Debt Rattle, February 9 2008

Updated 3.50pm

Yahoo Board to Reject Microsoft Bid

Yahoo Inc.'s board plans to reject Microsoft Corp.'s unsolicited $44.6 billion offer to acquire the Web giant, a person familiar with the situation says.

After a series of meetings over the past week, Yahoo's board determined that the $31 per share offer "massively undervalues" Yahoo, the person said. It also doesn't account for the risks Yahoo would be taking by entering into an agreement that might be overturned by regulators. The board plans to send a letter to Microsoft Monday, spelling out its position.

Yahoo's board believes that Microsoft's is trying to take advantage of the recent weakness in the company's share price to "steal" the company. The decision to reject the offer signals that Yahoo's board is digging in its heels for what could be a long takeover battle. The company is unlikely to consider any offer below $40 per share, the person said.

It's unclear whether Microsoft would be willing to pay such a premium, which would increase the value of its original cash and stock bid by more than $12 billion. The rejection comes as Yahoo's board has been considering various other scenarios, including a search advertising partnership Google Inc. Yahoo's directors are still considering that and other options that would safeguard the company's independence, people close the company say.

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Canada says more bank writedowns to come

More turbulence in global financial markets is inevitable as big banks continue to write down subprime-related debt but the world's top policy makers are finally coming to terms with how to solve the problem, Canada said on Saturday. "Certainly there is still concern with some of the U.S. financial institutions, there is no question about that," Finance Minister Jim Flaherty told Reuters in an interview prior to the G7 meeting of finance ministers and central bankers in Tokyo.

"It's clear that we're not out of the woods yet on these issues ... and not just in the United States. This is global turbulence and there's more to come. I think everyone realizes that," he said. Canada saw no need for governments to rush to tighten regulations to prevent future debacles like the one stemming from the collapse of the U.S. subprime mortgage sector, he said.

The changes should come from market players themselves, he will tell his Group of Seven colleagues in Tokyo in a Saturday meeting. "Who is primary here in terms of reform; is it the financial institutions themselves that should be leading the reform? In our view, yes it should be," he said. "We are more in favour of self-regulation than imposed government regulation for the simple reason that self-regulation works better."

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Updated 12.40pm

Ilargi: The Automatic Earth has repeatedly warned about what the ECB has been up to recently, in secret. Their massive veiled support of Spain’s banking system is by no means the only monster in the closet; it’s a systemic EU policy to buy up asset-backed paper at, or close to, par, regardless of its real value.

Propping up the banks at the expense of taxpayers is today’s game of choice around the globe. This puts the Euro as a currency in dangerous territory. It also indicates that Europe’s financial troubles are far more severe than most people think.

ECB: A Dumping Ground for Financial Toxic Waste

ECB President Jean-Claude Trichet said Thursday that European Banks have “pledged more private paper, such as asset-backed securities, to the European Central Bank to use as collateral in its liquidity-providing repurchase operations, but that does not mean that the ECB is bailing out private banks.” Trichet said that “It is clear that all of us on both sides of the Atlantic have noted an increase of the collateral [that is] in the form of private paper.

Treasuries were less utilized by banks as collateral and we have observed that on both sides of the Atlantic.” That’s the kicker. There’s just one problem. Trichet’s statement is disingenuous and grossly misleading. There is little similarity between the actions of the ECB to those of the Fed, both in kind, and in magnitude.[..] ... senior European bankers estimate that up to 500 billion Euros in ABS of questionable value has been pledged to the ECB in return for short term financing.

While the ECB’s Trashit says, “Hey! Everybody’s doing it, not just us”, it’s important to distinguish a couple of things. First, the Fed does not take ABS collateral in its open market operations, although they do accept it along with all other kinds of conventional collateral at the discount window and via the new Term Auction Facility (TAF) which the Fed started in December. The amounts taken at the discount window are inconsequential, and the TAF, at a rolling $60 billion, which it appears the Fed may make permanent, is insignificant compared with what the ECB is reportedly doing.

The Fed also takes a relatively small amount of Mortgage Backed collateral for its repo operations. The amount of MBS backed repos at any time is usually no more than $10 billion, and often not more than a few billion. The Fed is pretty tough about collateral. Their collateral rules for the TAF require 50% overcollateralization. While the Fed may have $60 billion in TAF credit outstanding, there’s no way to know how much of it is backed by ABS collateral. It’s probably safe to assume that not all of the collateral accepted is ABS. On the other hand, it would appear that the ECB is possibly financing up to a half trillion of ABS according to the Dow Jones report, quoting people supposedly in the know. The fact that the ECB’s Trashit felt it necessary to defend the ECBs actions lends validity to the estimates.

Much of this ABS collateral is likely to be fictitious capital, that is paper that is backed by assets which are worth less (Did Buffet really say “worth less” or “worthless” in his recent comments about the direction of the dollar?) in many cases much less, than the notional value of the securities. Under the circumstances the ECB is turning the Euro into trash compared to the US Dollar. The USD is sound money by comparison. At least the paper issued by the Fed is more than 90% backed by Treasury debt. That could be one reason why the US Dollar Index charts are evidencing the possibility of a major bottom. Compared to the Euro, you could say that the dollar is as good as gold. Yeah. Right.

