlanta-based Alpha Capital Management, an investment advisory business. “Last year there were some easy trades: short financials, short subprime, long non-U.S and emerging markets. This year there’s no clear trend and no safe place to hide.” So far few funds have suffered the same fate as Sailfish Capital. But the signs are troubling.

The average stock-picking hedge fund sank 4.1 percent in January. While that tumble was not as steep as the one taken by the broad stock market — the Standard & Poor’s 500-stock index was down 6 percent — it nonetheless represented the hedge fund industry’s worst showing since November 2000. Few of the investment strategies employed by these funds made money.

Big-name funds are suffering. David Slager and Timothy R. Barakett, who run the Atticus European Fund, lost more than 13 percent, and Lee Ainslie, who heads Maverick Capital, lost 9 percent through Jan. 25, according to SYZ & Company, which tallies hedge fund returns. (Compare that with 2007 performance when the funds returned 27.7 percent and 26.9 percent, respectively.)

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Fed Interest-Rate Cuts Fail to Lower Borrowing Costs

The Federal Reserve's interest-rate cuts last month have failed to lower borrowing costs for many companies and households, increasing the chance of further reductions from the central bank. Companies are paying more to borrow now than before the Fed reduced its benchmark rate by 1.25 percentage point over nine days in January, based on data compiled by Merrill Lynch & Co. Rates on so-called jumbo mortgages, those above $417,000, have increased in the past month, making it tougher to sell properties and risking further price declines.

"It's the clogging up of the credit markets that worries me most," Harvard University economist Martin Feldstein said in an interview in New York. "The Fed has done a lot of cutting, the question is whether it's going to get the traction that it did in the past." Banks and investors are demanding greater compensation for offering credit as losses mount on subprime-mortgage securities and concerns grow that ratings of bond insurers will be cut. Elevated borrowing costs mean Fed Chairman Ben S. Bernanke will have to reduce rates further to revive the economy, Fed watchers said.

"The problem is that every piece of news we're getting continues to be bad," said Stephen Cecchetti, a former New York Fed bank research director, and now a professor at Brandeis University in Waltham, Massachusetts. "They will have to ease more. It's the only thing they can do."

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Black Swan: LBO Debt Writedowns to Rise, Bank of America Says

Citigroup Inc. and seven other top investment banks may need to write down at least $15.1 billion on unsold loans and bonds for leveraged buyouts in their first quarter earnings, according to Bank of America Corp. analysts.As prices of high-yield debt continue to fall this year, banks including Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley and Merrill Lynch & Co. may have more writedowns for $157 billion of loans and bonds than they did in the third- quarter, analysts led by New York-based Jeffrey Rosenberg wrote in a research note yesterday.

Bonds waiting to be sold "have moderated since the beginning of the credit market turmoil in the summer of last year, but the digestion of pipeline deals has taken the market longer than originators had previously planned and hoped," the analysts wrote.
The value of high-risk, high-yield loans fell to a record low yesterday amid speculation banks will have to sell assets included in collateralized loan obligations, according to traders of credit-default swaps. The benchmark Markit LCDX Series 9 index of 100 U.S. loan credit-default swaps fell 0.4 point to 91.05 and earlier reached 90.8, the lowest since the latest series of the index started in October, according to Goldman Sachs.

The Markit iTraxx LevX Senior Index of credit-default swaps on 26 loans in Europe fell 1.18 to 90.5, according to Bear Stearns Cos., the lowest since the index started in October 2006. A level below 100 indicates loans are worth less than face value.
The amount of unsold dollar-denominated leveraged loans fell to $148.2 billion as of Feb. 7 from $237.2 billion at the end of July, while the high-yield bonds pipeline dropped 36 percent to $74.1 billion, the analysts at Charlotte, North Carolina-based Bank of America said. The analysts used the "black swan" analogy in describing the sharp fall of leveraged loan prices. The term refers to the surprise of a rare event, such as seeing a black swan when the birds are generally assumed to be white.

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Scrap heap for financial models

It is now clear that the credit crunch was not due simply to bull market over-optimism, but resulted very largely from the failures of a number of the financial models that have been a staple of the last generation. As the crunch spreads its malign tentacles ever wider into every corner of global economic life, the dust of collapse after collapse isn’t even beginning to clear. However there are now coming to be things one can usefully say about those models, and about the assumptions on which they were based.

