Debt Rattle, February 15 2008

Updated 3.18 pm


Ilargi: I don’t believe that what I’ve seen so far about this article truly appreciates the content. The very first thing I thought when reading it was: if and when hedge funds start to be worried about bank failures, and among prime brokers to boot, we should all sit up and pay attention.

Somewhere in there hides a wild-'n-out indication of how much Wall Street has deteriorated into a sleazy greasy two-bit cheap whore gambling house that would have made Bukowski envious, its upholstery ridden with the poignant odor of lysol and stale alcohol, covered in cigarette burn marks, with a full-blown wardrobe of stained dresses carelessly tossed into its many dark corners, and above all scared to see the light of day.

Hedge funds call banks to account

Call it the final indignity for banks: their hedge fund customers, generally regarded as the most hazardous financial operators, are questioning the creditworthiness of their prime brokers. Some of the world’s biggest hedge funds have reviewed agreements with their bankers, assessing whether assets and cash left with the prime brokers are safe.

Hedge funds, bankers and advisers say this has seen a shift in assets away from those banks regarded as riskiest following multi-billion dollar write-offs – bad news for the banks given the high profitability of prime broking. “It is quite paradoxical,” said Angelos Metaxa, a director of CM Advisors, a $3bn [€2.05bn] Geneva-based fund of hedge funds. “In August, everyone was worried about a hedge fund blowing up, but now they are worried about a bank blowing up and taking a few hedge funds with it.”

Hedge funds rely on prime brokers to provide financing and to act as custodian for their investments. But their exposure if there was a collapse depends on how their agreements are structured. So-called “rehypothecation” – when legal ownership of the assets rests with the bank, rather than the hedge fund – is now being re-examined by the funds. The move is being accelerated by pressure from investors, many of whom have begun to question the managers of the funds they invest in about the risks they may be running.

One of London’s largest managers said it had been grilled at length by the directors of its hedge funds about bank risk, and had moved some assets between prime brokers as a result. Robert Sloan, a managing partner of S3 Partners, a New York financing specialist, said: “I don’t think the hedge funds are the ones taking the risk [of a bank failure] seriously – but their investors are making them take it seriously.”

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When It Rains It Pours. Put On the Tin Foil Hats

“AAA” rated mortgage insurer, FGIC was downgraded yesterday, and when it rains it pours, in this case six notches, with the senior bonds going to junk status. One has to ask the obvious question: how can an outfit be AA2 one day, and junk the next? Perhaps the sudden realization that an obscure tin foil hat blog was right all along?

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Countrywide delinquency rate hits 7.47%

Countrywide Financial, the nation's largest mortgage lender, says delinquencies and foreclosures continued to rise in January. Delinquencies in Countrywide's servicing portfolio increased to 7.47% in January, up from 7.2% the previous month and 4.32% in January 2007.

Loan servicers collect mortgage payments and distribute them to the owners of the mortgages. Foreclosure rates as a percentage of unpaid principal balance increased to 1.48% in January, up from 1.44% in December and 0.77% in January 2007.

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Mortgage bankers, bank branches surrender licenses

At least 56 mortgage bankers gave up their New York licenses last year, more than double the 22 in 2006, and almost 700 branch licenses were surrendered, compared to 256 the year before, according state banking department data requested by Newsday.

The mortgage crisis fallout accounted for at least 270 out of the 750-plus surrendered licenses, including about 20 companies that filed for bankruptcy just before the subprime collapse last summer or experienced heavy financial losses afterward, banking officials said. Companies that went out of business include American Home Mortgage, based in Melville, and the California-based New Century Financial Corp., which was one of the nation's biggest subprime lenders. The annual license review, expected to be finished in a few weeks, will determine the net effect of new and surrendered licenses and break them out by region, partly to look for trends.

"It would provide the department with at least a basis for discussing whether or not there is some need to change certain policies or a need to handle certain companies differently," said Rholda Ricketts, deputy superintendent of banks. Behind the data lies a complex picture. Some lenders may have given up licenses as part of mergers. Certain branches may have closed, not because the lenders were failing, but because they were relocating, moves that require new licenses.

Ricketts said she was not surprised by the number of lenders that dropped out and noted that the closure of larger companies in 2007, including several headquartered out of state, accounted for the higher number of branch licenses dropped. "The companies that surrendered this time around were larger branch networks," Ricketts said

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The Hidden Costs of The Auction Failures

Unless you are in private wealth management, the term “auction rate securities” might be new to you. But over in the private wealth group, they’ve been treating these things as if they were cash. Clients were funneled into the bonds and told they were the most liquid investment short of actual cash. But yesterday the bond auctions failed in a dramatic fashion, leaving many investors in illiquid positions.

All that you can read in the Wall Street Journal today. But what the Journal doesn’t explain is that this investor liquidity is already having repercussions in the broader marketplace, including the stock market. Many individual investors would use the proceeds from the auction of their bond holdings to purchase equities. Now that they are locked into the bonds, they are effectively frozen out of the stock market. Brokers have told DealBreaker that many clients simply will not be able to purchase stocks until the market for auction rate securities begins operating again, and they expect this lack of purchasers will have a depressive effect on stock prices.

The situation could deteriorate further. Investors who need liquidity might be forced to sell stock, or refrain from making major purchases—such as homes. So far most of the attention of market watchers has been focused on the direct effects of the auction failures. But if this doesn’t turn around soon, there could be major financial consequences.

