Debt Rattle, March 16 2008: Will the doors open on Monday?

Ilargi: The talk has changed to ”an emergency bank holiday”. By now, anything is possible. You'd have to be a fly on the wall in the talks between the Fed, the Treasury and the major banks, if you'd want to know. What's certain is that the Fed is fast running out of instruments.

It hardly has the funds to pump in the next $500 billion, no rate cut has had any effect beyond a few hours, Bear Stearns failed the day after the last $200+ billion was made available, and perhaps most ominously, that $200+ billion won't even really be there till March 27. They very simply and surely don't have that long. Bear went within 1 day. March 27 is 11 days away. You don't have to be that fly on the wall to understand that extreme, drastic and severe measures are being discussed right now. My question, which I don't pretend to have the answer to:

Will the doors open on Monday? All of them?

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Updated 2.15 pm

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Ilargi: The suits are ordering in. Chinese and coffee. Lots and strong.

Bear races to forge deal with JPMorgan

Bear Stearns, the stricken US investment bank, was this weekend fighting against the clock to work out a deal to sell itself to JPMorgan Chase, amid growing concerns that failure to clinch an agreement by Monday morning could put other banks under severe strain. The Federal Reserve, which on Friday provided emergency funds to Bear, and the Treasury are believed to be watching the situation closely.

The authorities fear that, unless the crisis is resolved promptly, traders may turn their sights to other US and European banks. “The Fed is most nervous about the systemic risk,” said one senior executive at Bear Stearns, the fifth largest investment bank in the US, which is set to release its quarterly results on Monday. ”The government needs to stabilise the financial system.”

Hank Paulson, Treasury secretary, on Sunday sought to allay fears that the crisis of confidence that hit Bear, which was undone by clients’ rush to withdraw funds amid rumours over its financial health, would spread to the rest of the financial sector. Investor sentiment towards financial companies is likely to take another knock this week when investment banks, including Goldman Sachs and Lehman Brothers, are expected to report first quarter losses in their leverage loans and mortgage-related portfolios.

On Friday, Lehman announced a $2bn unsecured credit line to shore up its balance sheet. People close to the situation said that since Friday senior executives at Bear and JPMorgan, which is acting as a go-between for the Fed funds, have been locked in talks over a deal. ”We are definitely in the mix,” one senior person at JPMorgan said on Sunday.

With Bear’s equity close to zero already and its liabilities unknown, JPMorgan , could end up paying very little to acquire the firm. Bear’s market value has plunged to just $3.5bn, from a peak of nearly $20bn in January last year, largely because of frenzied selling of its shares over the past week. Insiders suggest that the value of Bear’s head office in a prime location on Madison Avenue, near JPMorgan’s offices, may be enough cover a large portion of the eventual sale price.

JPMorgan has been contacting clients to inform them of the coming consolidation. An executive in JPMorgan’s private banking side told one client that the private bank already had taken control of $150m in Bear Stearns’ clients assets. However, a deal is complicated by the fact that JPMorgan is believed to be interested in only some of Bear’s businesses, such as the mortgage business and the prime brokerage unit, and does not want other divisions, such as the investment bank. People close to the situation said the need to agree a speedy deal made an orderly break-up of Bear among different bidders difficult, making it more likely the firm would be acquired as a whole and later split into different parts.

Since the announcement of the Fed move, Bear’s prime brokerage business has been hit by the defections of some of its hedge fund clients. It is understood that Highfields Capital Management and Fir Tree Partners were among the funds to sever ties with Bear. Other bidders that had been rumoured to be interested in Bear, such as Royal Bank of Scotland and Barclays Capital in the UK and Citadel, the US hedge fund, are not believed to be talking to the company at present.

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Which bank is going to follow the Bear?

So who is next? As advisers to Bear Stearns struggle to find a buyer or funding in the next 28 days, Wall Street, the City and the financial district in Tokyo were scrabbling to find out who is the most exposed to Bear Stearns, either through loans or trading positions. Traders in all three centres were panicking even for those banks not directly exposed to Bear. They feared that the problems experienced at the stricken bank signalled that the credit crisis has deteriorated to a new level.