From what appeared to be a modest glitch in the mortgage market, the damage to the world of financial modeling is ever-extending, and has now come to be surprisingly widespread, involving huge swathes of modern financial theory:

• Subprime mortgages turned out to be correlated with each other, so that securities apparently rated AAA were in reality dangerously concentrated in a particular sector of the market that could and did collapse.
  
• That also blew out the theory surrounding monoline insurance, that a well capitalized insurance vehicle could insure debt representing a large multiple of its capital base, without its bond rating or profitability coming into question.
  
• Then there was asset backed commercial paper, under which commercial paper of short term maturity was issued by a shell company against the backing of financial assets of a long term maturity, and through this means removed from a bank’s balance sheet – it turned out that in a financial crisis the funding for these vehicles dried up.
  
• Finally, credit default swaps are showing signs of strain, and may have turned out to have concentrated risk in unsuitable hands rather than spreading it as had been promised for them. In particular the counterparty problem in the CDS market becomes acute when defaults rise to a substantial level and declared debt ratings turn out to be unreliable.

As well as the instruments themselves, their risk management turns out to have been flawed. Value at Risk, the paradigm of risk management systems, recognized by the Basel II system of bank regulation and incorporated into it, has proved to be almost entirely useless – like rain-proofing that works well in a light shower, but falls apart completely in a heavy storm.  The central assumption of VAR, that if you have measured and capped the moderate risks, then extreme risks will also fall into line at only a modest multiple of the moderate ones, has been proved wrong. In reality, if a particularly risk class goes wrong, it is capable of destroying an arbitrarily large amount of value.

The hapless David Viniar, Chief Financial Officer of no less an institution than Goldman Sachs, who announced last August that he was “seeing things that were 25 standard deviation events, several days in a row” had in reality announced to the market that Goldman Sachs’ risk management systems were so much waste paper, or, more likely, junk software. 25 standard deviation events should happen once every 100,000 years; if you think you are seeing them several days in a row, you are merely proving that in reality you have no idea of the characteristics of the risks you are supposedly managing.

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More Ponzi Finance Dilemmas

Increasingly we are getting clues about the real versus fictitious market. The real market (our primary focus) tends to show up when various Ponzi finance issuers attempt go ashore for fresh supplies from the natives. The Riskloves are in retreat, Aunt Millie is broke (see chart, cash in bond funds) , and interest in crap is not forthcoming. Notice the lack of transparency from College Loan. This also reflects the tokenism of their strategy: collect fees upfront and smile alot.

College Loan Corp., a San Diego- based lender, said some bonds it issued with rates determined through periodic auctions failed to attract enough bids. The company wouldn’t say which specific issues failed or identify the banks that managed the auctions. Demand for bonds in the $360 billion auction-rate securities market is waning on investor concern that dealers who collect fees for managing the bidding on the bonds won’t commit their own capital to prevent failures. Reduced appetite for auction-rate debt in the municipal market also reflects expectations that the credit strength of insurers backing the securities may deteriorate.”

Aunt Millie’s Bond Fund:

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Ilargi: Reading a story like the one below, we can clearly see what kind of society we live in, in particular what the moral standards are. There are none. The people who squeeze 400% annual interest out of the elderly who depend on Social Security, should be drawn and quartered in a public spectacle. And so should every politician, including the hapless twits that many of you will vote for this year, who, by not doing the job they were elected for, and making sure that their legislative powers are used to stop this criminal behavior, are accomplices to heinous crimes, each and every one of them. No society deserves to stand that encourages preying on its weakest members. If we allow this, we might as well start selling our new born babies for lab research, just so everyone can clearly see what our standards are..

High-Interest Lenders Tap Elderly, Disabled

One recent morning, dozens of elderly and disabled people, some propped on walkers and canes, gathered at Small Loans Inc. Many had borrowed money from Small Loans and turned over their Social Security benefits to pay back the high-interest lender. Now they were waiting for their "allowance" -- their monthly check, minus Small Loans' cut.

The crowd represents the newest twist for a fast-growing industry -- lenders that make high-interest loans, often called "payday" loans, that are secured by upcoming paychecks. Such lenders are increasingly targeting recipients of Social Security and other government benefits, including disability and veteran's benefits. "These people always get paid, rain or shine," says William Harrod, a former manager of payday loan stores in suburban Virginia and Washington, D.C. Government beneficiaries "will always have money, every 30 days."