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Ilargi: We can all do 1+1=3 without using a calculator. Look: the US government plans to massively increase its debt issuance (bonds, securities). In doing this, it will push local governments, companies and utilities even further to the wayside of that market, where they can already barely survive, which severely threatens their daily cash flow.

The result will be large scale problems, even defaults, in these smaller "units”. Another result in the present market is that the US government, if it really needs to sell all that paper, will have to pay much higher interest rates, just like Citigroup to Abu Dhabi, and the smaller players in today’s debt market. 15%-20% are no longer exceptions.

Just a thought: you think the US government will buy insurance for their issued debt? From whom?

And another thought: the same principle will show up when it comes to making up for lost tax revenue: the Federal Government will take their share of inevitable tax increases first, leaving the scraps falling of that table for local governments.

US Treasury, agency debt issuance to explode - UBS

Issuance of top-rated debt sold by the U.S. government and its chartered enterprises, such as Fannie Mae and Freddie Mac, will soar through 2009 to finance a ballooning federal deficit and the housing market, UBS Securities analysts said on Thursday.

The combination of an economic recession and the costs of President George W. Bush's stimulus plan will probably widen the deficit by 145 percent to $400 billion in 2008 and 2009, UBS strategist William O'Donnell said on a conference call. This will create a sea change in the supply of Treasuries just as investors appear to be chock full of the debt, he said.

"Recessions are absolutely toxic to budget deficits in the U.S.," O'Donnell said. "Growth drives tax receipts which drive budget deficits which drive Treasury borrowing. The links in that chain are pretty tight." The Treasury will probably begin increasing the size of its note auctions instead of relying mostly on short-term bills, he said. It will likely reinstate issuance of one-year Treasury bills and three-year notes, which it only just eliminated from its quarterly refunding last year, he added.

Investors will also be faced with net issuance of $114 billion in debt from government-sponsored enterprises Fannie Mae, Freddie Mac and the Federal Home Loan Bank system as lenders rely on the GSEs for mortgage funding, UBS strategist Ivan Hrazdira said on the call. But the "agency" debt may outperform Treasuries given the surge in government sales. Mortgage-backed securities issuance -- bonds that pass interest and principal from loan payments directly to the investor, but are guaranteed by the GSEs -- will also remain elevated, UBS's Laurie Goodman said on the call.

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Ilargi: 2 weeks ago, Sean Egan at Egan-Jones said the monolines each need $30 billion. But today, according to Bloomberg: ”The companies probably need about $5 billion and a line of credit for $10 billion.”. Believe who you will. Me, I’m just patiently waiting for the mass sell-off domino avalanche of no-longer-AAA paper. Will Boxing Day be in February, or can they stretch it to March?

FGIC Seeks Split to Salvage Municipal Debt Ratings

FGIC Corp., the bond insurer stripped of its Aaa guaranty rating by Moody's Investors Service, asked to be split in two to protect the municipal bonds it covers, according to the New York Insurance Department.

FGIC applied for a new license so it can separate its municipal insurance unit from its guarantees on subprime- mortgages, David Neustadt, a department spokesman, said in a telephone interview. "This is the kind of thing we have to do" to ensure municipal bonds retain the AAA rating protection, New York Insurance Superintendent Eric Dinallo told CNBC Television today.

FGIC's request follows comments by Dinallo and New York Governor Eliot Spitzer yesterday on Capitol Hill that insurers may need to be split if they can't raise enough capital to compensate for losses on subprime-mortgage guarantees. FGIC, owned by Blackstone Group LP and PMI Group Inc., MBIA Inc. and Ambac Financial Group Inc. are struggling to keep their companies intact after taking more than $8 billion in writedowns. "Other bond insurers will be tempted to follow suit, especially the ones that have already been downgraded by at least one rating agency," said Donald Light, an analyst at Boston-based consultancy Celent.

Brian Moore, a spokesman for New York-based FGIC, didn't immediately return a telephone call and an e-mail message seeking comment. "FGIC told us they are making a formal request to have the company split in two," Neustadt said. Neustadt said he can't say for certain that the new company would be AAA rated.

Dinallo and Spitzer at a congressional hearing in Washington yesterday said dividing the insurers was a last resort and urged banks to help put up capital for a bailout. New York's regulators last month organized banks to begin plans for a rescue and are talking to private-equity firms and sovereign wealth funds, Dinallo said. The companies probably need about $5 billion and a line of credit for $10 billion, he said

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Spitzer to Monolines: Drop Dead

The endgame for the monolines is upon us.

As reported in the Wall Street Journal and the Financial Times, New York governor Eliot Spitzer, in testimony before the House Financial Services committee, said that bond insurers needed to conclude deals to raise capital in five business days. Otherwise, they would be split into a municipal bond business, which would be controlled by regulators and presumably sold, and the problematic structured finance remainder would suffer downgrades and go into runoff mode.

The downgrade today of number three bond insurer FGIC by Moody's from Aaa to A3, a full six notches was another reminder that time is running out (although the rating agency mentioned that MBIA and Ambac were in better, if still doubtful. shape). It's generally a mistake to tangle with a regulator, particularly when he is acting to address a genuine problem (in this case, the costly seize up of the auction rate securities market, which is subjecting municipalities to nasty unexpected costs). However, Spitzer and his deputy Eric Dinallo have no authority over Wisconsin domiciled and regulated Ambac.

The biggest target for his message is MBIA, and that company has shown it is up for a fight (one illustration: it attempted to refute Pershing Square Bill Ackman's latest missive to the regulators). If they have any legal means of blocking a breakup, expect them to try. After all, management has nothing to lose at this juncture, so even a low-odds gamble or delaying tactic would look attractive to them. Wonder what those poor saps that bought MBIA stock in its recent offering are thinking now.