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ABS Use In Repos As Banks Stay On ECB Drip

A total of several hundred billion euros worth of ABSs have been deposited with national central banks in the euro zone to use in the ECB's repurchase operations, senior bankers said this week. That has happened as the public ABS market remains shut, with banks keeping top-rated government bonds for use in the interbank market.

"Everybody is doing it," a Frankfurt-based banker said, estimating that banks have deposited up to EUR500 billion of ABSs with the ECB. Some experts cautioned that the EUR500 billion figure was at the high end of estimates but confirmed that the use of ABSs in the ECB's repos has swollen massively.

The development may get critical if banks' become over-reliant on ECB funds, or abuse the ECB's generosity, bankers said. Since the credit crunch sparked by the meltdown of the U.S. subprime mortgage market last summer, the ECB has been a key source of funding. It currently provides about EUR430 billion liquidity through its main and long-term repos.

Banks, which lodge securities, can also tap the ECB for intraday credit or use the ECB's marginal lending facility for overnight money at an expensive 5% rate - 100 basis points above the minimum bid rate that applies to the ECB's main refinancing operations. The marginal lending facility was tapped to the tune of EUR627 million Monday and EUR129 million Tuesday.

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The debt delusion

The US economy relies upon asset price inflation and rising indebtedness to fuel growth - and this contradiction has global implications

A second big American interest-rate cut in a fortnight, alongside an economic stimulus plan that united Republicans and Democrats, demonstrates that US policymakers are keen to head off a recession that looks like the consequence of rising mortgage defaults and falling home prices. But there is a deeper problem that has been overlooked: the US economy relies upon asset price inflation and rising indebtedness to fuel growth.

Therein lies a profound contradiction. On one hand, policy must fuel asset bubbles to keep the economy growing. On the other hand, such bubbles inevitably create financial crises when they eventually implode. This is a contradiction with global implications. Many countries have relied for growth on US consumer spending and investments in outsourcing to supply those consumers. If America's bubble economy is now tapped out, global growth will slow sharply.

It is not clear that other countries have the will or capacity to develop alternative engines of growth. America's economic contradictions are part of a new business cycle that has emerged since 1980. The business cycles of presidents Ronald Reagan, George Bush Sr, Bill Clinton, and George Bush share strong similarities and are different from pre-1980 cycles. The similarities are large trade deficits, manufacturing job loss, asset price inflation, rising debt-to-income ratios, and detachment of wages from productivity growth.

The new cycle rests on financial booms and cheap imports. Financial booms provide collateral that supports debt-financed spending. Borrowing is also supported by an easing of credit standards and new financial products that increase leverage and widen the range of assets that can be borrowed against. Cheap imports ameliorate the effects of wage stagnation.

This structure contrasts with the pre-1980 business cycle, which rested on wage growth tied to productivity growth and full employment. Wage growth, rather than borrowing and financial booms, fuelled demand growth. That encouraged investment spending, which in turn drove productivity gains and output growth.

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Tiny Firm Gives Ratings Giants Another Worry

Mr. Egan's Ranks Gain Favor as S&P, Fitch, Moody's Draw Scrutiny

For the past 12 years, Sean Egan has slogged away in offices near Philadelphia, trying to establish his tiny credit-rating firm as an alternative to the industry's three giants. His time has finally arrived.

Moody's Investors Service and Fitch Ratings are reeling from criticism over the top-notch ratings those firms gave to mortgage bonds that looked safe until the housing market swooned last year. Regulators are probing whether the three companies were too cozy with investment banks. A slew of self-imposed overhauls have been denounced by New York state's attorney general, Andrew Cuomo, as "too little, too late." Despite the crisis of confidence in the roughly $5 billion-a-year credit-rating industry, business is booming at Egan-Jones Rating Co.

Revenue at the closely held firm surged 30% in 2007, according to Mr. Egan. Egan-Jones landed 100 new client accounts last year, giving it a total of about 500. Even more important: The Securities and Exchange Commission recently gave the firm official recognition that should help it gather clients and corporate information. Unlike the big rating companies, where revenue comes mostly from the companies issuing bonds to raise capital, Egan-Jones makes its money by charging investors $20,000 to $100,000 a year for ratings and related research.

Mr. Egan has never been shy about what he thinks is wrong with the big bond-rating companies. Since the 1970s, Moody's, S&P and Fitch have collected most of their fees from securities issuers. The tradition has its roots in rapid market growth and high-profile bankruptcies that caused ratings to become more important and more expensive. As a result, "the interests of issuers and investors are diametrically opposed," Mr. Egan complains. "The market is in dire need of alternatives." S&P, Moody's and Fitch say they aren't influenced by the conflicts of interest that come from being paid by issuers. Under their system, ratings also are distributed for free, making it easier for companies to raise capital. The big firms claim Mr. Egan's compensation formula isn't perfect, either, because customers who pay for ratings have biases that can influence the process, such as wanting bonds they hold to be rated highly. Mr. Egan says he doesn't know his clients' positions in particular bonds.

