Debt Rattle, March 11 2008

Updated 4.45 pm

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Ilargi: Maybe we should close this blog now?

Dow Climbs 416.66 for Its Biggest Gain in Over 5 Years

Wall Street enjoyed its best trading day in more than five years on Tuesday — complete with a 400-point gain in the Dow Jones industrial average — after the Federal Reserve injected a burst of financial adrenaline into the ailing banking system. The Dow finished up 416.66 points, near its high for the day, for a one-day gain of 3.6 percent, to 12,156.81, snapping a three-day losing streak. It was the biggest one-day point gain for the Dow since July 29, 2002. The Standard & Poor’s 500-stock index was up 3.7 percent, and the technology-heavy Nasdaq composite index gained 4 percent.

For weeks, investors have been concerned about a freeze-up in the credit markets, as banks cowed by round after round of multibillion-dollar write-offs became increasingly panicky about lending to businesses and consumers. On Tuesday, the Fed announced it would offer up to $200 billion in ultra-safe Treasury securities to the nation’s banks, including several major brokerage firms, in exchange for a variety of collateral options — including the very mortgage-backed securities that have spurred the recent financial crisis.

That means banks will be able to unload some of those soured assets, potentially freeing up money to keep the nation’s economic bloodstream flowing. For many investors, it was the central banking move they had been waiting for. “For the first time, the Fed now is doing the relevant work,” said David Kovacs, an investment strategist at Turner Investment Partners in Berywn, Pa. “This is a move by the Fed that has teeth to it.”

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Ilargi: Markets jumped this morning on news that ever more cheap debt is pumped into the bottomless world economy. In the past 6 months, these measures haven’t achieved anything positive (for more than a few hours), and they won’t this time. It's simply more shifting of wealth, from you to the banking system, from the public sector to the endless abyss beyond the event horizon of the private sector, from which nothing ever returns.

And if you think this is bad, note what will happen if this last pump-jump doesn't work, which is guaranteed. The next step will be the Fed and/or the government buying bonds and securities outright, under the guise of helping poor homeowners and pension funds. And that will cost you a whole shattering lot more than a $200 billion credit facility. The real hand-outs are yet to come. Check your wallet before leaving the house.

PS: And that's not all either, nor is it the main course. That title is reserved for the Great Unraveling of the derivatives trade. The Great Depression was pretty bad, but it took place within the existing banking system of the day. We now have a "second system" lurking in the darkest shadows, an order of magnitude larger than the first, and set for an all-out nuclear explosion.


Ilargi: Unusually crtitical for Bloomberg:

Moody's, S&P Defer Cuts on AAA Subprime, Hiding Loss

Even after downgrading almost 10,000 subprime-mortgage bonds, Standard & Poor's and Moody's Investors Service haven't cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments. None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.

Sticking to the rules would strip at least $120 billion in bonds of their AAA status, extending the pain of a mortgage crisis that's triggered $188 billion in writedowns for the world's largest financial firms. AAA debt fell as low as 61 cents on the dollar after record home foreclosures and a decline to AA may push the value of the debt to 26 cents, according to Credit Suisse Group.

"The fact that they've kept those ratings where they are is laughable," said Kyle Bass, chief executive officer of Hayman Capital Partners, a Dallas-based hedge fund that made $500 million last year betting lower-rated subprime-mortgage bonds would decline in value. "Downgrades of AAA and AA bonds are imminent, and they're going to be significant."

Bass estimates most of AAA subprime bonds in the ABX indexes will be cut by an average of six or seven levels within six weeks. The 20 ABX indexes are the only public source of prices on debt tied to home loans that were made to subprime borrowers with poor credit histories. About $650 billion of subprime bonds are still outstanding, according to Deutsche Bank. About 75 percent were rated AAA at issuance.

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Agency Mortgage-Bond Spreads Decline After Fed Announcement

Yields on agency mortgage-backed securities relative to U.S. Treasuries narrowed after the Federal Reserve said it would lend up to $200 billion in exchange for mortgage-backed bonds to add liquidity to credit markets.

The difference in yields on the Bloomberg index for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10- year government notes narrowed about 5 basis points, to 223 basis points, paring a larger decline. The spread helps determine the interest rate on new prime home mortgages of $417,000 or less.

The drop still left the spread about 87 basis points wider than on Jan. 15, the recent low. Banks and securities firms have demanded more collateral on loans secured by debt to investment funds including Thornburg Mortgage Inc. and Carlyle Capital Corp., forcing investors to sell assets, and few buyers have emerged. The spread reached the highest since 1986 on March 5.

"Dealers now have more liquidity and financing ability than they had and they can pass that along to investors as they see fit," Kenneth Hackel, the managing director of fixed-income strategy at RBS Greenwich Capital Markets in Greenwich, Connecticut, said in an interview today. "The Fed's move doesn't completely resolve" the effects of tighter bond-secured lending and trading difficulty, "but it is a positive step."

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Treasuries Decline as Fed to Accept Agency Debt as Collateral

Treasuries fell, pushing the two- year note's yield up the most since May 2004, as the Federal Reserve's move to relieve the credit crisis prompted investors to dump holdings of government debt.

Notes maturing in five years or less led the decline as the central bank said it will allow securities firms to pledge agency and private mortgage debt as collateral against as much as $200 billion in Treasury securities. Investors and securities firms have been hoarding government debt, considered the safest and most easily traded securities, amid the credit crunch.

"The Fed is trying to do anything it can to free up markets," said Jason Brady, a managing director in Santa Fe, New Mexico, at Thornburg Investment Management, which oversees $4 billion in fixed-income assets. "People have been in asset- preservation mode. To the extent we shift away from that mode, you sell the Treasuries."

The yield on two-year notes climbed 24 basis points, or 0.24 percentage point, to 1.73 percent at 10:52 a.m. in New York. The five-year note's yield increased 25 basis points to 2.62 percent for the biggest gain since May 2004. The benchmark 10-year note's yield was up 15 basis points to 3.61 percent.