Entertainingly, Spitzer was abrasive in his Congressional testimony, getting feisty with ranking Republican, Alabama's Spencer Bachus and bluntly telling Congress that they were too late to be helpful. Weirdly, after being rude, the New York contingent said a $10 billion line of credit from the Feds would be helpful. Go figure.

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MBIA, Ambac Rescue May Be Set Before Ratings Are Cut

A rescue plan for troubled bond insurers MBIA Inc. and Ambac Financial Group Inc. may be in place before they lose their top AAA ratings, New York Insurance Department Superintendent Eric Dinallo said.

Regulators are trying to help the companies raise $15 billion of capital to avert downgrades and may consider splitting their municipal bond and subprime-mortgage debt businesses, Dinallo said yesterday in an interview on Bloomberg Television. New York Governor Eliot Spitzer told Bloomberg Radio today that the insurers must get new money within days or he will step in.

"You are either going to see capital infusion plans or some kind of a more dramatic structural change," Dinallo said from Washington, where he testified at a hearing of the House Financial Services subcommittee on capital markets into the insurers. "A few months from now, the companies are not going to look exactly the same."

Dinallo may have less than two weeks to find a solution. Moody's Investors Service said it plans to complete its review of Armonk, New York-based MBIA and Ambac of New York by the end of the month. The world's two largest bond insurers guarantee $1.2 trillion debt and the loss of their AAA ratings would cast doubt on the rankings of thousands of schools, hospitals and local governments around the country.

"It is going to take a gargantuan effort for Dinallo to pull all of the disparate parties together on this to forge an enduring solution," David Havens, a credit analyst at UBS AG in Stamford, Connecticut, said in an e-mail. "But the threat of unilateral regulatory action should be a strong motivating factor for everyone."

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The next crisis will be over food

I used to think that the fastest way to become worried about markets was to stare into the bowels of a monoline. No longer. A few days ago, I happened to hear Goldman Sachs discuss the state of the global financial system with European clients. And what struck me most forcefully from this analysis – aside from the usual, horrific litany of bank woes – was just how much trouble is quietly brewing in corners of the commodities world.

Never mind that oil prices are high; that problem is already well known and gallons of ink have been spilt debating that, along with the pressures in metals and mineral spheres. Instead, what is really catching the attention of Goldman Sachs now is the outlook for agricultural prices. Or as Jeff Currie, head of commodities research at the US bank, says with disarming cheer: "We think we could go into crisis mode in many commodities sectors in the next 12 to 18 months?.?.?.?and I would argue that agriculture is key here."

Now, to some readers of the Financial Times, that observation might seem odd. After all, inhabitants of the western world typically spend far more time worrying about the price of petrol for their car, rather than the price of wheat or corn. And when western investors do think about "commodity shock", their reference point typically tends to be the 1970s oil crisis.

However, as Mr Currie observes, this is a dangerously blinkered view. Back in the 1970s, famine touched a much bigger proportion of the world's population than the energy crisis, he says. And even today, rising food prices pack a powerful political punch in the developing (or partly-developed) world, to a degree that is sometimes underappreciated by the pampered west. Indeed, there is already ample evidence that political tensions are building: the World Food Programme, for example, now thinks a third of the world's population lives in countries with food price controls or export bans.

However, Goldman Sachs thinks this is just part of a much bigger problem of capital and resource misallocation. After all, Mr Currie argues, if the world today was a rational economic place, then regions such as the Gulf which are food-constrained ought to be investing heavily in agriculture. And since the US is the world's biggest agricultural supplier, this implies that the Saudi Arabians, say, should be snapping up farms in Wisconsin – as America secures oil in the most efficient manner by sending teams of Texans to Riyadh.

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Bombfire of the Vanities

In order to keep the game of FIAT CURRENCY AND CREDIT CREATION going and save the most powerful sector of constituents (the financial and banking industries) of the G7 public servants, we are going to see one of the greatest redistributions of wealth from creditors to debtors in history.  Government treasuries, while appearing to be safe, are also set to lose purchasing power on a gargantuan scale, in what will become known in the history books as the “great reflation”. 

First, let’s recall the prophetic words outlining the G7 central banks’ unlimited power to create inflation by the Federal Reserve governor, and now chairman, “Helicopter” Ben Bernanke in November 2002:

“The U.S. government has a technology, called a printing press (or today, it’s electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation”.

In the United States a run on the banks has begun, foreign depositors and scared individuals are withdrawing their money in epic fashion.  However, it is being held out of the headlines as the Federal Reserve applies its latest techniques to underpin the systemic risks to the banks and financial systems -- known as the Temporary Auction Facility, aka TAF. 

This is where the Federal Reserve acts as lender of last resort and has opened the borrowing facility window in an anonymous fashion,  in order to prevent bank runs such as was witnessed with Northern Rock.  This is the mechanism the central bank has created that will allow banks to take their most impaired assets and monetize them to meet the calls for withdrawal from depositors and maintain daily/weekly/monthly/yearly operations.  Let’s take a look at a chart showing non-borrowed reserves since August from the Saint Louis Federal Reserve:


Now let’s take a look at borrowings since the 1920 from John Williams at www.shadowstats.com


These charts are nothing more then a reflection of a RUN ON THE BANKS, domestic and international.  The US banking system would be closed at this point, had the Temporary Auction Facility not been created.  It is clear that this technique was imported from the ECB (European central bank), which has lent about $500 billion euros of the same since November 2007.  As we have said to readers for years, the banks are nothing more then hedge funds in disguise and they are blowing up on a daily basis as their managers have never been up to the task of speculation on the scale which was being practiced, facilitated and financed. 