Mr. Egan has only 15 analysts in his company, compared with about 1,000 apiece at S&P and Moody's. Mr. Egan says he relies on the analysts but doesn't disclose their names, partly because of security concerns. He says he has been threatened with lawsuits and bodily harm by people who disagreed with his research conclusions. "We're big boys, but I have to do what I can to minimize it," he says.

Lately[..], he has been drawing attention for his negative views on bond insurers such as MBIA Inc., which he rates at B -- 14 notches below its triple-A financial-strength ratings from S&P and Moody's. "Triple-A means they'll pay come hell or high water," Mr. Egan says. S&P, which is reviewing MBIA for a possible downgrade, says it will take action when it thinks it is warranted. Moody's says it is proceeding with plans to finish its review of the triple-A-rated bond insurers this month.

For nearly a decade, Mr. Egan lobbied to get his firm recognized by the SEC as a "nationally recognized statistical rating organization" -- essentially a federal seal of approval. Many institutional investors have rules requiring them to buy bonds that carry a minimum rating by an SEC-approved ratings firm. S&P, Moody's and Fitch had such a lock on the "NR-SRO" designation that Mr. Egan frequently took his case to Congress. Around the office, Messrs. Egan and Jones joked that the acronym really stood for "No Room-Standing Room Only." On the Friday before Christmas, Mr. Egan was reviewing some financial statements about mortgage lender Countrywide Financial Corp. when a lawyer interrupted with news that the SEC had approved the Egan-Jones application. Mr. Egan plans to hire 10 new analysts - increasing the firm's research staff by two-thirds - and to start rating more complex mortgage and structured-finance bonds.

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Ilargi: Do storms come more perfect than this? On the one hand, people are maxed out, and increasingly delinquent, on their plastic, on the other hand lenders are tightening standards and raising their rates, and steeply too.

For many people, credit cards are (or even were) the last resort for money/credit, once refinancing becomes a non-starter; from here on in, the future looks bleak, empty and downhill. They can't even buy groceries with plastic anymore. When you figure in that over 70% of US GDP is based on consumer spending, you can figure out where that GDP is headed.
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Cash-Out Refi's Declining in Both Numbers and Amounts

In spite of declining house prices and tightening credit, Americans are continuing to pull cash out of their homes according to Freddie Mac's Cash-Out Refinance Report for the fourth quarter of 2007, but in fewer numbers and much lower amounts than recorded even one quarter earlier.

81 percent of Freddie Mac-owned loans that were refinanced during that quarter resulted in new mortgages that were at least 5 percent higher than the mortgages they replaced. During the third quarter 86 percent of refinances could be termed "cash-out."

The actual amount of money pulled out of home equity, however, declined more sharply between the third and fourth quarters. In the former $58.3 billion was cashed out while in the October-December period in 2007 $37.8 million was pocketed by homeowners refinancing their homes. This was less than half the amount cashed out in the fourth quarter of 2006.

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Credit-Card Pinch Leads Consumers To Rein In Spending

America's love affair with credit cards may be headed for the rocks. Credit-card delinquencies are rising across the nation, a sign that some Americans are at the end of their rope financially. And these mounting delinquencies, in turn, have prompted banks to tighten lending standards, keeping people who have maxed out their cards from finding new sources of credit. The result could be a sharp pullback in consumer spending that would further weaken the slowing U.S. economy.

Such a pullback may already be taking shape. Yesterday, the Federal Reserve reported an abrupt slowdown in consumers' credit-card borrowings. In December, Americans had $944 billion in total revolving debt, most of it on credit cards, a seasonally adjusted annualized increase of 2.7%. That was off sharply from seasonally adjusted growth rates of 13.7% in November and 11.1% in October. And it reflects the volatility in consumers' spending habits as economic growth sputters.

Sinking home prices have made it much harder to convert home equity into cash for living expenses. At the same time, plastic has pushed into every corner of American life, making new inroads that worry some economists and card issuers. In past economic downturns, Americans used credit cards mainly for discretionary purchases, such as furniture, appliances and jewelry. Now, however, many of them regularly whip out plastic to pay for groceries, gasoline and other everyday necessities. Credit-card issuers won't disclose exact figures, but they say it is evident that a growing percentage of card volume is for basic purchases. Many issuers even dole out extra rewards for such transactions.

Evidence is mounting that the plastic-fueled spending spree won't last. In December, an average of 7.6% of credit-card loans were either at least 60 days delinquent or had gone into default, up from 6.4% a year earlier, according to research firm RiskMetrics Group. The analysis includes a broad swath of more than $200 billion of credit-card loans that are sold off to investors by major card issuers like Citigroup Inc., Capital One Financial Corp., American Express Co. and J.P. Morgan Chase & Co.

Card delinquencies are ticking up from historically low levels, but the trend is sending shudders through lenders already reeling from the subprime-mortgage tumult. As a result, leery card issuers are bulking up their reserves against future card-related losses -- and getting so much tougher on borrowers that some consumer are reining in overall spending.