"A lot of short rate expectations are embedded in five- year notes," said Scott Gewirtz, head of Treasury note and bond trading in New York at Lehman Brothers Holdings Inc., one of the 20 primary dealers that trade daily in the repurchase market with the Fed. "If you think that the Fed is going to use new ways to deal with the current crisis outside of pure rate cuts, maybe that hits them the hardest."

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Fed turns on the spigot of money again

The Federal Reserve and other leading central banks doubled to more than $400 billion the amount of money they're willing to lend to banks and bond dealers, hoping to flood dysfunctional credit markets with enough money to get them working again.

The Fed announced a new temporary lending program on Tuesday that will allow participants in the bond markets to swap the mortgage-backed securities that they can't currently sell for highly liquid Treasurys that they can. The hope is that the extra money in the financial system will restore trust and keep prices of illiquid securities from plunging. Counting the latest action, the Fed will have provided more than $400 billion in Treasurys in an effort -- so far futile -- to grease the wheels of commerce that have seized up.

The Fed hopes the action will give bond dealers comfort that they'll be able to find financing, Fed senior officials told reporters. The move was not an effort to prop up any particular firm, they said. The latest move could make monetary policy more effective by easing specific market stresses, the Fed staffers said. The odds fell for an extremely aggressive 75-basis point cut in the federal funds target rate at next week's meeting of the Federal Open Market Committee, according to futures prices on the Chicago Board of Trade.

Financial markets welcomed the announcement, with U.S. stock markets and the dollar rising. Treasury prices fell on the flood of new supply from the Fed's portfolio. "The Fed's new term securities lending programis its most creative, and best, idea yet," wrote Lou Crandall, chief economist for Wrightson ICAP. "It will provide financing for an asset class [residential mortgage-backed securities] that is under severe pressure and which the Fed cannot finance through regular operations."

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Mortgage mess becomes prime territory for law firms

The collapse of the subprime-mortgage market has turned into a legal free-for-all not seen in the financial-services industry since the savings-and-loan crisis. Last year, 278 subprime-related civil cases were filed in federal court, equaling half of the 559 S&L cases handled by the Resolution Trust Corp. from 1989 to 1995, according to Navigant Consulting Inc. The study does not include suits filed in state courts.

"The S&L crisis has been a high water mark in terms of the litigation fallout of a major financial crisis," said Jeff Nielsen, managing director of Navigant Consulting. "The subprime-related cases appear on their way to eclipsing that benchmark."

Virtually every participant in the meltdown is being sued: Brokers, lenders, appraisers, home builders, bond underwriters, bond insurers and money managers, among others. And the suits keep coming in 2008, according to anecdotal evidence, as the number of foreclosures escalates and financial institutions suffer more losses. Estimated losses from the subprime mess could amount to close to $400 billion, not including litigation costs.

With that kind of fallout, it could take years to unclog the courts. Borrower class-action suits made up the biggest chunk of cases last year (43 percent), with claims that they were the victims of illegal or abusive lending practices. Within this category of borrower suits, however, are some atypical defendants. For instance, two California couples have accused home builder KB Home of conspiring to inflate prices by generating fraudulent appraisals.

Even cities with high foreclosure rates want someone to blame. The City of Cleveland has sued 21 investment banks, including Goldman Sachs, Merrill Lynch and HSBC, alleging they created a public nuisance by investing in subprime loans. Similarly, Buffalo is suing 28 lenders in hopes of getting them to take responsibility for abandoned properties in the city.

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UBS: U.S. Bailout for Homeowners Will Arrive by October

A homeowners' bailout by U.S. Congress is a "surefire thing", according to George Magnus, UBS senior economic advisor, and the first bailout package is likely to be implemented by October. Speaking in a video interview with Gillian Tett, global markets editor, Financial Times, Magnus also estimated that the total likely losses from the credit crisis could reach as high as a trillion dollars. The following are excerpts from that interview:

FT: Do you have a back-of-an-envelope calculation as to how big the total hit could be in the credit world?
GM: Well, looking at the losses in subprime and collateralised debt obligations and related instruments, including the spillover into leveraged loans, for example, certainly colleagues and I think that it's something of the order of about $500 or $600 billion, which would make it on a scale of the banking crisis of Japan between 1990 and 1994.

But I'm afraid we're still counting, because on top of all of these problems that we've had, of course, the US economy is in or close to being in a recession and the European economy is clearly slowing down very significantly... If you want to take a sort of a round number, something close to $1,000 billion at the end of the day is not an impossible number.
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FT: So, if monetary policy is not going to solve this by itself, what else can governments do? Are we going to basically end up with a situation where taxpayers will be footing the bill for the credit excesses?
GM: I think it's inevitable. Of course, here in the United Kingdom, the saga about Northern Rock, of course, is now, I think, kind of reaching, or has reached, a conclusion, and, clearly, to the extent that we have some form of nationalisation or public intervention, there is a bill for taxpayers. This is pretty small beer, I think, compared with the kind of activities which I think are going to take place in the United States. And I think that a bailout for homeowners in the United States is as close to a surefire thing as I can imagine.

The losses on mortgages are so high and the stories and estimates which, perhaps, more significantly, people make about repossessions and delinquencies in the housing market are so high that, especially in a presidential election year, I think it's just inevitable that there will be very strong action from the Congress. The chairman of the Senate banking committee, Senator Christopher Dodd, is already on record as having indicated the way in which he personally would prefer the situation to be dealt with.

And I think we have something of a time limit too because, of course, in October the US Congress goes into recess and the new Congress won't reconvene, I suppose, until after the State of the Union message in late January 2009. So by the time they get round to action it might actually be quite late in the day, so I think the first bailout package, to be honest, I think is going to happen between now and the end of October.