Yesterday, traders began to look anxiously at the robustness of Lehman Brothers, which, although bigger than Bear, is small compared with JPMorgan Chase, Morgan Stanley and Citigroup. Shares in Lehman dropped 11 per cent yesterday, a far bigger fall than its other rivals, which saw their stock decline by about 3 per cent.

Although Lehman is more diversified than Bear, it has a similar investment profile, with huge holdings in mortgage-backed debt. Lehman sought to reassure the market when it said yesterday that it had secured a $2 billion (£1 billion) credit line with Paolo Tonucci, the bank’s global treasurer, calling it “a strong signal from the market and our key bank relationships”.

However, Chris Whalen, of the Wall Street consultancy Institutional Risk Analytics, said: “This is going to go all the way up the chain. There is a risk that all broker dealers are going to become an endangered species if the credit crisis is not sorted out. If they can’t fund themselves, they will have to shrink. All the other firms are in danger, too.”

He said that should the US Federal Reserve, the US Treasury and the Securities and Exchange Commission not devise a broad rescue plan to address the credit turmoil on Wall Street this weekend, “I would not be surprised to see an emergency bank holiday announced. That hasn’t happened since Roosevelt.”

During the Depression, 75 years ago almost to the day, Franklin Roosevelt declared a four-day bank holiday, which stemmed a frantic run on banks. Mr Whalen added that should banks such as Lehman continue to be unable to sell the billions of dollars of mortgage-backed securities held, they were doomed. He said: “Broker dealers have to be able to get rid of assets. If they are illiquid, they die.”

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Wall Street fears for next Great Depression

Wall Street is bracing itself for another week of roller-coaster trading after more than $300bn (£150bn) was wiped off the US equity markets on Friday following the emergency funding package put together by the Federal Reserve and JPMorgan Chase to rescue Bear Stearns.

One UK economist warned that the world is now close to a 1930s-like Great Depression, while New York traders said they had never experienced such fear. The Fed's emergency funding procedure was first used in the Depression and has rarely been used since.

A Goldman Sachs trader in New York said: "Everyone is in a total state of shock, aghast at what is happening. No one wants to talk, let alone deal; we're just standing by waiting. Everyone is nervous about what is going to emerge when trading starts tomorrow."

In the UK, Michael Taylor, a senior market strategist at Lombard, the economics consultancy, said on Friday night: "We have all been talking about a 1970s-style crisis but as each day goes by this looks more like the 1930s. No one has any clue as to where this is going to end; it's a self-feeding disaster." Mr Taylor, who had been relatively optimistic, has turned bearish: "It really does look as though the UK is now heading for a recession. The credit-crunch means that even if the Bank of England cuts rates again, the banks are in such a bad way they are unlikely to pass cuts on."

Mr Taylor added that he expects a sharp downturn in the real UK economy as the public and companies stop borrowing. "We have never seen anything like this before. This is new territory for us. Liquidity is being pumped into the system but the banks are not taking any notice. This is all about confidence. The more the central banks do, the more the banks seem to ignore what's going on." Mr Taylor added that the problems unravelling at Bear Stearns are just the beginning: "There will be more banks and hedge funds heading for collapse."

One of the problems facing the markets is that, despite the Fed's move last week to feed them another $200bn, the banks are still not lending to each other. "This crisis is one of faith. We are going to see even more problems in the hedge funds as they face margin calls," said Mark O'Sullivan, director of dealing at Currencies Direct in London. "What we are waiting for now is for the Fed to cut interest rates again this week. But that's already been discounted by the market and is unlikely to help restore confidence."

Mr O'Sullivan added that the dollar's free-fall is set to continue and may need cuts in European interest rates to trim the euro's recent strength against the dollar. "But the ECB doesn't like cutting rates," he said. On Europe, Mr Taylor said that while the German economy remains strong, others such as Italy's and Spain's are weakening. "You could see a scenario where the eurozone breaks up if economies continue to be so worried about inflation."