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Ilargi: The next three articles all cover the same topic: the negative non-borrowed reserves numbers for banks that recent Fed documents are showing. Opinions vary, to put it mildly. First, a UBS strategist, second, Caroline Baum at Bloomberg, and third, Karl Denninger reacting to Baum. I'll let it speak for itself. The only thing I have to add is that when I read M(r)s. Baum's article yesterday, I had the impression that she's trying awfully hard, too hard, to make her "nothing going on here" point. And the "experts" she quotes have strange ideas:

"There is no such thing as a banking system short of reserves."
"...in a world where "the Fed can print money, there is no shortage...""

The Fed was available in the same role in 1929. What happened then, "expert"? What went wrong? If Citigroup pays 14% interest on its "capital infusions", doesn't that mean anything at all with the Fed Funds rate at 3%?

UBS Raises Concern About Negative Non-Borrowed Bank Reserves

In an earlier post, we had taken a worried look at the fact that banks' net non-borrowed reserves went negative in January. We were only somewhat concerned because this unprecedented pattern was clearly the result of the Fed's implementation of its TAF, the Term Auction Facility, which gives banks funding if they post collateral (and it can be plenty crappy collateral) at better rates than they can get in the interbank market. In other words, banks would be nuts not to use it.[..]

A reader passed along a research note from Simon Penn, a London-based strategist at UBS, who takes the grim view that the Fed is indeed propping up the banking system:

What if the Fed's rate cuts aren't motivated by the desire to stave off recession, rather they're to prevent a major banking crisis. Not one of escalating subprime losses or monoline downgrades, but actually a sheer lack of cash. The Fed's not telling anyone what it's up to because it doesn't want to cause panic, but the evidence is actually there in its own data...

Ok, so things might not be quite as bad as that, but the situation isn't far off. That's because of the TAF. ....a savvy bank can put down lesser quality paper that it can't generally do very much with (and certainly no one else really wants it), raise funds through the TAF, then use those funds to put down as reserves, and then conveniently gets paid a modest rate of interest against those reserves (which acts as a partial offset against the TAF). While there's a small net cost to the banks, the real loser here is the Fed, what it gets stuck with is an ever growing pile of collateral.

Now consider this - that collateral is actually what's backing the entire US banking system by way of its conversion to dollars and then the flow of those same dollars back to the Fed.... All this changes the complex of the US banking system somewhat. From the gold standard to the subprime standard perhaps?

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How Non-Borrowed Reserves Became a Sexy Subject: Caroline Baum

The writer of the e-mail directs his readers to the most recent H.3 report, which shows total reserves ($41.6 billion) less TAF credit ($50 billion) less discount window borrowings ($390 million) equals non-borrowed reserves (minus $8.8 billion). The negative number is really an accounting quirk: If banks borrow more than they need, non-borrowed reserves are a negative number.

This gentleman is overlooking the fact that the Fed is "a monopoly provider of reserves," said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. "This is a non-starter. There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply."

There may be times, such as late last year, when banks are reluctant to lend to one another for a period longer than overnight. "And any one bank can have a problem" funding itself, Glassman said. But in a world where "the Fed can print money, there is no shortage," he said. "The banks get the reserves they want." Those hyperventilating over TAF borrowing may want to consider an alternate scenario.

"Suppose the Fed cut the discount rate so that it stood below the funds rate," Kasriel said. (He said this yesterday, not two decades ago.) "Would these folks be upset if banks went to the discount window for funds? What's the difference? It's a difference without a distinction."

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Another "KoolAid Drinking Reporter

This morning we had yet another "KoolAid Drinking Reporter" - this time its Bloomberg's Caroline Braun. She cites many "bloggers" who sounded alarm bells at the latest H.3 report. I'm one of them, by the way.

Well, if I'm a tinfoil hat wearer (in her opinion) for noticing that Citibank was forced to borrow hard money from the Arabs at 14% interest, yet is allegedly a "perfectly solid and wonderful US financial institution", and the banks (in aggregate) are in fact funding their reserve requirements via the TAF specifically to avoid transparency in going to the discount window then I accept the label with pride.

Tell 'ya what Caroline - why don't you do your "journalism job" and tell us why Shitibank had to borrow money from the Arabs at 14% interest if everything is ok, why these other "safe and sound" banks are borrowing money via preferred issues in the 7%+ range when Fed Funds is 3%, and why this demonstrates that ALL THESE INSTITUTIONS ARE PERFECTLY GOOD AND SOUND BANKS WHEN THEIR DEBT ISSUES ARE PRICED AT JUNK BOND LEVELS!

I know that part of the media's "purpose" is to lead the sheep in where they can be SHEARED, but in my view this has gone well beyond the usual yellow journalistic pumping that compels me to wrap dead fish in the newspaper.

The fact of the matter is that the "hard money" guys - you know, those Arabs and other foreigners who have actual money which we gave them in exchange for their oil and cheap imported products, are increasingly demanding senior status for the use of their money AND interest rates which exceed that which I pay to borrow on my credit cards!

