Debt Rattle, February 22 2008

Ilargi: Judging from the increased use of words like collapse and apocalypse, it looks like the skies are getting darker. It's also striking to note that Credit Default Swaps is fast becoming a household term.

German State-Owned Banks on Verge of Collapse

The situation for Germany's public banks has become so dramatic that it threatens to topple what has been one of the key pillars of the country's banking system. The state-owned banks are supposed to bail each other out when necessary, but the problem is that many are in trouble themselves and hardly in a position to help their peers. And things could get even worse.

If an industry giant like WestLB were forced to its knees -- which almost happened two weeks ago -- at least two other state-owned banks and a dozen savings and loan associations would crumple along with it. The member banks of the German Savings Banks Finance Group (Sparkassen-Finanzgruppe) are closely interlinked, and they are required to vouch for each other -- as long as they are in a position to do so, that is. The failure of a major state-owned bank like WestLB would also inevitably affect corporate customers, even forcing some into bankruptcy.

It is a nightmare scenario that the government financial supervisory authority now believes is increasingly likely. Germany's public-sector banks speculated far more heavily than private banks in American subprime mortgage securities. Now these banks' beleaguered executives are calling on the government to bail them out from a disaster of their own making.

It is a paradoxical situation, because the government, responding to pressure from Brussels, was required to withdraw its guarantee of protection for state-owned banks as of July 2005. Since then, it has only been liable for risks incurred before that date.

The consequences of the change were devastating for the public-sector banks, which suddenly found their business model pulled out from under their feet. In the days of government backing, they were able to borrow money at lower rates, which in turn allowed them to offer loans at lower rates than their private competitors. But that advantage ended in 2005.

Hard up for funds, many of the public-sector banks began speculating with high-risk securities. According to a former bank executive, many "literally stocked up on these investments" shortly before the cut-off date. Others even continued to do so after the cut-off date. Lacking a functioning business model, they turned to what was essentially gambling -- and lost.

The hard-hit German banks are now trying desperately to save their skins. The situation is most dramatic at Düsseldorf-based IKB, the first German bank that was almost driven into bankruptcy by the US real estate crisis. Last week, once again, IKB's equity capital vanished into thin air. Jochen Sanio, president of Germany's banking supervisory agency BaFin, threatened to close the bank on Friday unless it could raise €1.5 billion ($2.2 billion). But KfW, IKB's biggest shareholder, was no longer able to bail out the Düsseldorf bank without jeopardizing its official mission, namely supporting small and mid-sized businesses.

In the end, the federal government and private banks came up with the funds for the bailout. For Finance Minister Peer Steinbrück, it was critical that IKB not be allowed to go under. The bankruptcy of a bank with such a high credit rating would trigger an unprecedented loss of confidence in the German financial market. In addition, a number of other banks had deposits at IKB worth a total of €18 billion.

"The issue here is ultimately about choosing the lesser evil, and about what is less damaging to the economy," Steinbrück explained at last Wednesday's meeting of the KfW supervisory board, shortly before the board decided to bail out the bank once again. Last Friday, the finance ministry justified the financial injection in a letter to the budget committee of the German parliament, the Bundestag: "Otherwise, we could have seen massive effects on the banking sector, with corresponding effects on the real economy."

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Philly Fed index hints deep recession in the cards

Economists are no longer talking about a U.S. recession but a deep recession after figures yesterday showed business sentiment continued to plummet in early February. Forecasts for a more severe retreat came as CIBC World Markets predicted U.S. house prices would end up sliding 20% before the dust has settled on the American housing meltdown. CIBC estimated 50% of U.S. homeowners who took out below-prime mortgages in 2006 will end up in a negative-equity position -- owing more than their house is worth.

"There seems to be a sense of a very deep-seated collapse in the economy," said Michael Englund, chief economist at Action Economics. The Philadelphia Federal Reserve's index of manufacturing activity in the U.S. northeast dropped to -24.0 in February from January's already terrible reading of -20.9. Analysts had been expecting a bounce to about -10 after that sharp drop in January.

"As far as this indicator is concerned, a recession, and a severe one at that, is already underway," said Paul Ashworth, at Capital Economics. "The headline index is now consistent with a deep recession, if sustained at this level," said Ian Shepherdson, chief economist at High Frequency Economics in a note.