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Central banks try again to ease credit crunch

The U.S. Federal Reserve on Tuesday announced it is ramping up efforts to provide more relief in the spreading credit crisis, saying it will make up to $200-billion (U.S.) in cash available to cash-strapped financial institutions. The Fed said it will lend the money to financial institutions for a term of 28 days, rather than overnight.

The action is being co-ordinated with central banks in other countries to try to provide help in a global credit crises that threatens to push the U.S. economy into its first recession since 2001 if it hasn't already.

Futures jump like athletes

“Pressures in some of these markets have recently increased again,” the Fed said in a statement. “We all continue to work together and will take appropriate steps to address those liquidity pressures.” The other banks involved are the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank.

In addition, the Fed has authorized increases in existing programs called “swap lines” with the European Central Bank and the Swiss National Bank “These arrangements will now provide dollars in amounts of up to $30-billion and $6-billion to the ECB and the SNB respectively,” the Fed said, extending the term of these swap lines through Sept. 30.

The new lending initiative “is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally,” the Fed said. Its announcement said that securities will be made available through an auction process on a weekly basis beginning March 27.

The new program, called the Term Securities Lending Facility (TSLF), is geared to provide primary dealers — big investment firms that trade directly with the Fed — with short-term loans. They would pledge other securities — including federal agency debt, federal agency residential-mortgage-backed securities — as collateral for the loans. The loans would be made available through an auction process. Auctions will be held on a weekly basis, beginning on March 27, 2008.

The Fed since December has been making short-term loans available to banks through a new auction facility. It has provided $160-billion available to squeezed banks in hopes it will help them to continue lending to individuals and companies.

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Bandaid on a Ruptured Jugular

Let’s talk about the Fed’s expansion of its securities lending program that the market is so excited about this morning. It seems to me that the market does not understand the implications of this action. We’ll take this one step at a time. What is the purpose of borrowing securities from your broker? It’s the same for Primary Dealers borrowing Treasuries from the Fed. Why do PDs borrow securities from the Fed? To sell them short.

The Primary Dealers are heavily short Treasuries at all times. They are heavily long all other debt securities simultaneously. The level of securities lending in recent months is unprecedented in all of human history, by an order of magnitude of 10. Why is that? Because they were heavily short Treasuries and are being subject to the greatest Treasury short squeeze in history. Their only out was to borrow more securities from the Fed and short more into the market as the public clamor and panic for “safe” Treasury securities rose to a mad crescendo.

The Fed is now responding to the pressure of the imminent collapse of the Primary Dealers and major banks worldwide, because not only are the PDs heavily short the stuff that is going up, Treasuries, they are heavily long the stuff that is going down, which is all other debt securities. This is the worst of all possible worlds and the Fed’s action is like putting a bandaid on a ruptured jugular vein. Accordingly, I predict that this morning’s massive short squeeze will be reversed in due course, perhaps no more than a few hours.

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Central bankers cannot stop this contagion

This has not been a liquidity crisis, but a hugely contagious solvency crisis, affecting sector after sector, starting off with subprime mortgages, spilling over to the rest of the mortgage market, into municipal debt, corporate debt and many obscure sectors of the financial market. A good example of how contagion works in practice came last week when Carlyle Capital defaulted on a margin call from its banks. What is happening here is known in financial jargon as "haircut contagion".

In its September 2007 global stability report, the International Monetary Fund* provided a useful hypothetical example of how a small fall in asset prices can easily wipe out an investor. Say, a fund invests $100 in a portfolio of risky securities. The margin requirement from the lender is 15 per cent. So on that basis, the fund borrows $85 from the bank.

The rest is the fund's equity. Assume the portfolio drops 5 per cent in value, and is now worth only $95. At that point, the fund faces a margin call. To meet it, it is forced to sell securities. When the bank decides to raise the margin requirement, or the "haircut", more forced selling becomes necessary. At some point, the fund's investors start to panic and get out. And the fund is forced to sell again. In this hypothetical IMF example, forced selling turned a portfolio of $100 into one of $36.

Interest rates do not even enter into the picture. Central banks could cut their short-term rates as much as they liked and they still would not be able to stop this kind of contagion. I cannot offer an effective solution either, and believe that this crisis will slowly spread from segment to segment of the credit market. It will spill over into the rest of the financial market and to the real economy. Perhaps there exist some regulatory devices one could deploy to mitigate the forced-selling problem.

I suspect we will ultimately end up with some combination of regulatory relief, fiscal bail-outs, nationalisations and many, many bankruptcies of financial institutions not too big to fail.

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Fed Attempts to Stop the Madness

Once again, the Federal Reserve has reached into its bag of tricks. The initial reaction has been a positive one, but of course the market has been through this before. In its announcement today — along with several other central banks world-wide — the Federal Reserve has put together a term lending facility that will lend Treasurys to the primary dealers in government debt in exchange for, among other things, agency debt and mortgage-backed securities, which have bedeviled the credit markets in the last few weeks.

“Basically, the Fed decided to go long agencies in a big way,” says Steve Van Order, fixed income strategist at Calvert Asset Management. The new facility will lend up to $200 billion in Treasury securities for up to 28 days (instead of overnight, as it has done with the TAF), and is accepting mortgage-backed debt and federal agency debt as collateral. In response, spreads on agency debt — debentures sold by Fannie Mae or Freddie Mac — have tightened by about 10 basis points, lately traded in the low 90s over Treasury securities. Meanwhile, Treasurys have sold off dramatically, as the two-year note’s yield rose (see chart) to 1.71%, and shares of large banks and brokerages are rallying; Citigroup gained 6.6%.

Mortgage-backed securities, which had widened to more than 300 basis points, had not moved as much. David Ader, credit-market strategist at RBS Greenwich Capital, noted that this “may be a disappointment as they are not taking the paper off of balance sheets on a permanent basis.”