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UK tycoon Joe Lewis loses $800m on Wall Street

Joe Lewis, the secretive British billionaire, has lost an estimated $800m in the collapse of the American investment bank Bear Stearns. The 71-year-old currency trading tycoon, who runs his empire from the Bahamas, holds almost 10% of the bank's shares. Bear’s shares fell 40% on Friday to $27, after it secured a 28-day credit lifeline to stave off collapse. Lewis began building a stake in Bear last September, when the shares were changing hands for more than $100.

The huge paper losses could force Lewis to sell out of some of his other positions, according to traders, in order to meet margin calls from his lending banks. Bear Stearns stands on the brink of collapse or break-up this weekend. The bank’s woes come as Wall Street braces itself for another week of pain. Some of America’s biggest financial institutions are set to announce first-quarter figures showing fresh losses and write-downs of billions of dollars. The disclosures come amid desperate attempts to bail out Bear Stearns, which secured a 28-day lifeline on Friday to stave off collapse.

That would have caused a sale of Bear’s $42 billion (£21 billion) of loans and $176 billion of securities that could have triggered a meltdown in the financial markets. On a Friday conference call, Bear’s chief executive Alan Schwartz said the bank was considering a full range of options - a statement many took to mean the bank is on the block. Lazards is advising Bear on its options. JP Morgan Chase has stepped in alongside the Federal Reserve Bank of New York to provide emergency funding.

Jamie Dimon, JP Morgan chief executive, is interested in Bear’s prime brokerage business and parts of its mortgage operations, according to sources. “Bear Stearns is over,” said one banker. “By the end of the month - if not this weekend - someone is going to come up with a plan to take it out or break it up.” Wachovia, the giant American retail bank, is also said to be interested in parts of the business and so is JC Flowers, the private-equity group that attempted to buy Northern Rock.

A takeover is not expected to place a high value on Bear Stearns shares, which lost almost half their value on Friday. Richard Bove, a banking analyst at the Punk Ziegel investment bank, said he thought a buyout was likely to fail, as it did with Britain’s Northern Rock. “I don’t think the Fed will approve a purchase,” he said. “Customers are leaving in droves, so what would they be buying?” Bove said Bear was “a new Northern Rock” that would be propped up by the government as it dwindled away. He predicted the bank will limp on, losing clients, until it ends up being a regional broker.

Bear’s woes come as its blue-chip rivals prepare to announce first-quarter results. Analysts have cut their 2008 earnings outlook for Bear Stearns, Goldman Sachs, Lehman Brothers and Morgan Stanley. Bove said the results were less important than the strategy the banks were now following. “We have a totally mismanaged economy in America and that has been allowed to happen because the rest of the world accepted our debt. “Well that’s over and now, like a banana republic, we are going to have to prove we are sorting out our act.”

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Beware Of Feds Bear-ing Gifts

With Bear Stearns having to be rescued by the Fed (i.e. the government), the credit crisis is entering the seriously ugly phase. And I say this now because we Street types exhibit sangfroid when a sub-prime family gets thrown out of its home ("they should have been more responsible in managing their debt"), but when the sheriff comes calling to our neighborhood "it's the market's fault". Come to think of it, I have never seen a mirror at a bank/broker/investment bank office - I wonder why..?

Anyway, prior to rescuing Bear Stearns yesterday, there were only two prior occasions when the Fed used the obscure provision about funding non-bank institutions through the Discount Window. As The Economist points out, the last time was in the 1960s - and before that in the 1930s. References and parallels to the Great Depression are getting all too frequent lately, it seems.

While the failure of one major-bracket investment bank to get funding on its own is bad enough, worse is yet to come. Broker/dealers are entirely dependent on ample short term loans and trading lines to carry their securities' inventory and to clear transactions. Any hint of trouble and counterparties pull their lines and customers pull their accounts. The end comes instantly, usually no more than a few hours: Sudden Debt, to coin a phrase*..