The index is based on a survey of manufacturing firms by the Federal Reserve Bank of Philadelphia and their plans for general activity, shipments, new orders, employment and hours worked. It is one of the earliest readings on the U.S. economy in the month and has had a solid track record at predicting national manufacturing and future trends in actual output.

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Capitalism in an Apocalyptic Mood

Skyrocketing oil prices, a falling dollar, and collapsing financial markets are the key ingredients in an economic brew that could end up in more than just an ordinary recession. The falling dollar and rising oil prices have been rattling the global economy for sometime. But it is the dramatic implosion of financial markets that is driving the financial elite to panic.
And panic there is.

Even as it characterized Federal Reserve Board Chairman Ben Bernanke's deep cuts amounting to a 1.25 points off the prime rate in late January as a sign of panic, the Economist admitted that "there is no doubt that this is a frightening moment." The losses stemming from bad securities tied up with defaulted mortgage loans by "subprime" borrowers are now estimated to be in the range of about $400 billion. But as the Financial Times warned, "the big question is what else is out there" at a time that the global financial system "is wide open to a catastrophic failure."

In the last few weeks, for instance, several Swiss, Japanese, and Korean banks have owned up to billions of dollars in subprime-related losses. The globalization of finance was, from the beginning, the cutting edge of the globalization process, and it was always an illusion to think that the subprime crisis could be confined to U.S. financial institutions, as some analysts had thought.

Some key movers and shakers sounded less panicky than resigned to some sort of apocalypse. At the global elite's annual week-long party at Davos in late January, George Soros sounded positively necrological, declaring to one and all that the world was witnessing "the end of an era." World Economic Forum host Klaus Schwab spoke of capitalism getting its just desserts, saying, "We have to pay for the sins of the past." He told the press, "It's not that the pendulum is now swinging back to Marxist socialism, but people are asking themselves, 'What are the boundaries of the capitalist system?' They think the market may not always be the best mechanism for providing solutions."

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The next credit tidal wave

The rocketing cost of protecting corporate bonds has shone a light on another arcane corner of the financial world – the $45trn (£23trn) market for credit default swaps (CDS). The cost of insuring the debt of US and European companies against default surged to all-time highs so that buyers of protection in the market were paying €126,500 (£95,500) a year to insure €10m of debt over five years.

The markets eased a little yesterday but Wednesday's surge to an all-time high was triggered by a panic that market experts are struggling to explain. Credit-default swaps are financial instruments linked to bonds and loans that are used to bet on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower does not honour its debt. A rise in the cost of the instruments indicates greater fears about credit quality.

The troublesome part of the market is constant proportion debt obligations (CPDOs) – products that package indexes of credit-default swaps. The trouble is caused partly by fears about the corporate debt that underpins the products.

But "fundamentals" do not necessarily have to get worse to cause a widening of spreads – the difference in the cost of insuring a security compared with risk-free debt. Structured products have been set up with triggers to stop investors losing more than they put in, and it can take only a small fall in the value of the securities to hit these triggers which force the structured products to start to unwind.
This causes further nervousness so that spreads widen still more. A similar thing has happened to structured investment vehicles (SIVs), which are having to be bailed out by the banks that manage them.

What is going on in the CDS market is, analysts say, an example of the vicious cycles that have been a feature of the credit crunch. Analysts say structured products based on corporate debt may be tarred with the same brush as those backed by US sub-prime mortgages as investors flee the exotic debt instrumentse constructed in recent years.

Willem Sels, head of credit strategy at Dresdner Kleinwort, says: "Given that the market has seen a big fall over past weeks, losses in the derivatives and levered loan markets are so high that certain structured products hit contractual triggers where managers are forced to sell the portfolio. By doing so, they exacerbate the widening in the market, which in turn causes trigger levels with other investors to go off."

Some believe the market is "front-running" a jump in corporate debt default. The problems are made worse because the market has become illiquid.

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Banks Lose to Deadbeat Homeowners as Loans Sold in Bonds Vanish

Joe Lents hasn't made a payment on his $1.5 million mortgage since 2002. That's when Washington Mutual Inc. first tried to foreclose on his home in Boca Raton, Florida. The Seattle-based lender failed to prove that it owned Lents's mortgage note and dropped attempts to take his house. Subsequent efforts to foreclose have stalled because no one has produced the paperwork. "If you're going to take my house away from me, you better own the note," said Lents, 63, the former chief executive officer of a now-defunct voice recognition software company.