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US banks braced for a battering in storm

Boom and bust cycles are always felt more keenly on Wall Street than anywhere else in the economy. This time is no different. Investment banks have been battered in the past six months by the credit squeeze and the evaporation of demand for asset-backed securities.

Now the question is whether the squeeze will lead to a prolonged recession in the broader economy, crippling sectors from housebuilding to retailing. If it does, the banks that helped create the crisis will be among the hardest hit. Writedowns on mortgage-related holdings and leveraged loan commitments have already led to the first quarterly loss in the 84-year history of Bear Stearns and cost the jobs of chief executives at Citigroup and Merrill Lynch.

But in a recession some of Wall Street's biggest businesses, such as advising on acquisitions and underwriting stock offerings, would be moribund for months. Banks that have so far avoided the worst of the writedowns, including Goldman Sachs, Lehman Brothers and JPMorgan Chase, will see profit growth stall. Executives across Wall Street hope this will not be the case. The optimistic view is that the current malaise is based on writedowns and not a drop in revenues. Under this scenario, once the markdowns are done, profit growth will resume.

An executive at a top Wall Street bank said: "This is not a revenue problem. It is a writedown problem. Revenue is still strong and there is still a tremendous amount of liquidity moving through the system." Some writedowns will be at least partly reversed, boosting future profits, he said, and rate cuts and the fiscal stimulus package will help avoid a serious downturn. But many analysts are more downbeat. Brad Hintz, an analyst at Sanford Bernstein, said: "It doesn't look a pretty picture. If this cycle is like others, businesses like equity underwriting and M&A will get hit first followed by retail brokerage."

Mr Hintz said there was already evidence that retail investors were pulling money out, though he does not expect the retreat to gather pace until later this year. "History shows retail investors tend to be optimistic all the way down and then finally throw in the towel," he said.

This would be especially problematic for Morgan Stanley and Merrill Lynch, which have large brokerage networks. Dick Bove, an analyst at Punk, Ziegel, said that if the economy moves into prolonged recession, Wall Street earnings will suffer until growth improves. "The investment banks have shown historically that they cannot deal with recession," he said.

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Citigroup Stops Withdrawals from Hedge Fund

Citigroup has barred investors in one of its hedge funds from withdrawing their money, and a new leveraged fund lost 52 percent in its first three months, the Wall Street Journal reported Friday.

The largest U.S. bank suspended redemptions in CSO Partners, a fund specializing in corporate debt, after investors tried to pull more than 30 percent of its roughly $500 million of assets, the newspaper said. Citigroup injected $100 million to stabilize the fund, which lost 10.9 percent last year, the newspaper said.

The fund's manager, John Pickett, left following a dispute with Citigroup executives and complaints from investors after he tried to back out from committing more than half the fund's assets to buy leveraged loans tied to a German media company, the newspaper said. That matter was settled when CSO agreed to buy $746 million of the loans at face value, though they were trading at 86 percent to 93 percent of face value, it said.

Meanwhile, Falcon Plus Strategies, launched Sept. 30, lost 52 percent in the fourth quarter, after betting on mortgage-backed and preferred securities and making trades based on the relative values of municipal bonds and U.S. Treasuries. Some collateralized debt obligations in the fund trade at 25 percent of their original worth, the newspaper said.

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Paulson on the Hindenburg: 'The worst is just beginning'

It's a good thing Hank Paulson wasn't around in 1929 or we'd all be hawking apples on a street-corner. Paulson is currently on a personal losing-streak that would have been the envy of 'Marvelous Marv' Thorneberry and the '67 Mets. In the last three months he's put together three new wacko programs to deal with the subprime crisis which have fizzled out in a matter of weeks. First, he tried to entice struggling investment banks to put their mortgage-backed bonds in a Super SIV (structured investment vehicle) to see if it would help off-load billions of dollars of down-graded junk onto unsuspecting investors. That flopped.

Then he brokered 'Hope Now'which was designed to help the banks and homeowners work out the details for a 'rate freeze' on mortgage resets. Paulson assured the public that 500,000 homeowners would take advantage of the program, which would dramatically reduce rate of foreclosures. So far, the Hope Now hotline has provided counseling to just 36,000 borrowers. Representatives have suggested loan workouts for fewer than 10,000 of them, a small fraction of borrowers in need. "Only 10,000 homeowners; and Paulson promised 500,000?!? That's a difference of 490,000. Another slight miscalculation.

This week, Paulson announced another new program, "Project Lifeline", which focuses on homeowners who are delinquent 90 days or more on their mortgages. Here's a run-down of how it works: (thanks to Calculated risk)

Project Lifeline involves servicers sending letters to borrowers--prime, Alt-A, or subprime, we're past pretense on that part--who are very seriously delinquent (90 days or three payments down or more). The letter says that if the borrower contacts the servicer within ten days, agrees to homeowner counseling, and provides sufficient financial documentation that the servicer can consider a case-by-case, deep-analysis style modification of the mortgage terms, the servicer will agree to put the foreclosure process on hold for 30 days while the workout is considered. If the borrower fails to respond to the letter, foreclosure proceeds.?

At the very best, the program buys a little more time for the homeowner to pick out a nice rental where he and is family can live after the bank repos his home.