The trouble at Bear will now cause every firm to become even more cautious with counterparty risk, clamping down on credit lines to trading partners and customers. The immediate reaction is "Bear is history, who's next?". Unlike the isolated 1998 LTCM snafu - one bad apple threatening to contaminate many otherwise healthy apples - the current crisis is fundamentally more serious and widespread. We know that many healthy-looking apples are already wormy inside, but we don't know which ones. The result is less trust in "apples" overall, a major problem in an industry where trust is the cornerstone of daily business.

Bottom line: short-term market credit (aka margin) is going to get squeezed much harder in days and weeks to come, forcing the Fed into even more "gifts" of TAFs, TSLFs, etc. That's too bad: to use mythological parallels, Pandora has opened the box... or the Trojans have wheeled a certain horse into their city.

Finance Goes To The Fed

* Yes, hours. To provide an example, during the 1987 crash my then firm (a major bracket, too) asked that customer margin calls be satisfied immediately - as in "wire or bring a check to the cashier by 2 pm or you will be sold out". Fun, eh? When survival is at stake in the Street, noblesse never oblige.

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Global financial system braced for ripple effect

Bear Stearns is hardly Wall Street’s biggest investment bank but its travails have far-reaching consequences for the global financial system because of its crucial behind-the-scenes role in some of the world’s most troubled markets. Bear is a significant underwriter of mortgage securities, an active trader of derivatives and leading financier of hedge funds. Analysts said it was almost impossible to know what impact Bear’s problems would have on its clients, its counterparties and on other investors holding securities or derivatives that Bear is trying to liquidate.

“The ripples could be widely felt because Bear Stearns has so many points of contact with everyone else in the financial industry,” said Matt D’Amico, partner in the banking business at law firm Bryan Cave. Evidence of bubbling contagion in the financial markets can be seen in the dramatic surge in the cost of credit insurance for global banks. Many banks have double-A credit ratings, but the price charged to insure their debt is more typical of lower-rated companies.

This breakdown in the credit derivative market illustrates the close ties of global finance. Insurance contracts on the banks are transacted in the over-the-counter (OTC) market, an arena created by the banks where they and their customers trade directly with each other. The $45,000bn of contracts in the credit default swaps market, in turn, is part of a bigger OTC derivatives market. It includes common financial instruments used by corporate treasurers and investors such as interest-rate swaps – with $347,000bn in notional outstanding contracts.

“Bear Stearns is counterparty to a huge number of OTC derivatives, and it is not just the unwinding of contracts with Bear that are a concern, but the ability of this market with relatively weak and untested infrastructure to handle such a shock,” said Karen Petrou, managing partner at Federal Financial Analytics. Participants post collateral with each other when they trade derivatives, but it is unclear whether this will cover potential losses in the event of a crisis.

The effects of Bear Stearns are already felt in markets where the bank has tried to sell assets to meet its cash requirements. A shortage of liquidity has forced investment banks and hedge funds to offload mortgage-backed securities and other assets at discount prices.

Indeed, some rivals say Bear’s distress was evident on Thursday when it sold a large number of securities backed by Alt-A mortgages at distressed prices. Wall Street investment banks are already expected to report significant additional losses on the mark-to-market valuations of securities when they report earnings next week.

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Fears that new liquidity cycle will stoke inflation

Efforts by the Federal Reserve to restore order to financial markets are about to enter a new and potentially dangerous phase.The Fed is expected to cut US interest rates by 75 basis points to 2.25 per cent, following its recent, more aggressive policy moves to improve liquidity conditions. There re-mains a clear possibility that interest rates will only be reduced by 50 basis points as policymakers attempt to evaluate the impact of their earlier efforts to restore confidence to financial markets.

Joachim Fels of Morgan Stanley says the Fed is about to enter a new phase in the easing of monetary policy that will take real interest rates below zero. This would be achieved with a 75 basis point cut.