Judges in at least five states have stopped foreclosure proceedings because the banks that pool mortgages into securities and the companies that collect monthly payments haven't been able to prove they own the mortgages. The confusion is another headache for U.S. Treasury Secretary Henry Paulson as he revises rules for packaging mortgages into securities. "I think it's going to become pretty hairy," said Josh Rosner, managing director at the New York-based investment research firm Graham Fisher & Co. "Regulators appear to have ignored this, given the size and scope of the problem."

More than $2.1 trillion, or 19 percent, of outstanding mortgages have been bundled into securities by private banks, according to Inside Mortgage Finance, a Bethesda, Maryland-based industry newsletter. Those loans may be sold several times before they land in a security. Mortgage servicers, who collect monthly payments and distribute them to securities investors, can buy and sell the home loans many times.

Each time the mortgages change hands, the sellers are required to sign over the mortgage notes to the buyers. In the rush to originate more loans during the U.S. mortgage boom, from 2003 to 2006, that assignment of ownership wasn't always properly completed, said Alan White, assistant professor at Valparaiso University School of Law in Valparaiso, Indiana. "Loans were mass produced and short cuts were taken," White said. "A lot of the paperwork is done in the name of the original lender and a lot of the original lenders aren't around anymore."

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The Peoples' Bank of USA

Panicked bankers are now all over Washington suggesting ("imploring" describes it better) that the federal government should buy and guarantee their risky mortgages, effectively turning Uncle Sam into the Peoples' Bank of The United States.

Don't you just love it? When times are good, bankers are all for invisible hands, laissez faire and Friedmanite free markets; but let Mr. Market give them a bit of the stick and they turn bolshier than Rosa and Leon (that's Luxembourg and Trotsky, for those less versed in communist hagiography).

Fine, then. The Brits have already shown the way with Northern Rock: if you want your bank rescued you must give up equity ownership proportional to the government's involvement. It's only fair and definitely within laissez faire economics: he who provides the capital gets to own the means of production, no? If the government, i.e. the people, provide the money, then the people should own the banks. And the process has started, anyway: it's the People of Dubai, Qatar, Singapore, China, Korea, et. al. who already own sizeable chunks through their SWFs. Why should Americans be left behind - in their own country, no less?

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British Banks Face Two Problems

Exposure to toxic U.S. subprime debt coupled with pressure from Britain's own real estate downturn spells trouble for British banks. Every day brings more bad news about the global financial-services sector. It's no surprise, then, that market watchers are waiting with bated breath for Britain's largest banks to announce their 2007 results over the next two weeks. The country's top five institutions -- HSBC, Royal Bank of Scotland, Halifax Bank of Scotland, Barclays, and Lloyds TSB -- all are in the firing line as investors fear additional subprime-related writedowns that could further weaken balance sheets and depress share prices.

The outlook isn't encouraging. For Britain's globe-straddling money center banks, such as HSBC and RBS, further losses from complex securitized products are expected across the board. At the same time, more domestically oriented banks such as Lloyds TSB and HBOS are feeling pressure from a deteriorating British real estate market and worsening consumer debt that could squeeze them just as forecasts predict an economic downturn.

Barclays kicked off earnings season Feb. 19, announcing $3.1 billion in writedowns. But investors were relieved the damage wasn't worse, and the bank's pretax profits of $7.08 billion, though down slightly, were in line with the market's subdued expectations. Other losses tied to the subprime mess are likely to follow. "This is definitely the end of the beginning, not the beginning of the end (for bank writedowns)," says Pete Hahn, fellow at City University's Cass Business School and a former managing director at Citigroup. "We're entering an undefined time where holes in the financial infrastructure are becoming visible."

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Behind the Mess at UBS

Swiss banking giant UBS (UBS) is the most mauled European financial player in the global credit crisis. The bank took $18.4 billion in write-offs last year from subprime mortgage securities gone bad—and it still has at least an $80 billion exposure to risky securities on its books. Last December, UBS had to line up a $12 billion capital injection from the Government of Singapore Investment Corp. and an unidentified Middle Eastern investor. And future writedowns at UBS are probable. "We don't have confidence the worst is over," says Huw van Steenis, a London-based analyst with Morgan Stanley.