So far, all of Paulson's 'solutions' have been nothing more than ?business-friendly? band-aides which fail to address the core issues of rising foreclosures, falling home prices, skyrocketing inventory, and tumbling sales. Yesterday, at a press conference in Washington, Paulson made this shocking admission in response to a reporter's question:

Reporter: "Sir, is the worst over, yet? Will 2008 have fewer foreclosures?"

Paulson: 'In terms of sub-prime and the resets, the worst isn't over. The worst is just beginning.... There's close to 2 million adjustable rate mortgages where the rate is going to be reset over the next couple of years. These loans are of a vintage where there was the most lax underwriting. So, this is the biggest challenge and this is why this is so important.

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Ilargi: I need no more than this statement to confirm what I’ve warned of before: local governments, large facilities/utilities, and private corporations, are at risk of not being able to finance daily operations anymore:
"The Port Authority [..] will have its weekly interest payments on $100 million in auction-rate securities soar to $389,000 from $83,600."

Municipalities Feel Pinch as Another Debt Market Falters

The credit crisis paining Wall Street is reaching out across the nation, afflicting municipalities, hospitals and cultural touchstones like the Metropolitan Museum of Art. In recent days another large but obscure corner of the financial world has come under acute stress. Alarmed by the running turmoil in the debt markets, investors have refused to buy certain securities that not long ago many regarded as equivalent to cash.

Even though the securities are long term, banks hold auctions periodically to set the interest rates. During the last three days, almost 1,000 of these auctions failed because there were not enough buyers. The banks that marketed the instruments, known as auction-rate securities, also declined to buy.

The Port Authority of New York and New Jersey now finds itself paying a rate of 20 percent on $100 million of its debt, almost quadruple its costs a week ago. The Metropolitan Museum of Art is now paying 15 percent on auction securities. It is unclear how long such high rates will persist, or when the market for these instruments will revive, if at all. “What is going on here is a credit crunch,” said G. David MacEwen, chief investment officer for fixed income at American Century Investment, the big mutual fund company. “And the cost of the credit and the availability of credit even for good borrowers has clearly taken a big hit.”

The auction-rate securities market, which totals about $330 billion, accounts for a small fraction of the debt sold by municipalities. But this source of financing has suddenly become astronomically expensive, even though the Federal Reserve has cut short-term interest rates to stimulate the economy. The turmoil has heightened worries about how states and towns, particularly poorer ones, will pay their bills as a weakening housing market and potential recession squeeze tax revenues.

For some communities and government authorities, even a small increase in interest rates — costs usually measured in hundredths of a percentage point, or basis points — can hurt. The Port Authority, for example, will have its weekly interest payments on $100 million in auction-rate securities soar to $389,000 from $83,600.

Other recent casualties in the auction-rate market include universities like Georgetown, student loan providers like the College Loan Corporation, municipalities like Washington, states like Wisconsin and cultural institutions like the de Young Museum in San Francisco. Faced with higher costs, some borrowers are moving to overhaul the variable-rate auction securities. Among the options municipalities are considering are redeeming the bonds, reorganizing them into long-term fixed-rate securities, or turning to banks for alternative financing.

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Latest credit-market trap could hit closed-end funds

J.P. Morgan analysts said Thursday they anticipated the costs from some of these funds, which had issued auction-rate securities as a source of cheap financing, could increase after the market for these securities nearly dried up. "The cost of leverage will rise for closed-end funds," J.P. Morgan analysts Kenneth Worthington and Timothy Shea wrote in a report, noting that these higher costs "should weigh on returns."

Closed-end funds are different from their cousins, mutual funds, because they do not continuously offer shares for sale. Firms such as Eaton Vance Corp., Nuveen Investments, Calamos Advisors and BlackRock Inc. manage closed-end funds that have used the auction-rate market for a source of funding. They've done this by issuing what's known as auction-rate preferred shares. "Auction failures means this preferred market may go away," the analysts said.

Once a large but formerly low-profile segment of the financial markets, auction-rate securities are the latest investment vehicles to convulse, singeing investors and cutting off financing for issuers. Municipalities, whose bonds made up many of these vehicles, have seen the rates on their debt skyrocket after investors have shunned recent auctions. "It just speaks to the interconnectedness of capital markets," said Tanya Azarchs, banking analyst at Standard & Poor's. "This has been a little like pulling on a string."

When running smoothly, the $331 billion market works the following way. An investor such as a corporate treasurer buys auction-rate securities, often municipal bonds but also sometimes preferred stock or corporate bonds. These have long-term maturities, but act like short-term investments because the holders can sell them at weekly or monthly auctions, when their rates reset. Some investment managers regarded them as a cash alternative for investors looking for safe but liquid investments.

Investors ranging from family trusts to large corporations like Bristol-Myers Squibb Co.and 3M Co.had used auction-rate securities to get a little more yield on their savings for not much more risk -- or so it seemed. "A year ago, no one talked about or thought about this market," added Azarchs. "It had been functioning the way it had for 20 years."

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New Trouble in Auction-Rate Securities

Some well-heeled investors got a big jolt from Goldman Sachs this week: Goldman, the most celebrated bank on Wall Street, refused to let them withdraw money from investments that they had considered as safe as cash. The investments at issue are so-called auction-rate securities, instruments at the center of the latest squeeze in the credit markets. Goldman, Lehman Brothers, Merrill Lynch and other banks have been telling investors the market for these securities is frozen — and so is their cash.

The banks typically pitch these securities to corporations and wealthy individuals as safe alternatives to cash, investors said. The bonds are, in fact, long-term securities. But the banks hold weekly or monthly auctions to set the interest rates and give holders the option of selling the securities. Only this week almost 1,000 of these auctions failed. The banks also refused to support the auctions, leaving many investors wondering when they will get their money back.