To put it bluntly, Citibank's credit, in the eyes of these folks with actual money, is worse than MINE, as I can borrow UNSECURED at a LOWER RATE OF INTEREST THAN CAN SHITIBANK WHICH IS FORCED TO SEEK SECURED FUNDING!

To put this in even MORE stark relief, JOE SIX PACK AVERAGE can STILL get a 30 year fixed mortgage for a bit over 6%, secured by his house, WHILE CITIBANK WAS FORCED TO PAY FOURTEEN PERCENT, OR MORE THAN TWICE AS MUCH, FOR SECURED FUNDS!

I think that Caroline needs to revise her thesis just a little bit - when not only I (and I admittedly have a very high FICO score and am quite liquid) but Joe Overlevered Sixpack can borrow for less than half the cost of one of our nation's largest banks, I believe that something is wrong with that bank's risk profile and balance sheet.

Do you disagree Caroline? Or is your next missive going to be to tell us how the management of Citibank intentionally overpaid by more than 100% for the capital they either wanted or needed to access?

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Ilargi: Congressman Kajorski, Cairman of the Capital Markets Subcommittee, issued the following statement this week. As you can see, he knows where the hurt will be: he mentions the ability of municipalities to issue bonds several times, and understands that the insurers’ mess is a major threat in this field. ”States, counties, and localities often rely on bond insurance to lower their borrowing costs for building bridges, repairing roads, fixing schools, and easing budget constraints.” Congress tries to find a way to prevent a situation in which local government can no longer finance its projects. This will not be easy, there is hardly any trust left in the markets, including bond insurance. Moreover, those same local governments are being hit by often huge losses in tax revenue.

Kanjorski Releases Assessments by Regulators of Bond Insurance Concerns

Capital Markets Chairman Also Schedules Hearing Date and Calls for Reform in the Wake of Ongoing Financial Market Unrest

Congressman Paul E. Kanjorski (D-PA), the Chairman of the House Financial Services Capital Markets, Insurance, and Government Sponsored Enterprises Subcommittee, today released the responses he has received from key State and Federal financial regulators. In these letters, the regulators assess the ongoing problems in the bond insurance marketplace and outline potential implications for the financial services industry, municipal finance, and the broader economy. Chairman Kanjorski also officially scheduled a hearing of the Capital Markets Subcommittee to further explore these matters for Thursday, February 14.

"The comments of financial regulators about the problems affecting the bond insurance industry and the shortcomings of its current regulatory regime have convinced me of the real need to reform the oversight of this important sector of our financial system," said Chairman Kanjorski. "Because the problems created by unrest in the bond insurance markets go to the heart of our economy and the very vitality of municipal finance, we must examine these matters as soon as possible in a hearing before the Capital Markets Subcommittee."

In January, Chairman Kanjorski initiated an examination of the bond insurance industry, focusing on its strength, the resulting implications for the financial marketplace and municipalities of ratings downgrades, and the potential need for regulatory reforms. As part of the review, Chairman Kanjorski contacted primary financial regulators on January 23 seeking their input. In recent days, seven State and Federal regulators responsible for overseeing insurance, securities, and banking entities have replied with their assessments.

"In reviewing the responses of the State insurance regulators in New York, Wisconsin, and Maryland, as well as the current president of the National Association of Insurance Commissioners, I was impressed with their candor in evaluating the situation. These primary regulators also offered constructive ideas for how to pursue regulatory reform," commented Chairman Kanjorski. "Because we need to protect our national economy and the continued ability of municipalities to issue bonds at affordable rates, I am hopeful that going forward we will work together to put in place new protections and better oversight of the bond insurance industry. These reforms ought to reflect the realities of today's complex and integrated financial system."

Chairman Kanjorski is especially concerned about the effects of the recent decisions by ratings agencies to downgrade a number of bond insurers on municipal debt markets. States, counties, and localities often rely on bond insurance to lower their borrowing costs for building bridges, repairing roads, fixing schools, and easing budget constraints.

"In recent years, many bond insurers moved from their core business expertise of assuring municipal debt and began guaranteeing risky, complex structured finance products backed by subprime mortgages," added Chairman Kanjorski. "The recent bond insurer ratings downgrades as a result of exposures to this subprime debt, and the possibility of more reductions in the future, could have unfortunate consequences for municipal governments. We must, therefore, take action to protect our cities, towns, and boroughs from experiencing unnecessary costs and project delays."

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Ilargi: I’m not so sure of the limited impact of allowing Fannie and Freddie to take on jumbo mortgages. It looks like a great way for lenders to offload loans that, if and when they fail, cause huge losses compared to smaller ones. And it’s not as if F&F are in such great shape financially. Alternatively, if the standards are to be as tight as some suggest, the whole jumbo loan/F&F issue may be an empty shell, with hardly any loans qualifying. Hard to foresee.