It's all a surprising twist for a once-conservative lender and dominant force in private banking that has some $2 trillion in assets under management. Now the unfolding drama, which has already cost Chief Executive Peter A. Wuffli his job, clouds the bank's future. The U.S. Securities & Exchange Commission has launched a probe into whether UBS properly valued its subprime securities, a bank spokesman confirmed.

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Another kick in the ARS

In the latest sign of trouble for auction rate securities (ARS), Massachusetts's securities regulator has demanded information from nine financial services firms around the country regarding problems they have had with long-term investment schemes that invest in ARS.

ARS have long been considered a safe and liquid investment, and many companies record them as cash equivalents on their balance sheets. But in recent months, investors have spurned auctions where the securities are sold, calling their liquidity and par value with the dollar into question. The failure of the auctions has forced some companies, most notably Bristol-Myers Squibb, into the unusual step of writing down cash. Likewise, some investors have found it hard to unload their holdings, despite past assurances that the securities were highly liquid.[..]

Galvin's questions focused on whether the recent auction failures have made it difficult for investors to redeem their investments in closed-end funds. Galvin's concern also is likely driven by the fact that the market failures will make it harder for municipalities to raise money. According to Moody's Investors Service, roughly half of the estimated $328 billion ARS market is made up of tax-exempt (and some taxable) issues of state and local governments, not-for-profit hospitals, colleges and universities. Many long-term investors choose the funds because the securities are tax-exempt.

"The failures in these auctions cause many and diverse problems," Galvin said in a statement, "but the impact on closed-end municipal bond funds can be daunting for the investor who has sought a safe and dependable harbor for life savings."

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Florida Schools, California Convert Auction-Rate Debt

California, Florida schools and the operator of John F. Kennedy International Airport joined a growing list of municipal borrowers exiting the U.S. auction- rate bond market as record failures push taxpayer costs higher. Thousands of auctions run by banks to set rates on the debt failed this month as investors shunned the securities and bankers refused to submit bids, sending interest costs to 10 percent or higher on some bonds. Auctions covering as much as $26 billion of bonds a day failed to attract enough buyers since Feb. 13, according to Bank of America Corp.

Florida's Palm Beach County Schools converted $116 million of the securities into fixed-rate debt this week, while the Seattle area's Valley Medical Center refinanced $170 million. The Port Authority of New York and New Jersey said it would redeem $200 million next month after its weekly interest rates rose as high as 20 percent. "We expect to be out of the auction-rate market business in six to eight weeks," said Steve Coleman, a spokesman for the Port Authority, which operates JFK and New York City's other major airports and owns the World Trade Center site.

Rates in the more than $300 billion auction market, where local governments, hospitals, museums, student-loan agencies and closed-end mutual funds borrow, are determined through a bidding process every seven, 28 or 35 days. Auctions fail when there aren't enough buyers. That's left bondholders who wanted to sell stuck with the securities and taxpayers or other backers of the debt with higher interest costs.

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The fall of a financial model

Recent changes in the world economy and financial markets mark the end of the present standard model of financial capitalism, built up over the last decade or so. In this model, financial stability is mainly based on the self-regulation of the financial sector, which alone assesses the risks produced by its financial innovations.

Moreover, the link between finance and the real economy hinges on an adequate return on investment for shareholders, who punish poor management by making share prices fall, leaving the company open to takeover. The only role assigned to governments is to guarantee free circulation of capital between companies and between countries. As alternative economic models collapsed over the past two decades, public opinion came to accept this model of financial capitalism. Today, governments and labour unions accept profit as the most relevant criterion for assessing a company's efficiency. This model is experiencing three crises, all of which refer to changes in the relationship between governments and markets.

The first concerns the significant, yet silent, return of governments to the economic playing field. Three of the five richest nations by total gross domestic product have become de facto neo-mercantilist, setting their sights on trade surpluses. China is keeping its currency artificially low in order to increase its trade surplus and lower its costs of production vis-a-vis competitor countries. Japan is pursuing government-oriented policies to bolster its position in high-technology markets.