Many strategists agree that outright purchases of agency debt would be the Fed’s next move if this does not work. But the hope is that this does alleviate the stress in the markets. Mortgage-backed spreads were widening steadily after dealers raised margin requirements on borrowers, requiring more collateral from those wishing to borrow to buy these bonds. With capital constrained, those borrowers — such as the likes of Thornburg Mortgage — were forced to sell securities or face margin calls, which only exacerbated the problems.

“You can’t have triple-A mortgage-backed securities getting whacked like that in the market,” says Jim Caron, head of U.S. interest rate strategy at Morgan Stanley. “It’s a step in the right direction.” What remains to be seen is whether it alleviates the problem on a more permanent basis. “The fear of, ‘I don’t know how much selling is behind us’ gets hold of people,” says Mr. Van Order. “There will be more selling.”

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The American Bond Crisis

I was talking to the head of the fixed income desk of a major investment bank in London the day last week when agency debt spreads increased more than 90 basis points over US Treasuries. Agency bonds, namely mortgage bonds from GSEs, have an implicit US government guarantee so they usually trade close to treasuries with little spread.

Then all of a sudden they didn’t. The reason? Leverage – and lot's of it. In fact, my friend told me, there is by his estimate $6 trillion in excessive leverage built up over the past ten years that has to be unwound. So the credit crisis that started June 2007 with obscure financially engineered debt products such as CDOs has not evolved to include bonds presumably backed by the US government. Guess what’s next after Agency debt? You guessed it!

Our road to the American Bond Crisis starts with another note from my pal Rick Ackerman today. As Ronald Reagan would say, “There he goes again!”

The first challenge of an argument with Rick is that he tends to invent a position for me then take the other side. If Rick and I were arguing about how to treat an illness versus the economy and I said, “Take an aspirin” he’d say in his rebuttal, “Eric says we should eat carrots when in fact we all know perfectly well that we should use leaches.” For example, “Eric and the inflationists implicitly believe not only that those fat raises for airline employees and autoworkers are coming, but that our homes are about to increase in value dramatically.”

Why say that I imply something when you can instead simply restate what I actually say? I’ve been warning of an eventual major correction in real estate since August 2002 and finally called a top in June 2005 after describing the crash process in Jan. 2005 that pretty much lays out what’s happened. More recently I said I expect a 38% correction nationally before the whole sorry episode is over. Well, 38% at least in real terms. Perhaps in nominal terms prices won’t fall so much.

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The Great Fall: Here Comes The Humpty Dumpty Economy

Hey, why is everyone so down-in-the-mouth? We mean, we can understand why the Finns traditionally turn into melancholics this time of year -- who wouldn't with nights that never end? But this is the good old U.S. of A., where people are born optimists and never get over it. Yet everybody we know -- and a lot of people we wish we didn't -- seem to have come down with a serious case of the heebiejeebies. And we're not talking just about the poor souls who nearly succumb to a paroxysm of palpitation when they open the envelope and get a peek at their heating oil bill.

Or the jolly Joe who suddenly goes bug-eyed and desperately motions for oxygen when told that the house next door, the spit and image of his own, just sold for a couple of hundred grand less than he paid for his. But even folks who rent or live in the balmy reaches of Florida or Arizona or Southern California and are mercifully not burdened with $4-a-gallon-based heating bills to warm their cozy tepees mope around looking like their beloved grandmother passed from this vale of tears and plumb forgot to include them in her will.

We're happy to report, after painstaking investigation, the old bird is chirpy as ever and the only deaths in those mournful families are of the dogs in their stock portfolios, which, of course, is very sad, but somehow doesn't quite earn the sobriquet of tragedy. Anyway, they should find solace in the knowledge that granny, who's edging toward 100, has her nest egg salted away in FDIC-insured savings accounts. The trouble with striving to look on the bright side of things is that it's pretty darn hard these days, to tell the truth, to find the bright side of anything. For what we're all being forced to bear witness to is an extraordinary and extraordinarily blood-curdling sight: the enormously endearing and widely presumed eternal Goldilocks economy is, right before our startled eyes, metamorphosing into the Humpty Dumpty economy.

Just to lift your spirits a bit, we hasten to reassure you that even though like its prototype in the old ditty, the Humpty Dumpty economy is due to suffer a great fall, the pieces most definitely can be put together again. It's just that it may take quite a few years, or maybe more than quite a few years. And, we should admit, too, that the end result will look more like Humpty Dumpty stuck together with Band-Aids than Goldilocks.

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Ilargi: All the write-downs and margin calls and losses will inevitably come hammering down on the derivatives market. And since that market is much bigger than anything else and all else put together, rest assured that you haven’t seen anything yet. Here’s a few recent pointers: (Note: current estimates for global derivatives trade is over $700 trillion, up from $516 trillion last year)

Derivatives are the new 'ticking time bomb'

Data on the five-fold growth of derivatives to $516 trillion in five years comes from the most recent survey by the Bank of International Settlements, the world's clearinghouse for central banks in Basel, Switzerland. The BIS is like the cashier's window at a racetrack or casino, where you'd place a bet or cash in chips, except on a massive scale: BIS is where the U.S. settles trade imbalances with Saudi Arabia for all that oil we guzzle and gives China IOUs for the tainted drugs and lead-based toys we buy.

To grasp how significant this five-fold bubble increase is, let's put that $516 trillion in the context of some other domestic and international monetary data:
• U.S. annual gross domestic product is about $15 trillion
• U.S. money supply is also about $15 trillion
• Current proposed U.S. federal budget is $3 trillion
• U.S. government's maximum legal debt is $9 trillion
• U.S. mutual fund companies manage about $12 trillion
• World's GDPs for all nations is approximately $50 trillion
• Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
• Total value of the world's real estate is estimated at about $75 trillion
• Total value of world's stock and bond markets is more than $100 trillion
• BIS valuation of world's derivatives back in 2002 was about $100 trillion
• BIS 2007 valuation of the world's derivatives is now a whopping $516 trillion

Moreover, the folks at BIS tell me their estimate of $516 trillion only includes "transactions in which a major private dealer (bank) is involved on at least one side of the transaction," but doesn't include private deals between two "non-reporting entities."