'Jumbo' Loan Increase May Not Stem Housing Decline

A congressional plan to let Fannie Mae and Freddie Mac insure larger mortgages may not be enough to reverse the U.S. housing market slide, said Nishu Sood, a homebuilding analyst with Deutsche Bank Securities. Congress yesterday passed a $168 billion economic stimulus package to head off a recession. The bill will allow Fannie and Freddie to raise the limit on purchasing "jumbo" loans to $729,750 from $417,000. Mortgages will be eligible if they were granted between July 2007 and Dec. 31, 2008.

"The headlines are more exciting than the potential for real impact," Sood wrote in a research note yesterday. "Not only do the proposals have limited reach and a short timeframe, but also qualification standards could limit the number of buyers that could benefit." Mortgage lending will fall to an eight-year low this year as home prices continue to drop, the Mortgage Bankers Association projected last month. Record foreclosures, lax lending standards and speculation have contributed to the worst drop in home sales on record.

Supporters of higher loan limits said the plan will help struggling homeowners finance larger mortgages at lower interest rates, especially in expensive metropolitan areas such as New York, Washington and Southern California, where median home prices now exceed the $417,000 limit. The bill would also allow the Federal Housing Administration to insure loans up to the same $729,750 limit. President George W. Bush said today he will sign the bill next week.

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OFHEO Questions Mortgage Proposal

A federal regulator yesterday suggested that a measure that would allow Fannie Mae and Freddie Mac to take on jumbo mortgages could divert loan money from less expensive housing. Funding one $600,000 mortgage takes as much capital as funding three $200,000 loans, James B. Lockhart III, head of an agency that oversees the federally chartered mortgage companies, told the Senate Banking Committee.

The economic stimulus package passed by Congress last night would temporarily permit District-based Fannie Mae and McLean-based Freddie Mac to buy or guarantee mortgages 25 percent higher than an area's median home price -- to a maximum of $729,750, up from the current limit of $417,000. The increase would allow the companies to fund bigger mortgages in areas with high housing costs, such as the Washington area, where the median price is $450,000, according to the National Association of Realtors. Advocates have argued it could provide relief to housing markets. Lockhart, director of the Office of Federal Housing Enterprise Oversight, testified that the change would push the companies deeper into some of the riskiest real estate markets, including parts of California.

Chartered by the government to bring affordability and stability to the housing system, Fannie Mae and Freddie Mac package mortgages into securities for sale to investors, promising to pay the loans if the borrowers default. They also buy mortgages themselves. Fannie Mae and Freddie Mac have long sought the freedom to fund larger mortgages, and some lawmakers have argued that a uniform limit of $417,000 doesn't make sense given the variation in housing prices across the country. Until recently, it appeared that any increase in the limit would be coupled with long-stalled legislation giving regulators more power over Fannie Mae and Freddie Mac, such as a bill approved by the House last year.

The downturn in the housing sector and growing concern about the economy could hand them a major legislative victory -- the opportunity to expand their business without new regulatory constraints. The change "will be a significant and profitable new business" for the companies, said Sen. Charles E. Schumer (D-N.Y.), a member of the Banking Committee. Freddie Mac chief executive Richard F. Syron countered that setting up new systems to handle the larger loans will cost his company a lot of money and will be "kind of a bear to do."

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Analyst: Fannie Mae faces worse credit

Shares of Fannie Mae fell Friday as a Morgan Stanley [analyst] said he expects it to report decaying credit quality in its portfolio, a worrying sign that the meltdown in subprime lending may be spilling over into prime mortgage.

In November, Fannie Mae disclosed about 0.9 percent of its single-family mortgage loan portfolio was "seriously delinquent." Morgan Stanley analyst Kenneth Posner wrote in a client report he expects this rate crept up to 1 percent in December. His "Underweight" rating on Fannie Mae is predicated on deteriorating credit quality. Fannie Mae buys mortgage loans, packages them into bonds and sells the bonds to investors. Because the company is chartered by Congress, investors assume the government would not let Fannie Mae default, and so its bonds trade at a premium.

Still, the company has not been immune to the widespread decay of credit quality plaguing mortgage lenders across the U.S. Fannie Mae's stock has lost more than half its value in the past six months as investors worry about more missed payments on the company's mortgage portfolio, which is responsible for covering losses on more than $2.4 trillion in loans. "Credit quality is now deteriorating sharply even for prime mortgages," Posner said, referring to home loans issued to people with good credit. "Delinquency trends and transition rates have deteriorated in the last few months at an accelerating pace."

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Fed's Big Dilemma: What If Rate Cuts Don't Work?

As the Federal Reserve tries to head off a recession, it's facing the troubling reality that its primary weapon--interest rate cuts--may not matter anymore. Despite several rate cuts--including a 1.25 point decline in January alone--the moves have done little more than give the stock market a temporary bounce. Meanwhile, recession worries continue to grow--even among Fed officials themselves.

The problem, analysts, say, is that the rate cuts haven't encouraged banks to start lending again. After billions of dollars of losses from subprime debt, banks are still reluctant to put money into the cash-starved economy. As a result, doubts are growing that the Fed can do much of anything to get the economy--and the markets--back on solid footing.