“Investors have lost confidence in the liquidity of these instruments,” said G. David MacEwen, the chief investment officer for fixed income at American Century Investments, a mutual fund company. “These types of instruments depend on new investors showing up to own the securities.” The $330 billion auction-rate market is dominated by municipalities and other tax-exempt institutions like the Port Authority of New York and New Jersey, which had issued some auction securities and had its interest rate soar to 20 percent on Wednesday. Closed-end mutual funds, student loan companies and corporations also issue such securities.

A failed auction does not mean the securities go into default, because the issuer continues to pay interest at the higher rate, or “fail rate.” The market, however, has a troubled history. In 2006, the Securities and Exchange Commission reached a $13 million settlement with 15 investment banks, and the industry agreed to impose a voluntary code of conduct for the auction-rate market. The S.E.C. investigation centered on how bidding was conducted for these securities. Critics complain that investment banks have the upper hand in bidding because they can bid after seeing what other investors have bid.

Brokerage firms are not legally obligated to make a market in auction securities, or give clients a price even if there is not one in the market. But clients who are unable to sell are likely to argue that they were wrongly put into long-term securities when their intention was to buy shorter-term debt. “If these were pitched as cash equivalents, if that is what the broker said they were, the banks may be held responsible for losses and clients’ inability to get their money out,” said Jacob H. Zamansky, a securities lawyer who represents individual investors.

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Banks at Risk From $203 Billion Writedowns, Says UBS

The world's banks "remain at risk" of up to $203 billion in additional writedowns, largely because the bond insurance crisis could worsen, UBS AG said. "Banks have made progress in credit-market related writedowns," London-based UBS analyst Philip Finch said in a note to investors today. "But more are expected," he added.

Writedowns for collateralized debt obligations and subprime related losses already total $150 billion, Finch estimated. That could rise by a further $120 billion for CDOs, $50 billion for structured investment vehicles, $18 billion for commercial mortgage-backed securities and $15 billion for leveraged buyouts, UBS said. "Risks are rising and spreading and liquidity conditions are still far from normal," the note said.

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Ilargi: It’s starting to look like everyday brings tidings of another troubled bank in Germany. We get the sneaky feeling that these problems are widespread, much more so than we know so far.

Commerzbank subprime woes spoil 2007 record profit

Commerzbank AG saw its bill from the subprime crisis creep up towards 800-million euros ($1.2-billion) in 2007 and warned that it could get worse, taking the shine off a record profit. Falling provisions for bad debts helped Germany's second-biggest listed bank raise net profit 19 percent to 1.9-billion euros last year, broadly in line with what the market expected.

The lender's problems with its 1.2-billion euro portfolio of subprime-linked investments cast a shadow over the results and chief Klaus-Peter Mueller's last year with the bank before he moves into the role of non-executive chairman in May. The Frankfurt-based bank made further writedowns on its subprime-linked investments of 248-million euros in the final three months of the year, taking the full bill to 774-million euros. But with markets still rocky, Mueller warned that the cost could rise even further.

Mueller's pledge to up the dividend by a third to one euro per share failed to deflect disappointment at how much the credit crunch was costing the bank. Commerzbank's stock tumbled and was trading down almost 3.3 percent to 20.52 euros at 6:24 a.m. EST. Earlier this year, Martin Blessing, who takes over from Mueller, said he had sought to prepare the market for the worse, warning that there were further subprime ructions to come.

In an interview with Reuters, he said management had blundered by failing to take decisive action and ditch their investments in subprime mortgages when the market first wobbled. "We have made mistakes and must learn our lessons," the 44-year-old manager had said. Commerzbank's share price has slumped by about 40 percent over the past six months, as fears about the cost of its subprime bill grew.

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Subprime Mortgage Litigation Outpacing Savings-and-Loan Crisis of the Early 1990s

Navigant Consulting, Inc., a global provider of business, regulatory and financial advisory services, released a study today that shows the number of subprime-related cases filed in federal courts dramatically outpacing the savings-and-loan (S&L) litigation of the early 1990s.

According to the Navigant study, the number of subprime-related cases filed in 2007 already equals half of the total 559 S&L cases handled by the Resolution Trust Corporation (RTC) over a multiple-year period. The subprime numbers represent only federal court filings. “The S&L crisis has been a high water mark in terms of the litigation fallout of a major financial crisis. The subprime-related cases appear on their way to eclipsing that benchmark,” said Jeff Nielsen, managing director of Navigant Consulting.

The number of subprime-related cases filed doubled during the second half of 2007, from 97 to 181 (for a total number of 278) cases. These cases included borrower class actions (43 percent), securities cases (22 percent), and commercial contract disputes (22 percent), along with bankruptcy, employment, and other cases. “This appears to be just the beginning,” said Nielsen. “We are already observing a steady acceleration of continuing litigation activity into 2008. The course of regulatory investigations, the prospect of government intervention and marketplace variables may affect the volume of filings, but the explosion of cases in 2007 suggests a daunting forecast of what is still to come.”

The study found that virtually every participant in the subprime collapse is being sued. Fortune 1000 companies were named in 56 percent of cases. Mortgage Bankers and Loan Correspondents represent the highest percentage of defendants (32 percent) but defendants also include mortgage brokers, lenders, appraisers, title companies, homebuilders, servicers, issuers, underwriting firms, bond insurers, money managers, public accounting firms and company directors and officers, among others.