The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today's slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.

Recently Pimco's bond fund king Bill Gross said "What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August." In short, not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't "figure out" the world's $516 trillion derivatives.

Why? Gross says we are creating a new "shadow banking system." Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way of creating money outside the normal central bank liquidity rules. How? Because they're private contracts between two companies or institutions. BIS is primarily a records-keeper, a toothless tiger that merely collects data giving a legitimacy and false sense of security to this chaotic "shadow banking system" that has become the world's biggest "black market."

That's crucial, folks. Why? Because central banks require reserves like stock brokers require margins, something backing up the transaction. Derivatives don't. They're not "real money." They're paper promises closer to "Monopoly" money than real U.S. dollars. And it takes place outside normal business channels, out there in the "free market." That's the wonderful world of derivatives, and it's creating a massive bubble that could soon implode.

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Credit derivatives turmoil strikes

Turmoil in the credit derivatives markets is having an increasingly brutal impact on the wider financial system as a vicious cycle of forced selling drives risk premiums on company debt to new highs.[..]

Institutions that lapped up credit risk products in recent years – many financing their purchases through borrowing – are scrambling to reduce their exposure following heavy losses, traders say. But many investors fear conditions could worsen as hedge funds, banks and other financial institutions come under pressure to cut their losses before conditions deteriorate further.

Liquidating structured credit instruments requires buying large amounts of protection using credit default swaps. This, in turn, drives the cost of protection higher, potentially triggering a chain reaction. “There is potential for some wild and possibly inexplicable price movements as the unwinds get bigger,” said Mehernosh Engineer, credit strategist at BNP.

The markets are so illiquid that a few trades can lead to sharp movements, producing violent price swings and knock-on effects. Tim Bond, head of global asset allocation at Barclays Capital, said: “It’s inflicting heavy losses on the banking system, eroding their capital and reducing their ability to lend. The spread widening is so severe, you’re seeing a rise in borrowing rates across the board for everybody except top-quality governments. It’s affecting both the price and availability of credit.”

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Risk Assessment of Credit Derivative Market Turmoil

With the current turmoil in the credit derivatives market, the business risks have substantially increased.
Here are a few of the risk factors rising from the credit derivatives turmoil that I think any prudent financial manager should take into consideration:

Counterparty Default Risk : For those investors who are “In the Money,” the focus is on whether the counterparty, the party who is on the other side of the trade and owes the money, can pay on the trade. As the uncertainty of the counterparty’s ability to pay increases, investors will choose to buy credit default swaps [CDS] to hedge against the possibility of the counterparty not being able to pay.
Leverage Risk : For those investors, such as hedge funds, who had borrowed money to buy credit derivatives, managing their leverage risk becomes important. Typically, being leveraged 10 to 1 or more, any drop in the value of their credit derivatives will trigger a margin call from the lender. If the investors do not have sufficient cash or cash-equivalents, typically UST, to provide additional collateral to the lender, the lender may force the investors to liquidate some or all of their credit derivatives holdings. This forced liquidation drives down the value of the credit derivatives.
Market Risk : As more investors begin selling credit derivatives to meet margin calls, the risk of these investors not being able to meet the margin call or going out of business increases. This will force lenders to buy new or additional CDS as insurance. As more lenders buy CDS, the price of CDS increases. This is clearly evident in current markets as reported by the Financial Times.[i]
Liquidity Risk : As more lenders worry about whether they will be made whole on credit derivatives trades, their expenditure on CDS increases, resulting in lower earnings. As the risk of counterparty default increases, there is less desire on lenders to lend. As lenders slow or even stop their lending, a liquidity crunch will occur, forcing borrowers to seek alternative and more costly sources of funds.
Modeling Risk : As the volatility in credit derivatives pricing increases, the risk of the models used to price the credit derivatives being inaccurate increases. The underlying variables used to value the credit derivatives may not be updated on a timely basis, causing incorrect position marking and financial reporting requirements. This may result in material financial losses. As models' complexities have increased over the years, teams of ‘quants’ are now required to maintain the integrity of the models used to price and trade credit derivatives. For investors who rely on monthly review of their models' integrity, their risk of mis-pricing and/or mis-marking their credit derivatives positions have increased.
Financial Risk : Due to the complexity, lack of transparency, and difficulty in properly pricing and marking credit derivatives, the risk that an investor may incorrectly price their credit derivatives positions has increased. This may result in material financial losses from the incorrect mark-to-model pricing.
Reputational Risk : Some counterparties who have reported or to report financial losses may see rating agencies reviewing their credit ratings for possible downgrades. Although the downgrades may not occur, the perception of credit weakness will result in higher cost of CDS to the lender, should they decide to lend. This perception will reduce their ability to borrow at a favorable rate or miss investment opportunities.

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U.S. Slowdown to Be Deeper, Rebound Weaker, Says Poll

The economic slowdown in the U.S. will be deeper and the recovery weaker than previously forecast, according to a Bloomberg News monthly survey. The world's largest economy will grow at an annual rate of 0.3 percent from January through June, a half point less than projected in February, according to the median estimate of 62 economists polled from March 3 to March 10.

Rising fuel prices, shrinking payrolls and falling home values will weaken consumer spending and blunt the impact of tax rebates that start going out in May. The Federal Reserve, struggling to offset the credit crunch and housing contraction, will cut the benchmark interest rate by another percentage point and keep it at 2 percent through December, the survey predicts. "We're now more pessimistic about the pace of recovery into 2009," said Richard Berner, co-head of global economics at Morgan Stanley in New York. "We now see the Fed pursuing a slightly more accommodative path for monetary policy than just a week ago."

The odds of a recession over the next 12 months were pegged at 50 percent, the same as in the February survey, according to the median estimate of 42 economists that responded to the question. "The debate is shifting from whether it is a downturn to how long and how deep it will be," said Kurt Karl, chief U.S. economist at Swiss Re in New York. "We have a 55 percent probability of recession. Now it looks like it's starting in the current quarter."