Morgan Stanley forecasts a further 50 basis points reduction to 1.75 per cent in April and rates to then remain on hold for the remainder of 2008.

Mr Fels says this marks the start of a new global liquidity cycle in which the combined but not necessarily co-ordinated efforts of central banks should lift growth and asset prices in 2009. However, the clear danger is that easier monetary policies will cement a new regime of higher global inflation, undoing years of hard work by policymakers to anchor price stability and inflation expectation

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Ben Bernanke in dilemma over bank bail-out

“Indications of contagion have started to appear in other credit markets . . . defaults in the US markets are spreading to higher quality segments of the US mortgage market and to credit-card debt and automobile loans . . . balance sheets remain vulnerable to a further deterioration in the credit quality of assets . . .” There’s more, but you get the drift of the draft report put before EU heads of government last week by the European Council on Financial Market Stability.

Across the ocean the US Federal Reserve Board’s monetary policy committee needed no such briefing. Fed chairman Ben Bernanke had been cutting short-term interest rates in an attempt to ease the credit log-jam, to no effect. Longer-term rates remained stuck on high. So the Fed laid down its blunderbuss – rate cuts – and took aim at a specific target: the credit markets. Come to us with your AAA-rated mortgages, Bernanke told strapped financial institutions, and we will lend you in exchange $200 billion of the risk-free Treasury securities that we hold on our own balance sheet. And for 28 days, rather than the few hours, as is our usual custom.

Not quite the same thing as buying these mortgages from the banks, which would prefer to unload them permanently for cash. That would be a bail-out, something Treasury secretary Hank Paulson is eager to avoid lest it creates moral hazard, economists’ jargon for encouraging a repeat of bad behaviour. The Fed’s non-bail-out is aimed at driving up the price of mortgages to increase their valuation on bank balance sheets.

That, along with the risk-free Treasury notes against which the banks can borrow cash, would enable the banks to start lending again. All of which puts me in mind of the Clintons, who in a desperate bid to salvage Hillary Clinton’s Democratic campaign, decided to “throw the sink” at Barack Obama - which they have done, but with only limited success: Obama remains on course to win. Bernanke has now thrown the sink at the credit crunch. And with only limited success: share prices rallied and banks lined up to take advantage of his offer at an auction to be held on March 27.

There are four problems with all of this. The first is that bad news overwhelms good. The collapse of one of the Carlyle Group’s funds, and rumours of the impending demise of Bear Stearns, trumped Bernanke’s announcement. The second problem is that the Fed is a tiny player in the mortgage market. The $200 billion of mortgages Bernanke will be taking on are a drop in the ocean that is the $11 trillion mortgage market. And he has only another $400 billion in Treasurynotes to play with - if he is willing to have these mortgages make up his entire stock of assets.

Third, so long as house prices continue falling, the value of mortgages will continue falling. The Fed can’t do much to stop that decline, and we seem to have a long way to go before house prices reach some bottom, unsold houses are absorbed, and the market turns up. Finally, the Fed might be fighting yesterday’s war, when the problem seemed to be a liquidity crisis.

The Fed first lowered interest rates to facilitate borrowing. No luck; long-term rates were immovable. It then made funds available to credit markets for very short periods on attractive terms. No luck; credit markets remained frozen. So now we have the offer of $200 billion of high-quality assets to replace those of lesser quality. Tune in after a few weeks to find out if this has significantly eased credit markets, or merely created a bit of euphoria in stock markets.

Meanwhile, the Fed’s critics are saying that the enemy is no longer liquidity, but the threat of insolvency. We have already had billions in write-offs, and hundreds of billions more of such “marking to market” is coming. So steep will these write-downs be that the banks will find they are bust - what they owe to depositors and creditors exceeds the value of their shrivelled assets. Unless they can get more capital, say the doom-mongers, they will have to shut their tellers’ windows.

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Ilargi: Between the lines of incredible nonsense ("Our institutions -- our banks and investment banks -- are strong.", "Paulson repeated his support for a "strong dollar,"), what seems to shine through is blunt refusal from the White House to help anyone. Meanwhlie, in this weekend’s emergency talks, Paulson’s tone will be entirely different. But those talks are secret.