The law bars the government from sending a recipient's benefits directly to lenders. But many of these lenders are forging relationships with banks and arranging for prospective borrowers to have their benefits checks deposited directly into bank accounts. The banks immediately transfer government funds to the lenders. The lender then subtracts debt repayments, plus fees and interest, before giving the recipients a dime. As a result, these lenders, which pitch loans with effective annual interest as high as 400% or more, can gain almost total control over Social Security recipients' finances.

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Ilargi: What’s happening in Europe is truly scary. Spain’s banking system would be belly-up without ever larger infusions from the ECB, based on shady collateral, for which nobody is in any hurry to require realistic valuation. How many of the 27 member countries can, and must, the ECB play this trick with?

Spanish banks' reliance on ECB surges with €44bn borrowing

The European Central Bank has effectively funded new lending in Spain in recent months, replacing banks' use of wholesale capital markets, which have been strangled by the global credit crunch. Spanish banks doubled their share of the ECB's weekly funding auctions in the final quarter of last year, taking their borrowing up to €44bn in December from a running average of about €20bn over the previous 15 months, according to the most recent data from the Bank of Spain.

This extra lending from the ECB of almost €24bn outstrips the quarterly amounts raised previously by Spanish banks from securitisation markets, which is an important comparison because the banks have increasingly used mainly mortgage-backed securities as collateral with the ECB. The market for securitised debt and for mortgage-backed bonds in particular has been almost entirely shut since the credit crunch hit last summer and investors began shunning complex, structured debt. The Spanish banking system is second only to the UK in Europe in its use of mortgage-backed bond markets and other securitisations to fund lending.

However, the Bank of England did not accept mortgage-backed debt as collateral in similar lending operations until after the run on Northern Rock. The big difference is that European banks must re-raise this funding every week and the mortgage-backed bonds pledged at the ECB will have to find their way to the capital markets eventually, which many analysts say could mean markets such as Spain are potentially storing up problems for the future.

While markets for securitised debt remain closed, it is difficult to put a price on uropean mortgage-backed securities, and banks in the region can be much slower to mark down the value of holdings of such bonds. By accepting them in exchange for cash, the ECB may be delaying the repricing of risk that analysts believe is necessary for the orderly resumption of markets in such debt.

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Ilargi: The article below is from the Times in England. It’s well written and researched, but still I wonder why they focus on the US, and how they see the vicious circle that trapped the UK.

The vicious circle that trapped America

In these grim times, one of the few sources of optimism about the outlook for the US economy has been the idea that, thanks to lower interest rates, financial conditions are getting a lot easier. According to economic theory and common sense (not always the same thing), that should mean that over the next year or so — these things tend to work with a bit of a lag — demand will recover as businesses and consumers are attracted by lower interest rates to borrow more money. It is the basic assumption that is underpinning the view that, even if the economy is in recession, growth should accelerate later this year.

But what if, despite the Federal Reserve's 225-basis-point reduction in interest rates over the past five months, financial conditions are actually still getting tighter? How much further damage might there be to the economy then? The credit crunch induced by the sub-prime mortgage debacle was supposed to be easing by now. Yet there are increasingly worrying indications that it might be getting worse.

The economists at Citigroup in New York compute an index of overall financial conditions in the economy that measures not only official interest rates but all kinds of variables, such as asset prices, credit spreads and other exotica. The latest Citigroup index shows that there has been a sharp deterioration in conditions since the Fed began to cut rates last autumn. Back in October, at what was then thought to be the worst moment in the credit crunch, Citigroup's index suggested that conditions overall were about neutral — neither stimulative not accommodating. Last week the index had dropped to its most negative level in more than five years.

Despite the rate cuts, Robert DiClemente, Citigroup's chief US economist, estimates that the index is consistent with an 80 per cent probability of a recession. How can this be, given that interest rates are much lower — not only official rates but ten-year bond yields and most other market rates? The problem is that conditions are deteriorating on so many fronts that the official interest-rate cuts have been overwhelmed by negative movements elsewhere. Equity prices have declined, raising the cost of capital for businesses. Falling property prices have significantly eroded the value of household balance sheets.

And then, of course, there is the blunt reality of the credit crunch — the increasing reluctance of banks to lend money, even to relatively creditworthy customers. Last week the Fed published its quarterly survey of lending officers at commercial banks around the country. Almost one third of these lenders said that they had tightened their credit standards for loans to all categories of business customers — small, medium and large.