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WaMu Shares Fall, Report Says it Seeks Cash

Washington Mutual Inc shares fell as much as 9 percent on Friday after a published report said the largest U.S. savings and loan, which has been battered by mortgage losses, has approached private equity firms and sovereign wealth funds about possible cash infusions.

The Wall Street Journal, citing people familiar with the matter, said the Seattle-based thrift and other struggling lenders are seeking help. It said regulators including the U.S. Federal Reserve and the Office of the Comptroller of the Currency are quietly pushing a handful of lenders to seek outside capital. Libby Hutchinson, a spokeswoman for Washington Mutual, declined to comment.

Shares of Washington Mutual were down $1, or 8.5 percent, to $10.76 in afternoon trading on the New York Stock Exchange after trading as low as $10.67 earlier in the session. Washington Mutual lost $1.87 billion in the fourth quarter, hit by mortgage defaults, write-downs and a substantial increase in the amount it set aside for bad loans.

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Latest drain on banks? Corporate drawdowns

Corporate drawdowns of bank lines could become another drain on bank capital, further complicating banks’ funding problems. “We estimate that U.S. and foreign banks could need from $17 billion to $40 billion of additional capital if companies begin to draw on revolvers,” Kabir Caprihan, credit analyst at J.P. Morgan Chase, wrote in a research note last week.

Some companies, such as Sprint Nextel and Porsche, have recently started drawing on their revolving credit facilities, although they had no immediate need for liquidity. According to the shared national credit survey compiled by the Federal Reserve, U.S. banks held $892 billion of the $2.3 trillion in loan commitments outstanding as of the end of the second quarter of 2007, while foreign banks held about $952 billion.

J.P. Morgan assumed 60% of these commitments will mature within a year and 40% would mature after a year (based on data disclosed by Citigroup, the largest syndicated lender in the U.S.). It also assumed that 85% of the companies that choose to draw on revolvers will be rated BBB or BB, while 10% will be rated A and the remainder will be rated AA or AAA. Based on those assumptions, J.P. Morgan estimated that banks could need anywhere from $17 billion to $40 billion of additional capital.

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Bank of England Offers Further Three-Month Loans to Ease Tension

The Bank of England said it will hold two more auctions of emergency funds, joining the Federal Reserve in stepping up efforts to ease renewed tensions in money markets. The U.K. central bank will offer 10 billion pounds ($20 billion) of three-month loans on March 18 and will hold a further auction on April 15, according to a statement. The size of the second auction will depend on the outcome for the first.

"The Bank of England will maintain its expanded three- month" loan sales against "a wider range of high quality collateral in its scheduled operations," the central bank said today. "The bank is taking this action in view of continuing elevated pressures in short-term funding markets." The Bank of England and other central banks are struggling to restrain an increase in money market interest rates after about $190 billion of losses from the U.S. subprime mortgage slump made financial institutions reluctant to lend to each other.

While central banks damped market rates in December when they announced joint measures to counter the credit shortage, conditions have tightened since then. The cost of borrowing pounds and euros for three months rose to a two-month high today. "It's a relief that this facility has been rolled over," said Philip Shaw, chief economist at Investec Securities in London. "This was an essential tool in driving bank rates back down at the end of last year. There's some question as to whether the action should have been bigger."

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U.S. States Revolt Against Muni Credit-Rating System

The municipal bond market doesn't have enough to worry about with the bond insurers struggling to keep their AAA ratings, bond and closed-end fund share auctions failing, swaps and derivatives backfiring and a criminal investigation into the investment of proceeds business. No, that's not enough. Let's have a national debate on credit ratings, in particular about why the companies that rate municipal bonds see fit to grade most of them lower than corporations, although they almost never default.

On March 4, Bill Lockyer, the treasurer of California, sent a five-page letter to Moody's Investors Service, Standard & Poor's Corp. and Fitch Ratings asking for justice. "State and local governments almost never default on the bonds they issue," the letter says. "The safety of municipal bonds is grounded in a fundamental fact: a city or state simply is not going to go out of business during the life of its bond issue."

The letter was signed by 14 other state and local officials, including Michael Murphy of Washington, Michael Fitzgerald of Iowa and Patrick Born, the chief financial officer of Minneapolis. I mention these three in particular because they are public finance veterans who really understand the business. Maybe every one shouldn't be rated AAA, the letter asserts. Just most of them.

We probably wouldn't be having this debate right now if not for, well, take your pick: the subprime crisis, the bond insurers' meltdown, the efforts of short-seller William Ackman of Pershing Square Capital Management in New York, the quixotic admission by Moody's in March 2007 that most municipal bonds would be rated AAA on a global scale.

The Moody's decision was probably the most damaging, at least to that firm's own credibility. Yet all of the reasons played a part in the current credit-ratings drama. On March 12, the U.S. Congress will get a preview, with the House Financial Services Committee holding a hearing on the insurers and the credit raters. Moody's has a starring role right now. The other two major rating companies are unwitting, and unwilling, co-stars.

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Citigroup Acts to Bolster Hedge Funds

Citigroup, the banking giant, moved Monday to shore up six of its hedge funds pressured by a tightening in the municipal bond market, the newest problem to entangle the struggling company. The bank has committed to injecting $1 billion across six highly leveraged municipal bond funds with $15 billion in assets, which were sold to wealthy customers under the names ASTA and MAT.

About $600 million had been provided as of last week, according to people briefed on the situation, after lenders issued a margin call in response to falling securities values. The effort is the latest by the chief executive, Vikram S. Pandit, to stabilize the bank, which has been ravaged by the credit crisis.

Citigroup’s alternative investments unit has been particularly hard hit. Last month, Citigroup suspended redemptions in a large corporate debt fund, CSO Partners, after investors tried to withdraw more than a third of its $500 million in assets. In January, Citigroup injected $100 million into the fund, which suffered heavy losses last year.