Finally, and to a lesser degree, Germany has been carrying out reforms to restore industrial competitiveness. In addition, countries that have access to natural resources, notably oil and gas, have revenues that serve as both an instrument and aim of their international policy. Trade surpluses have resulted, demonstrating the capacity of governments to acquire massive amounts of foreign assets through sovereign wealth funds. The problems that arise are not economic, but political. Governments may use technology transfer or control of strategic national assets as a means to increase bargaining power in international affairs.

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Exotic Financial Markets May Collapse Next

An economy already reeling from the sub-prime mortgage mess could be in for a big hit from another type of financial instrument, experts warn. They say possible problems in the gargantuan "credit default swap" market could cause credit-tightening and interest rate-hiking ripple effects, making it harder for consumers and companies alike to obtain credit.

CBS News correspondent Kelly Wallace explains that credit default swaps constitute a shadow financial system, out of sight and unregulated, that greases the wheels of business. The swaps are a form of insurance, Wallace observes, with "big players - banks, pension and hedge funds - engaging in a high-stakes crap-shoot, trying to protect themselves if companies fail."

"This is a big one," cautions Harvard Economics Professor Kenneth Rogoff. "If this one got into trouble, it would be a big problem." Wallace points out that the market for the exotic financial instruments has leaped, by some measures, from $1 trillion to $45 trillion - about twice the size of the entire United States stock market.

What could be scarier than a market about defaults when things go bad, Wallace asks, rhetorically? How far-reaching could the problem be if they all start going belly up? "Remember," says Forbes magazine Associate Editor Matthew Mill, "that ... everything in the economy is tangled together."

And, Financial Times U.S. Managing Editor Chrystia Freeland told "Early Show" co-anchor Harry Smith Thursday, "An estimate from (one very bearish economist) this week was about $250 billion could be the hit from credit default swaps, which is similar to the hit from the sub-prime mortgage instruments."

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Credit Default Swaps, a hedge funder's view

I wonder how well the banks, insurance companies, and others that are on the other side of these transactions can actually afford to cash out the CDS holders. To date, most of those contracts have reflected unrealized losses, but if there’s a run on the banks to cash out the realized losses could mount very quickly.

We have yet to see a major CDS blowup from someone who is was writing these contracts for banks to hedge their credit portfolios and/or hedge funds to speculate on credit spreads widening. That seems inevitable at some point. We talked to a fairly large buy-side institution a few weeks ago that’s been dealing in CDS for some time (mostly going long spread widening).

Even they are unsure who is on the other side of their transactions, and these are sophisticated guys. They tend to settle their positions with their brokers and don’t know if that cash at settlement is coming from the broker or someone buying in to take over their position. Either way, there have been some nice fortunes made from the spread widening (Paulson, Hayman, Blue Ridge, Lone Pine, etc.) but I have yet to see where the fortunes are being lost on the other side of those trades.

I guess you don’t have to blow up until you have to cash in those positions for massive losses. I think, though, that if we follow the cash on these transactions we’ll see that something ugly will happen at some point as more book losses convert to realized losses. Time will tell but, as I said above, I think another blow up or two might be inevitable. Within six months it’s possible the term “counter-party risk” will have become almost as colloquial as “subprime” has.

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Whistle-blower Web site ordered shut down

A San Francisco federal judge has taken the highly unusual step of ordering the shutdown of a Web site devoted to anonymous allegations of high-level wrongdoing after it posted documents purporting to describe offshore activities of a Swiss bank. U.S. District Judge Jeffrey White issued an injunction Friday ordering a Bay Area Internet host to disable the Wikileaks.org site and prevent the organization from transferring to any other server until further notice.

Wikileaks, founded in 2006, describes itself as an enabler of "principled leaking" by government and corporate insiders. Its site was the first to post the confidential Defense Department manual about operations of the U.S. detention camp at the Guantanamo Bay naval base in Cuba, and has also posted rules of engagement for U.S. forces in Iraq.

Despite the order aimed at its domain name, Wikileaks remained accessible Tuesday through its Internet Protocol or IP address, 88.80.13.160, and through so-called mirror sites in Europe that replicate its contents. In a news release, the organization called White's order "clearly unconstitutional" and promised to "step up publication of documents pertaining to illegal or unethical banking practices.