More intriguing was the reason these bankers gave for their greatly reduced willingness to advance loans. It was not, they said, because of any capital or liquidity concerns at the bank itself, but primarily because of rising concerns about economic conditions that could adversely affect the borrowers' ability to meet their obligations. This suggests that the economy may now be in the grip of a vicious circle. The initial credit tightening from last autumn seems to have led to a sharp drop in confidence and a slowing in economic activity. But this, in turn, has made lenders much more reluctant to extend loans, even to high-quality borrowers.

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Urban home foreclosures surge in '07

Home foreclosure filings surged in the largest metropolitan areas in the United States during 2007, with cities in California, Ohio, Florida and Michigan reporting among the highest rates in the country, real estate data firm RealtyTrac said on Wednesday. The U.S. foreclosure rate of households in the top 100 metropolitan areas was 1.38 percent and the total number of foreclosure filings rose 78.2 percent last year to 1.775 million, said RealtyTrac, an online market of foreclosure of properties, in its Year-End 2007 Metropolitan Foreclosure Market Report.

Fifteen of the metro areas with the top 20 metro foreclosure rates were located in four states: California with six; Ohio with four; Florida with three and Michigan with two, the report said. "As expected, the number of properties entering some stage of foreclosure in 2007 was up in the vast majority of the nation's 100 largest metro areas, with 86 metros reporting increases from 2006," James Saccacio, chief executive officer of RealtyTrac, said in a statement.

Most of the metropolitan areas with the highest foreclosure rates were places like Stockton, California and Las Vegas, which experienced meteoric growth and unsustainable price appreciation over the past few years, or cities such as Detroit, which have undergone a widespread economic downturn with higher unemployment rates, he said

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Homes in Bubble Regions Remain Wildly Overvalued

If you own a home in a former bubble region like California or southern Florida, there's bad news… and really bad news. And they suggest that it is still way too early to go bargain hunting in these markets, although -- of course -- there is always the occasional deal around. The bad news is fresh market data published Monday night by real-estate Web site Zillow.com. They show prices, as expected, kept slumping through the end of last year.

But the really bad news is that, even after a year of misery and falling prices, homes in many of these regions still aren't cheap. They remain wildly overvalued compared to average personal incomes. There is a strong long-term correlation between the two figures. And in many regions, house prices would still have to fall a very long way to get back into line. How far? Try around a third in Florida and Arizona -- and closer to 40% in California. Yes, from here.

Even if house prices stabilized, it would take a decade or more for rising incomes to catch up. The data on median house prices and per capita personal income in these states have been tracked by Karl Case, economics professor at Wellesley College. (He is one half of the duo behind the closely-watched Case-Schiller real estate index).

Professor Case's numbers ran through the end of the third quarter. I decided to see how they might look today, using Zillow's data for the fourth quarter. The company hasn't posted statewide data, but the price falls across the many cities it tracks give a pretty strong picture. From these I assumed, for the sake of calculations, that California prices fell 8% last quarter from the third quarter, a huge number by historic measures but not out of line with Zillow's data. For Florida and Arizona I assumed declines of 5% and 5.5%. You could use other, more modest estimates for the recent declines: They won't change the outcomes much.

The results? In all three markets, the prices are well off their peaks when compared to incomes. But they remain far above historic averages. Median prices in California peaked in 2006 at 13.3 times per capita incomes. Hard to believe, but true. They may be down now to about 11.1 times. But that's still way above the ground. Throughout most of the 80s and 90s they ranged between six and seven times incomes. Just to get down to seven times incomes, prices would have to fall 37% tomorrow.

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Ilargi: See, now I think that when a company calls a $5 billion loss “not material”, there’s something really wrong with it. We’ll see later this month. The auditor seems unwilling to play hide and seek with the numbers any longer. Apart from the whole numbers game, isn’t it stunning that the world’s largest insurer was a material player at the derivatives crap table? Gambling with other people’s money, a recipe for mayhem.

AIG Says Potential Derivatives Loss Not Material

American International Group Inc on Tuesday moved to calm investors shaken by its earlier disclosure that derivatives losses could more than triple to about $5 billion, a development that earned it a rebuke from its auditor for a "material weakness" in internal controls. AIG, the world's largest insurer, said in a statement on Tuesday that the size of any write-down was not expected to be material to the company. AIG shares gained 4 percent to $46.60, after falling nearly 12 percent on Monday to the stock's lowest level in five years.