Citigroup has also rescued seven affiliated investment funds, shifting more than $49 billion in securities onto its already strained balance sheet. And several other Citigroup alternative investment funds are sputtering. A big fixed income hedge fund, Falcon Strategies, fell more than 30 percent last year after betting wrongly that the worst of last summer’s market turmoil was over. And Old Lane Partners, the investment fund founded by Mr. Pandit, has posted dismal results.

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Fitch, MBIA fight it out over request to stop ratings

In the latest salvo in a now highly public war of words, ratings agency Fitch said it will continue to rate MBIA Inc.'s subsidiaries without charge, despite the bond insurer's request that it stop. The increasingly confrontational dialogue was initiated on Friday when MBIA asked Fitch in a letter to stop providing some ratings on the firm. That letter, released to the public, also asked Fitch to return or destroy data MBIA had provided to Fitch.

MBIA Chief Executive Jay Brown defended the firm's decision and said the company has started to generate new business.
In response, Fitch CEO Stephen Joynt said the agency plans to keep rating the bond insurer and questioned the company's reasons for trying to end their relationship.

"It seems disingenuous at best to assert in your letter to investors published yesterday, March 9, that you 'intend to work with Fitch to perform the analysis needed to rate MBIA's debt securities,' while privately demanding return of the portfolio information and materials that you freely provided to support our ratings and that of other rating agencies for many years," Joynt wrote.
MBIA shares fell 10% to $10.77 on Monday, leaving them down 29% so far this year.

Fitch's decision to keep rating MBIA is a positive development, according to Joseph Mason, associate professor of finance and LeBow Research Fellow, at Drexel University's LeBow College of Business. "This is the kind of market discipline we need to get back to," Mason said. "Before the 1970s, there was a very prevalent traditional of unsolicited ratings. This kept the agencies that get paid to do the ratings in line."

Most ratings agencies are paid by the companies they analyze. That's created the perception of a conflict of interest because agencies may be less inclined to come out with lower ratings because they don't want to upset the firms that pay them.
If more agencies rated companies without being paid by them, this potential conflict could be reduced.

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Lehman Brothers Laying Off 5% Of Global Workforce

Lehman Brothers Holdings said Monday it is laying off about 5% of its workforce, or 1,425 people, across all regions and businesses as the deepening crisis in financing takes its toll.

Lehman, which is expected to report $9 billion or more of writedowns on its deteriorating mortgage and loan assets in its first quarter next week, had 28, 500 employees when its fiscal year ended last November. A person familiar with the layoff plans told Dow Jones Newswires they supplement about 2,500 firings of primarily lower-paid residential mortgage lenders in the last six months or so.

Lehman's decision is stronger than the 5% cutbacks at Goldman Sachs Group (GS) , which culls its forces annually of its weakest performers, since it is not based only on performance, the person said. This year, however, Goldman is expected to cut a little deeper than the norm. Wall Street employees have been expecting large layoffs for months, and some believe that once one firm makes the first move others will follow.

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Countrywide probe may be game changer

FBI gives Bank of America a 'get out of deal free' card

If Bank of America ever needed an excuse to get out of the Countrywide deal, they've probably got it now. A report of an FBI probe of Countrywide sent shares of the once high-flying mortgage lender tumbling Monday morning. As recently as last week, BofA said it plans to go ahead with its planned $4 billion acquisition of the lender.

But it's hard to think of a better reason for changing your mind than the discovery that the company you're planning to acquire may be facing criminal charges. And hanging onto a breakup fee in such circumstances seems problematic at best. To be sure, no charges have been filed, and the company told the Wall Street Journal it wasn't even aware of an investigation.

Getting the FBI to do your due diligence doesn't seem like a particularly great business strategy. One is left wondering whether the folks who put this deal together spent any more time looking inside Countrywide than the folks who bought all those collateralized debt obligations spent looking inside them.

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Carlyle Capital begs nervous banks not to sell collateral

Carlyle Capital, the crisis-hit hedge fund, is desperately seeking a "standstill agreement" with its lending banks, many of which have been seizing fund collateral and selling it to recoup their loans. Run by the US buyout firm Carlyle Group, it is the latest fund to be hit by a stampede of panicked lending banks, determined to call in their loans as certain asset markets fall. Earlier this month, the London-based Peloton collapsed under a wave of bank pressure.

Troubles at Carlyle come as the US private equity house Blackstone reported an 86% dive in fourth-quarter profits.

Both Carlyle and Peloton are highly indebted funds with investments focused on securities linked to top-rated US home loans. They believed this market would benefit as the US sub-prime mortgage markets ran into trouble. But even the market for high-quality US mortgage loans suffered as house prices tumbled across the board and the credibility of the debt-rating process was called into question.

Carlyle has $21bn (£11bn) of assets under management. The fund has borrowings of more than 30 times the scale of its equity, making performance very sensitive to changes in asset values. Yesterday Carlyle said it had received more than $400m-worth of margin calls from nervous banks, many of which told the fund's managers that they see it as in default. A margin call is a demand from a bank to a hedge fund to put up cash to cover potential losses on an investment.

In its statement, Carlyle said it "believes that certain lenders may have liquidated in the open market the collateral securing approximately $5bn of indebtedness." Talks were ongoing with other lenders, it said, warning that a lack of agreement would likely lead to more sell-offs. "While these talks continue, the company has discussed and requested a standstill agreement whereby its lenders would refrain from foreclosing and liquidating their collateral, and we are awaiting responses."

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How building slump hurts nearly everyone

The construction industry, historically a cyclical business, is sliding down a steep slope now. And the evidence is building that the current cycle will be deep and long, which will have a deleterious effect on a wide swath of the economy since construction provides a large number of good paying jobs and supports businesses ranging from concrete suppliers to lenders.