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Pain in the ARS

But what about the ARS that help finance the levered closed end municipal bond funds? In my last piece, I wrote that the funds were nothing more than a "margin account in drag" and indeed they are. The basic structure of these funds is one to benefit issuers, brokers and investment banks.

Imagine that you go to the market and buy $100 million of municipals and then borrow $50 million at a lower rate that raises the yield of the fund, except for the fact that the average fund charges over 1% per year in management fees, which drags the yield back down to what you could earn if you just bought the bonds for yourself.

I'm not trying to beat up anyone here and am just pointing out how "Mom and Pop Retail" get stuck holding the bag. So here comes the real shoe to drop. What happens to you if you are the holder of an auction rate security of a closed end fund? As I stated previously, the "maximum rate" on many of the individual issuers is 10-15%. I suppose those rates were set arbitrarily as no one ever imagined the market could seize up like this. But I truly believe that will be a temporary phenomenon. The case for closed end ARS is much worse, perhaps catastrophic. Most closed end funds have a stated maximum rate of 110% of the 60 day commercial paper index. And let’s say that index is at 3% which results in a maximum rate of a whopping 3.3%. Not so great, right? Now here comes the bad part.

Let’s say that the Fed keeps cutting rates as we expect as the economy worsens. And let’s say that 60 day commercial paper drops to 2% and the maximum rate falls to 2.2%. This is not a great proposition for the holder. You are now left holding a long term piece of paper that you can’t get rid of (who would want to buy your bonds on a 2.2% yield?). One of the issues with ARS in closed end funds is that they have "workout dates" that are quite far into the future, as much as 40 to 50 years.

Going one step further, the bond now becomes a 40 year 2.2% world—in a world where 40 year municipal bonds trade at say, 5%, due to the aforementioned heavy amount of issuance. What would that security be worth? I can tell you that our firm has toyed with the idea of buying ARS of solid municipal credits north of 10% but if anything, I would consider selling short these ARS of closed end funds at par. The reason is that a 2.2% bond with a 2049 maturity and a 5% yield trades at 51.387 cents on the dollar. And a 2.2% bond that trades on a 6% yield (I could imagine that this sort of issue would trade at a discount to high quality individual issuers) would trade at 42.271 cents on the dollar. The only thing I can say is, if you can get out of these ARS with minimal pain, get out while you can. I imagine a market will develop over time for them, but most people bought these securities as ‘cash equivalents’ to pay income taxes and such. Instead, Wall Street once again created the worst of all securities that I like to call the "Roach Motel"—where you can get in but can never get out.

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Leveraged Loans: The Hangover Wasn't Worth the Buzz

Investment banks now face around $197 billion in exposure to leveraged loans used to back big buyouts in 2007, adding inestimable stress to their efforts to extricate themselves from the credit crunch. Was it worth it? Not really, no.

The investment banks look to have put a lot on the line for relatively little payoff. Citigroup, for instance, earned only $856 million in fees from private-equity firms in 2007, even though the bank underwrote leveraged loans totaling $114.3 billion and still holds $43 billion in exposure.

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Analyst Whitney Says Citi Has to Cut Dividend More

Meredith Whitney, Oppenheimer & Co's banking analyst who was the first to say Citigroup Inc. needed to cut its dividend last year, said on Thursday the bank would need to cut payouts again and raise more capital. Whitney also told television channel CNBC she believes financial stocks, which have been weak recently in the wake of the credit crisis, housing crunch and fears of a recession, could fall at least another 15 percent and as much as 50 percent.

"The best case downside scenario is that there is a 15 percent downside in the financials; worst case is 50 percent downside in the financials," Whitney said. Citi has already raised $12.5 billion from foreign funds this year after posting heavy losses last year. It also cut its dividend 41 percent. Citi's shares have lost a third of their value since Whitney's call last year.

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Analyst Meredith Whitney Asks Banks "Where's Waldo?"

Yes, capital impairment is preventing lending. However, lending is not going to revert back to what it was even if the capital issues are solved. Psychology has changed and it's extremely unlikely to change back for a long time. A secular peak in lending craziness has been reached and the pendulum has far, far to go in the other direction.

The process has just started. More writeoffs are coming from commercial real estate and credit cards. Furthermore there is no reason for businesses to hire or expand given rampant over capacity everywhere. This recession is going to be far deeper and last far longer than anyone thinks.