Investors pushed the shares down on Monday, after AIG disclosed in a regulatory filing that its mark-to-market unrealized losses on a credit default swap portfolio within its AIG Financial Products unit were expected to be about $4.88 billion through November, compared with an earlier indication of a loss of up to $1.5 billion.
The loss could wipe out AIG's fourth-quarter earnings, some analysts said.

AIG, which is expected to release quarterly results later this month, has not yet disclosed whether it saw further deterioration in December. "The valuation adjustment as of Dec. 31, 2007, is likely to be significant, and will likely cause AIG to report an accounting loss for the quarter," S&P credit analyst Rodney Clark said.

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Bonds slip as safe-haven bids ease before data

U.S. Treasury bond prices slipped on Wednesday, as traders pared safe-haven bond positions ahead of a government report on retail sales which offers a snapshot on consumers and the overall economy.

Appetite for U.S. government debt was also suppressed by demand for U.S. equities, as traders weighed the impact of billionaire investor Warren Buffett's proposal to reinsure $800 billion in U.S. municipal bonds.
"It's a follow-through from Tuesday. There's a bit more money committed to equities," said Georges Yared, chief investment officer at Yared Investment Research at Wayzata, Minnesota.

On Wednesday, Treasuries sagged and stocks rallied on Buffett's plan, which initially eased fears of the impact from a potential credit rating downgrade of bond insurers and the securities they guarantee. However, bond losses and stock gains dwindled as doubts emerged whether Buffett's offer would benefit the banks and financial companies that hold securities backed by bond insurers. Lingering fears about a U.S. recession also pulled stocks from their Wednesday peaks.

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MBIA, Ambac Bond Risk Jumps as Buffett Offer Shuns 'Toxic' Debt

The risk of bond insurers MBIA Inc. and Ambac Financial Group Inc. defaulting rose after billionaire Warren Buffett offered to assume responsibility for $800 billion of municipal debt, excluding subprime-linked securities. Credit-default swaps on Armonk, New York-based MBIA rose to $1.75 million upfront and $500,000 a year to cover $10 million of debt for five years, from $1.6 million in advance yesterday. Contracts on New York-based Ambac rose to $1.75 million upfront from $1.5 million, according to CMA Datavision. The contracts trade upfront when investors see a risk of imminent default.

Buffett is attempting to take advantage of bond insurers as they seek to raise capital and avoid downgrades to their AAA credit ratings. Buffett's Berkshire Hathaway Inc. plans to insure municipal debt for 1.5 times the premium charged by the bond insurers to take on the guarantee and will put up $5 billion of capital, he said in an interview with CNBC television. "It's taking away their cash cow and leaving them with the toxic waste," said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California.

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Warren the Munificent

No offense to Warren Buffett: All predators should be as gifted in cloaking themselves in a folksy demeanor. He yesterday offered to sell a bunch of troubled municipal bond insurers backup insurance for their municipal bond pools. He no doubt is charging an arm and a leg for insurance of that which hardly needs insurance, because he can.
Municipal bonds seldom if ever default. But the existing insurers who stand behind such bonds now are in trouble thanks to the other dodgy subprime business they dabbled in. Hence Mr. Buffett's opportunity, the announcement of which was implausibly credited with lifting the Dow 200 points at its peak yesterday.

Let's pause, however, to consider how some crazy rules helped inadvertently bring him his present opportunity -- and put the world seemingly on the brink of financial chaos. In the abstract, of course, neither bond insurers nor bond raters should exist. The market ought to be able to assess and price bond issues efficiently itself, leaving no profit opportunity for raters and insurers. But this overlooks "information costs." In effect, a triple-A insurer turns every bond issuer into a triple-A issuer, and does it more cheaply than the bond issuer could do it for himself. Thousands of towns and cities don't have to spend time and money advertising their bona fides to investors. Investors don't have to pore over credit reports on thousands of towns and cities.

Hooray for an efficient market solution. Or it would be an efficient market solution if participation by all parties were voluntary, therefore conditioned by appropriate skepticism. Unfortunately the kink in the great chain of being here is supplied by various government rules that require many large pension funds and other institutions to hold only bonds that receive an "investment grade" rating. Current upshot: If the rating agencies downgrade the bond insurers, they effectively downgrade thousands of municipal bonds, meaning many holders no longer would be legally eligible to hold them. That's where we are today.