Paulson Says He'll 'Do What It Takes' to Calm Markets

"I've got great confidence in our financial markets and our financial institutions," Paulson said. "Our markets are resilient, are flexible. Our institutions -- our banks and investment banks -- are strong." Paulson repeated his support for a "strong dollar," and said the long-term strength of the U.S. economy would be reflected in the country's currency.

The Bush administration has resisted the use of government funds or guarantees to stem the surge in foreclosures. Paulson has brokered a series of voluntary accords among lenders to freeze interest rates on subprime loans and negotiated a one- month moratorium on foreclosures.

A credit crisis that began in August has left markets "more fragile than we would like right now," Paulson said in a separate interview on ABC News's "This Week" program. "My concern is to minimize the impact on the broader economy." Paulson said the administration doesn't support measures in Congress to help struggling homeowners.

House Financial Services Committee Chairman Barney Frank and Senate Banking Committee Chairman Christopher Dodd offered a plan last week to let the Federal Housing Administration insure refinanced mortgages after lenders reduce principal to help struggling borrowers.

The two lawmakers are leading congressional efforts to tackle the surge in foreclosures, which reached record levels in the fourth quarter of 2007. Their plan goes beyond the Bush administration's approach that relies on voluntary agreements between lenders and loan servicers to modify mortgages for borrowers who can't make their monthly payments.
"I'm looking very carefully at any proposal, but all the ones I've seen call for much more government intervention, raise more problems, do more harm than do good," Paulson said in the ABC interview.

President George W. Bush, under fire from Democrats who say he's doing too little to help homeowners facing foreclosure, yesterday said he won't be stampeded into "bad policy decisions" that might harm the economy. "The market now is in the process of correcting itself, and delaying that correction would only prolong the problem," he said in his weekly radio address. "I believe the government can take sensible, focused action to help responsible homeowners weather this rough patch."

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Meltdown: the bad news is only just starting

I said last weekend that bankers believed the situation in the interbank lending market was as bad now as it was last August when Northern Rock, the mortgage bank, went into meltdown. I was wrong - it’s worse.

These are serious times in financial markets. The emergency funding given to Bear Stearns, the troubled American investment bank, shows just how bad it is. All banks are running for cover. They are frantically trying to build up their balance sheets and eliminate risk. They are not prepared to lend to each other and the biggest concern they have is not one of liquidity, but solvency. That is why Bear Stearns was left high and dry.

Most banks are still sitting on valuable assets, but they cannot sell them at sensible prices and are running out of cash. Some will eventually be forced to sell, and fast. There are scare stories aplenty out there about prominent institutions like Royal Bank of Scotland, Fortis and America’s AIG and a host of continental banks. They are repeatedly denied but if only half the rumours are true, we are looking at a very frightening scenario.

The most optimistic interpretation is that the collapse of Bear Stearns is the big casualty we have all been waiting for, and that we will now see a period of consolidation among financial institutions. The pessimistic view is that the Bear Stearns episode is the equivalent of a fall from a mountain top to a slippery ledge, and there is a greater tumble to come.

The global financial system is so interconnected that it is easy to believe that we will see more collapses. The American investment banks will start a round of quarterly earnings updates this week and the figures will do little to dispel the sense of gloom. Equity markets are slowly starting to catch up with the bad news. There are now nine companies in the FTSE 350 with dividend yields of more than 9%, often a sign of impending problems. Among them are three banks - Alliance & Leicester, Bradford & Bingley and Royal Bank of Scotland.

There are 41 companies in the 350 with shares yielding more than 6%. The market is starting to recognise that the financial meltdown will spill over into the wider economy. The first sign of that will be redundancies as companies attempt to slash their overheads as earnings fall. We are just starting to witness that and it’s bad news.