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Auctions yield chaos for bonds

As municipal bond auctions continue to fail — and to produce very odd interest rates when they succeed — it is becoming clear that the auction-rate market is in crisis and chaos, and many securities may never have a successful auction again.

If they continue, the auction failures could lead to the selling of billions of dollars in municipal bonds. That, in turn, could push up the rates that cities and states must pay to borrow money.

The failures also indicate that talk of rescuing municipal bond insurance companies, like Ambac and MBIA, has not reassured investors. Auctions continue to fail, even at absurdly high yields, if the principal guarantee of repayment is an insurance policy.

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California's deficit grows to $16 billion

California's non-partisan fiscal watchdog blames the slumping housing market for creating a rippling effect throughout the economy. The result? Sharp drops in tax revenue from three major sources. "The personal income tax, the sales and use tax and the corporate tax. That decline in revenues means we have a larger budget problem than what was estimated," said legislative analyst Elizabeth Hill.

Hill thinks Governor Schwarzenegger's plan of 10-percent across-the-board cuts is so flawed, she offered for the first time ever, her own plan to fix the state's budget problems. It calls for a combination of cuts and $2.7-billion in new taxes, including reducing tax credits for dependents, adding a dime to every gallon of gasoline bought in the state, increasing tuition by 10-percent at all Cal State and U.C. campuses and closing the yacht tax loophole. Talk of more budget cuts [is] sparking protests every day.

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Rescues for Homeowners in Debt Weighed

Not since the Depression has a larger share of Americans owed more on their homes than they are worth. With the collapse of the housing boom, nearly 8.8 million homeowners, or 10.3 percent of the total, are underwater. That is more than double the percentage just a year ago, according to a new estimate of the damage by Moody's Economy.com.

Administration officials say they still oppose any taxpayer bailout for either people who borrowed more than they could afford or banks that made foolish loans during the height of the speculative bubble in housing. But with the current efforts to arrest the housing collapse so far bearing little fruit, Washington is being forced to explore new ideas, among them the idea of a federal mortgage guarantee for troubled borrowers.

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Freddie Mac Portfolio Shrinks, Delinquencies Rise

Freddie Mac, the second biggest provider of funding for U.S. home mortgages, said its investment portfolio shrank for the fourth month in five in January while delinquencies rose. The portfolio, which provides some three-quarters of its profit, decreased by $3.9 billion to $716.9 billion, Freddie Mac said in a statement. The decline was 6.5 percent on an annualized basis, it said.

Delinquencies on mortgages guaranteed by Freddie Mac rose for a seventh month in December. Loans at least 90 days delinquent increased to 0.65 percent -- the highest since February 2006 -- from 0.6 percent in November.

Rising credit-related expenses led to a $2 billion loss for McLean, Virginia-based Freddie Mac in the third quarter. The government-chartered company said in November that it would take time for the troubled housing market to turn around, and has responded by raising fees to compensate for risks.

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When Bankers Fear to Act - Where is the next J. P. Morgan?

In times of market crisis, the safest course for any one market participant may be the riskiest course for the entire market. If everyone wants to sell, prices can go in only one direction. In past financial crises, it has fallen to someone — regulators, investment banks or even a single banker — to organize collective action and avert disaster.

Such moves involved persuading people to take steps that seemed to go against their own private interests. Buy stocks when everyone wants to sell? Lend money to a bank in danger of failing, when your own bank might need the money tomorrow? Join with others to buy securities from a desperate seller, rather than try to maximize your own profits from his precarious position? It goes against the basic principle of markets, that your job is to look out for yourself. But all those things have happened in the past. Unfortunately, nothing like them is happening in the current crisis.

In 1907, Morgan demanded that presidents of New York trust companies — then a type of second-class bank — act together to save one of their own, the Trust Company of America, from a bank run. The presidents, wrote Robert F. Bruner and Sean D. Carr in their book, "The Panic of 1907," were "convinced that it was their primary responsibility to conserve their assets in order to survive the financial storm that was swirling around them." Morgan said that would simply assure that all would fail, one by one.

Morgan, then the dominant figure in American finance, called the presidents to a Saturday meeting in his library — and locked the door. Not until dawn Sunday did he let them out, after they had committed the needed cash.