Enter Mr. Buffett, who offers to solve the problem in his own way, no doubt hoping regulators will quietly pressure the big bond insurers to acquiesce in his proposal to take their bread-and-butter muni business away from them, leaving them to sink into the mire along with their remaining subprime bets. How much money is at stake? Mr. Buffett says his head-in-the-bed offer to the three biggest bond insurers covers some $800 billion in municipal issues.

We should quickly note that he's not offering to solve the problem for many banks that own mortgage-backed securities also insured by the bond insurers -- but these banks have already shown themselves capable of facing up to their losses. Whether they do so indirectly by recapitalizing the insurers or by taking charges on their own books may not be a pregnant distinction. Besides, there's always Abu Dhabi.

But let's spare a moment for what's really the core problem here: "underwriting," and government's contribution to the undermining thereof. "Underwriting" means careful assessment of credit risk by lenders who have money at stake. When it comes to many of the biggest funds, however, government rules encourage them to defer to the judgment of rating agencies. Further complicating matters are rules requiring banks and other institutions to value their holdings at daily market prices -- even if the market price is temporarily zero for an income-producing asset that continues to produce income.

Somehow we have to get back to a world where people are directly responsible for the risks they take, and where they are using real judgment rather than following cookie-cutter rules, then turning to government to save the day because, after all, government is author of the rules. The current system also put the raters in an impossible position. Now they have to worry that any downgrade that forces some institutions to sell their holdings may drive other clients into insolvency, a dynamic that motivates all concerned to adopt an attitude of make-believe.

As we and many others have pointed out, banks are unique among business enterprises in their ability to bring low entire economies. To date, the latest test of this theorem has not provoked the global recession that many fear. But unless government figures out how not to be responsible for so much risk taking, sooner or later the boomerang will catch us in the face.

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Exxon Gets $242 Million by Delaying Venezuela Notice

Exxon Mobil Corp. waited 24 hours to inform Venezuela's state oil company of a court order freezing a New York bank account, a tactic that netted $242 million. The world's biggest oil company postponed serving the order to block the account until Venezuela freed up the money on Dec. 28, according to a Jan. 24 federal court filing in New York. Ninety minutes after Exxon Mobil received its wire transfer, the company notified Venezuela of the Manhattan judge's ruling that suspended the account.

The New York court order awarded a day earlier was one of four decrees Exxon Mobil obtained in the past seven weeks that locked up more than $12 billion of assets held by Petroleos de Venezuela SA. Venezuela's state oil company responded yesterday by cutting off sales of crude and refined fuels to Exxon Mobil. Exxon Mobil's "conduct is a classic example of unclean hands," Joseph Pizzurro, a lawyer with Curtis, Mallet-Prevost, Colt & Mosle LLP in New York who represents Venezuela, said in the Jan. 24 filing. "Not only is it a breach of contract, it is bad faith, plain and simple."

Exxon Mobil sought the freeze orders to keep Venezuela from shifting assets out of the reach of an international arbitration commission that's handling claims against President Hugo Chavez's government for last year's takeover of an oil field. Irving, Texas-based Exxon Mobil won court orders tying up assets in the U.S., the U.K., the Netherlands and the Netherlands Antilles. Company spokeswoman Margaret Ross declined to comment beyond a three-paragraph statement issued last week announcing the decisions and saying the company was seeking to recover damages for breach of its project agreements.

The Bank of New York account held payments for oil from the Cerro Negro field in an area of eastern Venezuela called the Orinoco Belt. Money from the account was used to repay debts, and Exxon Mobil and state-owned Petroleos de Venezuela shared what was left over, Pizzurro said in the court filing. Exxon Mobil abandoned the Cerro Negro project in 2007 rather than consent to a government seizure that would have reduced the company's profits and role in the operation. The nationalization triggered default covenants on $900 million in bonds and bank loans, at first preventing Venezuela and Exxon Mobil from withdrawing funds from the account. The company estimates that its $750 million investment in the country is now worth $12 billion because of rising crude prices.