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Top Officials See Bleaker Outlook for the Economy

With the credit markets once again deteriorating, the nation’s two top economic policy makers acknowledged Thursday that the outlook for the economy had worsened, as both came under criticism for being overtaken by events and failing to act boldly enough.

In testimony to Congress, Ben S. Bernanke, the chairman of the Federal Reserve, signaled that the Fed was ready to reduce interest rates yet again, pointing out that problems in housing and mortgage-related markets had spread more widely and proved more intractable than he predicted three months ago.
His sobering assessment was echoed by Treasury Secretary Henry M. Paulson Jr., who appeared with him. Both continued to avoid predicting a recession but said they were scaling back the more optimistic forecasts they had issued in November.

Ethan S. Harris, chief United States economist for Lehman Brothers, said that both policy makers had “come clean” about the economy’s problems but that investors were not impressed.
Stock prices, which normally rally when the Fed hints it will lower borrowing costs, tumbled instead. The Dow Jones industrial average dropped 175 points, or 1.4 percent; broader stock indexes dropped by similar amounts.

Anxiety is escalating among institutional lenders and major borrowers, as the panic over soaring default rates on subprime mortgages that began last summer continues to spread, freezing up credit for municipalities, hospitals, student loans and even investment funds holding the most conservative bonds.
On Capitol Hill, the economic policy makers found themselves in the line of fire. Senator Robert Menendez, Democrat of New Jersey, accused both Mr. Bernanke and Mr. Paulson of having “hit the snooze button.”

Senator Christopher J. Dodd of Connecticut, chairman of the Banking Committee, told reporters after the hearing that “it just seems as if they aren’t as concerned about the magnitude of the problem.” Testifying before the committee, Mr. Bernanke said he still expected the economy to grow at a “sluggish” pace over the next few months and to pick up speed later in the year. But he said “the downside risks to growth have increased,” noting that spiraling losses in home mortgages have dragged down the credit markets and shaken the broader economy.

While trying to be optimistic, Mr. Paulson said that the administration’s forecast “would be less, but I do believe we’ll keep growing.” Many Wall Street economic forecasters, however, are already estimating that the risks of a recession are at least 50-50, and a growing number of analysts contend that an economic contraction may have already begun.

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More Bad News on the GSE Front?

Some analysts (including myself), have long warned about the systemic risks posed by government-sponsored enterprises (GSEs) like Freddie Mac and Fannie Mae. Aside from the fact that GSEs are tremendously exposed to the free-falling housing market, they are also big players in the over-the-counter derivatives market (which has had a few disruptions of its own lately), have close ties with almost every financial institution in the country, and have issued billions upon billions of securities that are held by individual and institutional investors around the world.

In other words, if they have problems, it is unlikely to stop there. That is why the Reuters report that follows, "Freddie Mac Reduces Reference REMIC Deal," is worth paying attention to. If, on the one hand, today's news that "market forces" led to a reduction in the size of a planned securization deal reflects generally unsettled conditions in mortgage-backed securities markets, that's one thing.

However, if Freddie Mac was forced to scale back the offering because investors are beginning to get queasy about holding GSE-backed paper, then that points to what could be a far more serious problem. A loss of confidence in these well-known institutions at this stage of the game would almost certainly make the upheavals of recent months seem like kids play. Whatever the case, this latest development is unlikely to be seen as positive in the wake of recent credit market turbulence.

Freddie Mac, the second largest U.S. home funding company, said on Wednesday it reduced the size of a planned Reference REMIC (Real Estate Mortgage Investment Conduits) issue to $400 million, its smallest ever. Freddie Mac trimmed the issue due to current market conditions, it said in a statement.

On Monday, it said it planned to sell $700 million in the REMICs, It would be the first offering of Reference REMICs since October, when Freddie Mac sold $500 million of the securities. The new issue is expected to price on Thursday. The REMICs have a final maturity of Feb. 15, 2013. Settlement is Feb. 20. A Freddie Mac spokeswoman did not immediately return a call seeking comment.

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A Big MAC

Yes, the leveraged loan market is highly troubled right now. But has it changed so dramatically from this past late October as to justify a failure to fund a loan commitment made at that time? This is the $2 billion question right now in the Chapter 11 case of Solutia, which has had its plan of reorganization confirmed but whose exit from bankruptcy is now in jeopardy.

Solutia's prospective lenders, led by Citigroup, Deutsche Bank and Goldman Sachs, provided Solutia with a commitment letter dated October 25, 2007 for loans aggregating up to $2 billion to fund Solutia's obligations under its Chapter 11 plan and provide it with post-bankruptcy working capital. The lenders expressly agreed that the commitment was not conditioned on their ability to syndicate the loans.

However, the letter did contain (typically) "material adverse change" (MAC) language regarding Solutia's business and (far less typically) a so-called "market MAC", i.e., a provision that excuses the lenders from performing if there have been "any adverse change . . . in the loan syndication, financial or capital markets generally that, in the reasonable judgment of [the lenders], materially impairs syndication of the Facilities[.]" Citigroup and the other lenders have invoked this clause and are refusing to fund the loans. Solutia has brought an action to compel their performance. The matter will be contested on an extremely expedited basis; the hearing is scheduled for February 21st.

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The Waiting Game: Lenders, Borrowers Grapple With Uncertainty Over Property Values, Cap Rates

While the credit crunch is bona fide and has helped topple through-the-roof commercial real estate prices in the last six months, the unexplored reality is that there is still abundant money out there. It's just that lenders are reluctant to give it out as freely as they did this time last year.