"When Bankers Fear to Act"

Floyd Norris in the New York Times has an interesting article that laments the fact that, unlike past financial crises, no one has stepped forward to encourage the sort of risk-taking needed to restore order to the markets.

Even though I enjoyed the piece, ultimately, the effort to look for a single agent to rally the industry misses the peculiar and deeply-rooted nature of our current mess. After all, Hank Paulson has repeatedly waded in to try to find solutions to pressing problems with very little success. Admittedly, the Treasury is a comparatively disadvantaged position, but nevertheless Paulson have endeavored to play the very role that Norris calls for.

So what is different now? The is one element Norris alludes to but does not tease out sufficiently: the financial markets have grown so large and complicated that the number of financial firms involved and the number of big problems they face are too large to be tackled.There are too many problems on too many fronts for the regulators or the industry to analyze and come up with solutions. Each is fiendishly complex. So instead we are getting patchwork, symptom-oriented approaches....

....And the worst is even if the industry knew what to do, there isn't enough capital in the large institutions to execute a rescue, even in one crisis area. They've been forced to go begging to the sovereign wealth funds, who are already signaling that they are not keen to extend themselves any further. And they are far from done with taking writedowns.

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The Treasury Doth Speak With Forked Tongue

The plan is to take mortgages now in the hands of private investors (remember a lot of this paper is in securitized vehicles; there will need to be a substitution of assets; that alone is problematic, but let's assume the Fed will sprinkle fairy dust so this can happen) and substitute is with a new fixed rate mortgage probably from the FHA plus a "negative amortization certificate". (Note that the Washington Post story on this plan was more definitive, that the FHA would provide the mortgage).

Intuitively, I don't see how this will fly if the FHA doesn't also guarantee the certificate too, and that was Tanta's first reaction (I'm sure well see her usual robust analysis soon enough):

Apparently, only the FHA mortgage would be a lien against the property, with the certificate being an obligation of FHA? It certainly surprises me that the OTS feels confident it can work out the legal kinks with that quickly enough to make a difference.

Now I may be making the mistake of assuming this plan is earnest. It may be a deeply cynical effort to muddy the waters, with the real intent of simply stymieing the proposal to allow judges to modify mortgages in bankruptcy (as we discussed in an earlier post, the idea isn't as heinous as its critics make it sound). Given the difficulties with asset substitution in securitized deals, this could take a long time to see the light of day (if ever), which may be the whole point.

But if the powers that be seriously intend to move ahead with it, the presentation treats the public as too dumb to understand that the government is indeed stepping in and assuming considerable financial risk, which will lead to hard costs. The "this is not a bailout" really means "we don't don't have to ask Congress to authorize a disbursement." The idea that increasing FHA mortgages to weak borrowers isn't a liability that will result in losses down the road is absurd.

The FHA didn't qualify these borrowers initially (remember, the reason the FHA lost share to subprime is that they have good procedures as far as borrower screening is concerned). For this program to have any impact, the FHA almost certainly will have to relax its lending criteria considerably. And even if a fixed rate obligation reduces the homeowner's payment stress, the presence of the negative equity certificate will lower his incentive to keep the home. The market will have to appreciate considerably for him to show any gain.

There are good odds that homeowners may go through the hassle of getting the new financing and conclude in a year or two if their housing market doesn't improve, that they are better off giving up on the house (remember, research is now concluding that falling housing prices play a far bigger role in defaults than previously recognized).

So we'll see a transfer of losses. Instead of investors taking foreclosure-related losses now, we'll see the FHA taking foreclosure-related losses later. But that isn't a bailout because the Bush Administration is sticking its successors with it.

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Dinallo defends monolines handling

Eric Dinallo, New York's insurance regulator, has defended his handling of the bond insurer crisis, saying his decision to call in Wall Street's top banks last month for talks was an effort to flag up problems and not the heavy-handed intervention portrayed by critics.

Mr Dinallo rebuffed criticism that he was focused on protecting municipal bond issuers at the expense of Wall Street institutions and investors.

"Not doing anything is doing something, it is accepting the status quo," he said in an interview with the Financial Times. "I knew this would land on our door if we didn't get pro-active. Then I would have been accused of being asleep at the wheel."

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