"This particular recession may be somewhat immune to monetary stimulus," says Barry James, president of Cincinnati-based James Advantage Funds. "It's almost like pushing on a string."
Banks are essentially caught in a Catch 22.  They're being encouraged to tighten lending standards because of the subprime collapse, but those stricter policies are countering the effects of the Fed's aggressive rate cuts.

Analysts acknowledge that there's not much the Fed really can do to jump-start the economy beyond rate cuts. Some suggest, though, that working closely with the Treasury to encourage banks to start lending again might help. "We're looking to the Fed for some intervention to help unlock the frozen CDO marketplace," says Alan Rosenbaum, president of GuardHill Financial in New York, a mortgage brokerage that does not deal in subprime loans. "Until that happens, banks are not going to lend."

"It's very difficult for banks to be in the lending business without access to long-term unsecured money," says Bill Isaac, managing director at LECG in Vienna, Va. "Bringing rates down at the short end I don't believe would be as effective as trying to find ways to make more lending available to banks. I don't have the answers. I'm sure that would have to be worked out by the Fed and the Treasury." One such effort--special auctions allowing banks to borrow money cheaply from the Fed--has been only modestly successful so far. Though they attracted a lot of interest when they began in December, Thursday's auction was poorly received, with weak foreign demand sending prices on 30-year Treasury bonds plunging.

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Schiff: The Mother of all Bubbles

In contrast to the dismal forecasting record of mainstream economists over the last few years, the forecasts that I have made regarding the dollar, oil, commodities, precious metals, global stock markets, inflation, and the U.S. economy have all come to pass. In addition, unlike the top economic oracles on Wall Street and in Washington, I can also point to similar accuracy in predicting the bursting of growing bubbles, first with technology in the late 1990's, and more recently with real estate. However, my long-standing prediction about the fate of the bond market has fared much worse. I still do believe this prediction was not wrong, but simply premature.

For years I have predicted that the falling dollar, persistent trade deficit, and the lack of domestic savings would combine to send long-term interest rates sharply higher. The effects of these fundamental drivers would undermine the Fed's efforts to lower short-term rates and compound the problems for the housing market and the U.S. economy. Yet as of today, the yield on the thirty-year Treasury bond still stands below 4.5%, within 40 basis points of a generational low. Either this is the one piece of the puzzle that I somehow got wrong, or other factors are working to temporarily confound fundamental economics and prop up the bond market. As you might imagine, I am confident that it is the latter and consider the U.S. Treasury market to be the mother of all bubbles.

I have often said that the only thing worse than holding U.S. dollars is holding promises to be paid U.S. dollars at some distant point in the future. However, this is precisely what U.S. Treasuries represent. Given all of the inflation that already exists, and all of the additional inflation likely to be created over that time period, why would anyone pay par value for the right to receive $1,000 in thirty years in exchange for a mere 4.5% coupon? Although it looks like the sucker bet of the century, the fools have been lining up to buy. Alan Greeenspan called this a "conundrum." I simply call it mass delusion of the same variety that brought us pets.com, and $800,000 tract homes in the middle of the California desert.

It is important to remember that for every borrower there has to be a lender. For example, if a homeowner wants to refinance his mortgage, there must be someone willing to loan him the money. Practically everyone on Wall Street is hailing the Fed's recent rate cuts because they believe it will allow strapped ARM holders to refinance into more affordable mortgages. However, while low rates are great for borrowers, they are lousy for lenders. Why would anyone want to offer a thirty-year mortgage at an artificially depressed interest rate? As soon as the Fed raises rates again, as it clearly intends to do once the crisis ends, all that low yielding mortgage paper will collapse in value. Lenders can surely figure this out and will therefore refuse to volunteer to be the patsy in this plan.

Eventually, the world's lenders will reach similar conclusions with respect to U.S. Treasuries. No matter how low the Fed funds or discount rates get, private savers around the world will simply refuse to lend given the inherent risks and paltry returns. At some point the sheer absurdity of holding long-term, low-yielding receipts for future payments of depreciating U.S. dollars will be apparent to all. After all, it was not too long ago that investors thought holding subprime mortgages from financially strapped borrowers who could not possibly repay them was also a great idea -- so great in fact that many leveraged themselves to the hilt to buy them. Judging from the extremely poor demand at this week's $9 billion auction of thirty-year Treasury bonds, the day of reckoning may not be too far off.

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A Long Story

The economic news has been fairly dire this week. The credit crunch is getting worse, and a widely watched indicator of trends in the service sector — which is most of the economy — has fallen off a cliff. It’s still not a certainty that we’re headed into recession, but the odds are growing greater. And if past experience is any guide, the troubles will persist for a long time — say, into the middle of 2010.
The problems now facing the U.S. economy look a lot like the problems that caused the last two recessions — but this time in combination.

On one side, the bursting of the housing bubble is playing the role that the bursting of the dot-com bubble played in 2001. On the other, the subprime crisis is creating a credit crunch reminiscent of the crunch after the savings-and-loan crisis of the late 1980s, which led to recession in 1990. Now, you may have heard that those recessions were short. And it’s true that the last two recessions both officially ended after only eight months.