The distinction is more than semantics because it suggests that lenders are willfully holding back until such time as … And that's where it stops, because no one seems to know when that time is. The uncertainty about where property prices and cap rates are is "the elephant in the room, sometimes discussed, sometimes not, but impossible to ignore," as one banker put it.

Early in 2008, it remains unclear just how long the pause will continue, and that has borrowers scrambling to find money and restructure deals to make them more appealing to lenders right now. Investors still have access to ample capital to allocate to commercial real estate, and there are signs that the flow of (largely conservative) deals has begun to resume.

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Ilargi: Expect a flood of opinions on this little zinger:

US government closes Economic Indicators Service

Due to budgetary constraints, the Economic Indicators service (http://www.economicindicators.gov) will be discontinued effective March 1, 2008.

Economic Indicators.gov is brought to you by the Economics and Statistics Administration at the U.S. Department of Commerce. Our mission is to provide timely access to the daily releases of key economic indicators from the Bureau of Economic Analysis and the U.S. Census Bureau.

You may link to the most recent release by clicking on the report name in the table below. You may also subscribe to our *free Subscription Service to have these files emailed or faxed directly to you as soon as they are released.

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California home price off 18.7%, nation’s worst

First American CoreLogic says California home prices were falling at an 18.7% annual rate through late January, the nation’s largest decline. California has held that dubious distinction of FACL’s worst performing state since May.

FACL’s “paired sales” pricing indexes track gains or losses on individual homes that sold vs. watching changes in an overall median or average of all homes sold. It’s monthly snapshots are based on the first three weeks of activity in a given month and are later updated to full-month reports. After California in January came …

Florida, -13.87%
Nevada, -11.83%
Arizona, -11.06%
Louisiana -6.72%
Rhode Island, -5.95%
Maryland, -5.70%
Minnesota, -5.34%
Ohio, -4.99%
Illinois, -4.83%

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Dollar Falls Against Euro on Speculation Fed Will Cut Rates

The dollar fell against the euro, headed for its biggest weekly loss this year, on speculation the slowdown in the U.S. economy will prompt the Federal Reserve to keep cutting interest rates. The U.S. currency traded near a one-week low against the euro before a report economists say will show consumer confidence dropped last month. The dollar declined after Fed Chairman Ben S. Bernanke yesterday signaled the central bank may lower interest rates again to avert a recession.

The yen weakened after stocks in Asia rallied, boosting demand for higher-yielding assets purchased with loans made in Japan. "The market has taken on board Bernanke's bleak assessment of the U.S. economy," said Jeremy Stretch, senior market strategist in London at Rabobank Groep, the third-biggest Dutch bank. Traders "have scaled up expectations of rate cuts" and the currency may fall to $1.48 to the euro today.

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U.S. January Import Prices Rise More Than Forecast

Prices of goods imported into the U.S. rose more than forecast in January, pushing the increase for the last 12 months to a record, led by rising costs for energy products and food. The 1.7 percent increase in the import price index followed a revised 0.2 percent decrease the prior month, the Labor Department reported today in Washington. Prices excluding petroleum rose 0.6 percent.

Higher import costs, sustained over several months, may increase the chances U.S. companies will try to follow their foreign competitors in increasing prices. Still, Federal Reserve policy makers remain focused on risks to growth and are prepared to lower interest rates further, Chairman Ben S. Bernanke told U.S. lawmakers yesterday. "Growth is still the biggest worry, but inflation concerns are alive," said Nigel Gault, chief U.S. economist at Global Insight Inc. in Lexington, Massachusetts. "The Fed will be cutting interest rates."

Import prices were forecast to rise 0.5 percent, according to the median estimate of 52 economists in a Bloomberg News survey, after being previously reported as unchanged in December. Forecasts ranged from a gain of 2 percent to a drop of 1 percent

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Repo lots overflow with reclaimed cars

Car and truck repossessions this year are headed for the highest level in at least a decade, thanks to easy credit and a faltering economy, says an economist for one of the largest wholesale auto auction services. So many vehicles are being snatched from owners who stop making payments that some repo operators and auto auctioneers say lots are overflowing.

This year's predicted 10% rise in vehicle repos to 1.6 million would be a third higher than 10 years ago, says Thomas Webb, chief economist for a unit of Atlanta-based Manheim, which sells cars to dealers worldwide. The increase comes atop a 10% rise in repos last year. Webb blames overly "generous" auto loans in the past couple of years as a key factor in driving up defaults that lead to repossessions. He says the rate might be even higher if employment hadn't remained strong despite the slowing economy.

While the nation has been transfixed by rising home foreclosures, scant attention has been paid to what is usually a consumer's second-largest purchase: their car or truck. Wells Fargo, (WFC) for example, reported last month that it charged off $1 billion in auto loans last year, 3.5% of its portfolio, compared with $857 million in 2006. The bank says it expects a higher write-off rate this year.

The rise of bad loans, however, has meant busy times for "repo men," whose work can involve seizing cars from driveways in the dead of the night. "Our business has skyrocketed," says Patrick Altes, president of Falcon International in Daytona Beach, Fla. In recent times, his service saw a first wave of defaults that involved picking up boats and recreational vehicles. Now, it's cars and trucks, often in affluent neighborhoods.

"A lot of the vehicles we're getting are high-dollar pickups" whose owners got caught in the construction downturn, Altes says. The repo surge has boosted business for locksmith Amy Palmer. She makes new keys for seized vehicles at Manheim's auction lot in Ocoee, Fla., one of Manheim's 144 locations in 14 countries. "It's phenomenal," she says. "If you're not paying for your house, who is paying for the car?

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