Venezuela retired the Cerro Negro debt at 2:40 p.m. on Dec. 28, and the Bank of New York wired Exxon Mobil's $242 million share of the remainder to a Citigroup Inc. account, according to the filing. At 4:10 p.m., Exxon Mobil served the freeze order on Petroleos de Venezuela, the documents show. Waiting a day to tell Petroleos de Venezuela earned Exxon Mobil about $10 million an hour, almost double the company's pace of profits in last year's fourth quarter. Pizzurro accused Exxon Mobil of "duplicity" by supporting the debt redemptions without telling Venezuela of its pending legal complaint.

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A baby-boomer bubble is forecast

The common perception among economists is that the current housing mess will be a relatively short-term affair that should see a return to normalcy within the next few years. But, according to a new study by two USC researchers, problems of greater proportion lie just ahead. They call it the "generational housing bubble" and maintain that it will be fueled by the same baby boomers who have been bidding up prices since 1970 as they moved up the housing ladder.

Now, 78 million boomers are about to enter their twilight years when homeowners tend to become sellers rather than buyers. And as a result, the USC duo expects there will be "many more homes available for sale than there are buyers for them." As the elderly become more numerous than the young, and shift into seller mode, the researchers postulate, the market imbalance could come quickly around 2011, causing housing prices to fall.

Only time will tell whether the projections by Dowell Myers, a professor of urban planning and demography in USC's School of Policy, Planning and Development, and Sungho Ryu, a doctoral candidate at the school and an associate planner with the Southern California Assn. of Governments, will come to pass. After all, not all seniors retire or sell their homes and move to smaller places. Many prefer to age in place and live in their own homes. But eventually, as they die off, most of their homes will come on the market.

Myers and Ryu's foreboding prophecies bring to mind a 1989 study by a pair of Harvard economists, who predicted a 47% decline in housing prices during the 1990s because boomers would stop buying as they aged. Housing-industry economists lambasted that forecast as pure poppycock, and it eventually went up in smoke. The USC researchers don't expect the generational correction to begin until 2011 or so. That's just about the time the most pessimistic prognosticators suggest the U.S. market will return to normal after five years or so on the rocks.

But it's also when the first wave of boomers reaches age 65, the traditional dividing point between seniors and working adults. And once that tipping point is reached, Myers and Ryu say, they will put more houses up for sale than the market will be able to absorb.

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Ilargi: This one is for the people out there who look around and think that everything is still fine. Just go through that list and realize this hasn't even started for real.

Retailers Taking Their Medicine and Turning Cautious Over Growth

CoStar Advisor: Is 2008 an opportune time for retailers to close stores and pull back on expansion plans?

Nina Kampler, Executive VP of Strategic Retail and Corporate Solutions for Hilco Real Estate, said,

"Absolutely. This is the largest number of retailers who have announced store closings in my professional experience. I think we're at the beginning of the downtrend in the retail economy. There's a wave of conservatism that's hitting the consumer: there are very few people who 'need' another t-shirt or pair of jeans right now. So even if a retailer's core stores still perform okay, their stores are nonetheless likely comping down against last year's sales. So, they respond by examining the bottom 10% or 15% of stores, the underperformers that are not adding to the bottom line, and they're going to get rid of those -- in some cases that means getting rid of an entire concept."

Announcements over the last couple months include Movie Gallery closing another 400 stores; Charming Shoppes closing 150 stores and cutting expansion plans by 50%; Starbucks closing 100 stores and slowing expansion plans by 34%; Ann Taylor shuttering 117 stores and slowing store growth; Boston Market evaluating its real estate opportunities; Buffet Holdings sorting out its underperformers; Sprint Nextel closing 125 stores and 4,000 distribution points; Cost Plus World Market closing 18 stores; Liz Claiborne closing 54 Sigrid Olsen stores; New York & Company axing the Jasmine Sola brand and its 32 stores; Ethan Allen closing 12 stores; PacSun closing all of its 173 demo stores; and Talbots exiting its kids and men's lines through closure of 78 stores.

Others include Rite Aid exiting Nevada by closing 28 stores; Macy's closing nine stores; Krispy Kreme expecting many franchisees to close stores; Kirkland's Home likely closing 130 stores; CompUSA's remaining 103 stores being disposed of; Rent-A-Center closing 280 stores; Sofa Express closing 44 stores in bankruptcy; 84 Lumber closing 12 stores; Home Depot closings some call centers; Levitz Furniture disposing of 76 stores in bankruptcy; Pep Boys closing 31 stores; Lifetime Brands closing 30 stores; Big A Drugs liquidating its 21 stores; and more.

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