But the official end dates for those recessions are deeply misleading, at least as far as most peoples’ experience is concerned. There’s a reason that the Bush administration, in its (increasingly strained) efforts to tout economic performance on its watch, always talks about jobs added since August 2003. It was only then — two and a half years after the recession began — that the U.S. economy began to experience anything that felt like a recovery. And the same thing happened a decade earlier: the recession that began in 1990 officially ended in March 1991, but the jobless recovery that followed kept Americans feeling miserable about the economy right up through the 1992 election.

Since the current problems of the U.S. economy look like a combination of 1990 and 2001, the shape of this episode of economic distress will probably be similar to that of the earlier episodes: even if the official recession is short, the bad times will linger well into the next administration. How severe will the distress be? The double-bubble nature of the underlying problem — a housing bubble and a credit bubble combined — suggests that it may well be worse than either 1990 or 2001.

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Paris broker to appear in SocGen trading case

A Paris broker was due to appear before an investigating judge on Saturday as part of a widening probe into the rogue trading scandal at French bank Societe Generale, the prosecutor's office said. Confirming his identity as Moussa Bakir of the brokerage Newedge, prosecutors said they would ask the judge to place him under formal investigation on suspicion that he cooperated in illicit deals carried out by SocGen trader Jerome Kerviel.

Kerviel's $73 billion wrong-way gamble on the share market has been blamed by SocGen for a $7 billion trading loss, the biggest arising from unauthorized trading in banking history. The investigating judge could decide to put Bakir under formal investigation for "conspiracy to commit breach of trust," a judicial source told Reuters.

Being placed under investigation in France may lead to trial but is a step short of charges and does not imply guilt. Kerviel is already under formal investigation on three counts that include breach of trust.
Kerviel, 31, spent the night in a Paris prison after being placed in temporary custody on Friday when an earlier decision to grant him bail was overturned. Prosecutors are asking that Bakir also be placed in temporary detention while the investigation continues.

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Ilargi: The empty blabber pouring out of the G7 Finance meeting might yet set new standards.

U.K.'s Darling Says Britain's Inflationary Outlook Is 'Good'

U.K. Chancellor of the Exchequer Alistair Darling said the inflationary outlook for the British economy is good, allowing authorities room to spur the economy with changes in policy.

"The inflation outlook in Britain is good, provided we take the right action," Darling said in Tokyo today after a meeting of Group of Seven finance ministers and central bankers. "I am confident that throughout the course of this year through a combination of what central government does and the Bank of England does, we can keep inflation down."

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Ilargi: For an in-depth analysis of the Washington Consensus and its perverse impact around the world, read Naomi Klein’s “The Shock Doctrine”.

Breaking the Neoclassical Monopoly in Economics

For the past 25 years, the so-called “Washington Consensus” – comprising measures aimed at expanding the role of markets and constraining the role of the state – has dominated economic development policy. As John Williamson, who coined the term, put it in 2002, these measures “are motherhood and apple pie, which is why they commanded a consensus.” Not anymore. Dani Rodrik, a renowned Harvard University economist, is the latest to challenge the intellectual foundations of the Washington Consensus in a powerful new book titled One Economics, Many Recipes: Globalization, Institutions, and Economic Growth. Rodrik’s thesis is that though there is only one economics, there are many recipes for development success.

Rodrik has rendered a major service by stating so openly the claim of “one economics.” A critic who made the same claim that economics allows only one theoretical approach would be dismissed as paranoid, whereas Rodrik’s standing creates an opportunity for a debate that would not otherwise be possible. The “many recipes” thesis is that countries develop successfully by following eclectic policies tailored to specific local conditions rather than by following generic best-practice formulas designed by economic theorists. This challenges the Washington Consensus, with its one-size-fits-all formula of privatization, deregulated labor markets, financial liberalization, international economic integration, and macroeconomic stability based on low inflation.

But, while the many recipes thesis has strong appeal and empirical support, and suggests a spirit of theoretical pluralism, the claim of “one economics” is misguided, for it implies that mainstream neoclassical economics is the only true economics. Part of the difficulty of exposing this narrowness is that there is a family split among neo-classical economists between those who believe that real-world market economies approximate perfect competition and those who don’t. Believers are identified with the “Chicago School,” whose leading exponents include Milton Friedman and George Stigler. Non-believers are identified with the “MIT School” associated with Paul Samuelson. Rodrik is of the MIT School, as are such household names as Paul Krugman, Joseph Stiglitz, and Larry Summers. This split obscures the underlying uniformity of thought.

The Chicago School claims that real-world market economies produce roughly efficient (so-called “Pareto optimal”) outcomes on which public policy cannot improve. Thus, any state intervention in the economy must make someone worse off. The MIT School, by contrast, argues that real-world economies are afflicted by pervasive market failures, including imperfect competition and monopoly, externalities associated with problems like pollution, and an inability to supply public goods such as street lighting or national defense. Consequently, policy interventions that address market failures – as well as widespread information imperfections and the non-existence of many needed markets – can make everyone better off.

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