Construction spending fell 1.7% in January from December, the fourth straight monthly drop and the steepest decline in 14 years. While the slide in residential construction accounted for the biggest part of that, spending on the more stable, non-residential construction projects slid a surprising 0.8%, the Commerce Department reported last Monday. And there's no rebound in sight. The National Association of Home Builders has forecast a 31% drop in single-family housing starts for this year. In California alone, new home permit applications fell 62% in January.

Perhaps more ominously, public construction, which is typically prefunded and involves long-running jobs for governmental entities, fell 0.2% in January, the second monthly decline in a row, while private, non-residential construction also fell, for only the second time in 31 months, as commercial work slowed. Patrick Newport, U.S. economist for financial research firm Global Insight, said the industry's resources had shifted from building homes to building commercial buildings after the residential slide began, which supported its performance for several months. “But now, going forward, I don't think it will. The drop in private non-residential construction may be a sign of things to come. Its recent growth rates were unsustainable.”

The construction industry's contraction already has other businesses feeling the pinch, said Vicki Bryan, a home-building industry analyst for the credit rating firm Gimme Credit. She cited the concrete industry, which is the construction industry's “canary in the coal mine—they only make money at the beginning of projects.” Demand dropped about 9.5% in 2007 and is expected to fall about 10% this year, said Edward Sullivan, chief economist for the Portland Cement Association, an industry group.

He said the construction industry's steep decline is telegraphing a recession, “and we don't think it's going to be a mild one.” That's because the loss of construction-related jobs will result in lower tax revenue for local governments, causing them to cut back on public projects, which have traditionally been an economic stabilizer in downturns. “About 93% of public construction is performed by states, so with state revenue starting to collapse, they'll pull back on that,” Mr. Sullivan said. And that will add to the length of the downturn the industry faces. “If we have a recession in 2008, construction activity doesn't hit a trough until 2009,” and then takes many more months to recover, said Mr. Sullivan.

Construction employment is already being affected, as jobs are down by 284,000 from the peak in September 2006. The industry gave up 27,000 jobs in January, the second consecutive month of declines. That included a 2.7% fall in non-residential construction payrolls, again the second consecutive month of declines—the first such drops in that sector since August 2004. The delinquency rate for all construction loans rose to $31.3 billion, or 5% of the $628.9 billion of such loans outstanding, at the end of 2007, a doubling of delinquencies from mid-year to a rate not seen in 14 years, according to data reported by commercial banks and thrifts to the Federal Deposit Insurance Corp. and analyzed by Foresight Analytics.

The credit environment is only going to get worse as time rolls on, since the prospect of a recovery keeps getting pushed out, said Ms. Bryan. “Last year we were thinking that by the end of 2008 we'd be seeing some light at the end of the tunnel, but it turned out to be a train,” she said of the outlook for many of the publicly traded home builders she tracks.

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Recession fears hammer Asian stocks

Asian stocks tumbled Monday with Tokyo hitting a 30-month low as recession alarm bells rang louder in the United States following a shock drop in employment, dealers said. They said the big worry now is that exports to the United States will slump, curbing growth around the region and possibly dragging Japan into recession.

Political worries added to the gloom with trading in Kuala Lumpur suspended for an hour as shares plunged 10 percent after Malaysia's ruling coalition suffered its worst-ever result in weekend elections. Tokyo's benchmark Nikkei-225 index slid 1.96 percent to the lowest level since September 2005 amid concerns about the impact of weaker US consumer demand and a stronger yen on exports.

"Japan's economy lacks a domestic driving force," said Tomoko Fujii, the head of economics and strategy for Japan at Bank of America. "So a US recession-like state is boding ill for Japan's business cycle," she added. Shanghai share prices fell 3.59 percent as inflation concerns and weakness in overseas markets rattled investors. It was a similar picture elsewhere in the region as Manila plunged 4.0 percent, Seoul lost 2.3 percent, Taipei dropped 2.7 percent, Hong Kong shed 1.0 percent and Sydney fell 1.6 percent the lowest level since October 2006.

"With US employment now falling for two months in a row, it's now almost certain that the US economy is in recession," said Shane Oliver, the head of investment strategy and chief economist at AMP Capital Investors in Sydney. "A slump in US consumer spending, which is now looking highly likely, will also place much greater downward pressure on growth in the rest of the world, including in China and Asia," he said.

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U.S. may protect oilsands

In response to concerns that new U.S. environmental legislation will drastically impact development of Canada's oilsands, Washington is considering classifying oil produced from the region as "conventional" fuel rather than subject it to the stringent standards expected of "alternative" fuels.

The U.S. government passed a law that prohibits federal procurement of alternative fuels that generate more greenhouse gases than "conventional sources," which spurred a warning last month from Canada's ambassador to the United States, Michael Wilson. Mr. Wilson said a narrow interpretation of the legislation would include the vast deposits of the oilsands -- where U.S. firms are major investors and the U.S. government is a major customer.

An interdepartmental working group with representation from several U.S. agencies is looking into how to classify the Alberta deposits under the new rules, said a source who suggested the step was taken because "D.C. does not want to hammer" the region. Mr. Wilson's letter to several senior members of the U.S. administration -- including Robert Gates, the Secretary of Defence, and Condoleezza Rice, the Secretary of State -- outlined concerns with the Energy Independence and Security Act 2007, passed in December.

"The U.S. government would be seen as preferring offshore crude from other countries over fuel made in part from U.S. and Canadian sources," Mr. Wilson argued. "Further, the U.S. government would be contradicting other stated goals to encourage greater biofuels use and Canadian oilsands production."
The letter also warned of unintended consequences for both countries if it compromised the oilsands, which are a key supplier to U.S. military and postal fleets.

The rationale for classifying the oilsands as conventional oil is that, unlike alternative fuel sources, the deposits are well established, yielding more than one million barrels a day and likely to produce more than three million barrels a day by the middle of the next decade. As such, they are no longer "a science experiment," as one source put

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