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Why JPMorgan Should Buy Bear Stearns

The newspapers Friday were all a buzz about Bear Stearn’s liquidity crunch and the concerted efforts that the JPMorgan and the Fed are taking to provide some immediate relief. The New York Times reports that [bold and italics added for emphasis]:

For the next month, JPMorgan will work with Bear Stearns to reach a solution for its financing crisis. Options could include organizing permanent financing or, according to people briefed on the discussions, buying the bank for a discounted price.

Isn’t it ironic that Bear Stearns, which had refused to go along with other Wall Street firms to save Long Term Capital Management [LTCM] in 1998, is now faced with the same problem? However, Jamie Dimon, the CEO of JPMorgan, is a shrewd banker who will not let that bit of history get in the way of getting Bear Sterns at a very discounted price.

While JPMorgan has repeatedly publicly stated that it is not in the market for an investment bank, Bear Stearns makes a very good case from a risk/reward basis. Given the near collapse of the Bear Stearn’s stock price, the market cap of Bear Sterans is approximately $4.4 billion, as of midday Friday, March 14, 2008. Given JPMorgan’s strong capital position – $88.7 billion in reserve (resulting in an approximately 8.1% Tier 1 capital ratio and approximately 12.6% capital ration, overall) and $71.9 billion in tangible common equity, at the end of 2007.

Given the strength of their financial statements, JPMorgan can easily absorb Bear Stearns without substantially denting their capital. Additionally, Bear Stearns is not a true investment bank as it historically dealt heavily in mortgage back securities and did not diversify out of this niche. Additionally, Bear has valuable business units, such as its real estate, hedge fund servicing, and strong back office units.

Since Bear Stearns was really a mortgage back securities trading firm, rather than a full service investment bank, Bear’s mortgage-back securities and mortgage trading business will help to boost JPMorgan’s standing in the global debt capital league market. According to Thomson Financial's global mortgage-backed securities league table (B10) for FY 2007, JPMorgan at $77.9 billion was ranked 6th and Bear at $86.5 billion was ranked 3rd. If combined, JPMorgan would move to the top at $164.4 billion, displacing Lehman Brothers (LEH) at $115.8 billion.

Additionally, Bear Stearns has one of the best back office units in the business. The market for debt securities will improve. By using this period of uncertainty and slow business, JPMorgan has the time to combine the two back offices together and be prepared to take larger share of the settlement business when the market returns.

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Fed Action's Too Late to Save Bear Stearns

I’m starting to get the sense that U.S. Federal Reserve Chairman Ben Bernanke’s job is harder than any of us can comprehend. And a component of that Triple Black Diamond difficulty comes in the need for people in his position to have a sense of what problems are coming down the pike, and getting ahead of them. Last fall, “Helicopter” Ben was chastised by many market observers for missing the signs in the weakening subprime mortgage market. Mr. Bernanke’s critics are going to have a field day after last week.

On Monday morning, rumors about liquidity issues at Bear Stearns became very insistent. Despite having made the rounds for the prior couple of weeks, with little impact on the stock, the rumor seemed different this time. Bear’s shares started to crumple, falling 13% in the first 150 minutes of the trading day, and speculators were buying C$58 dollar puts even though BSC was trading in the mid-C$60s. Unusually out-of-the-money.

Around midday on Monday, Bear Stearns boss Alan Greenberg called in to CNBC to say the rumors (posted here, thanks to a great tip, before Bloomberg and Reuters filed their initial stories; back pat) “were ridiculous.” Not true.
The very people that provide credit to each other hundreds of times a day - the banks and brokerage firms - knew what they knew. Clearly, many of them were starting to get less comfortable advancing sums to BSC as of Monday. And perhaps Bear Stearns was no longer providing as much leverage to its “prime brokerage” clients as it had been in prior weeks. With less cash on hand, Bear wouldn’t be as able to provide as much credit to its hedge fund Dark-Arts clients. Who better to ascertain the financial health of a business than the customers and counterparties?

These are but two of the many ways the Bear rumor might have been started, and I’m pretty sure - in hindsight - that it wasn’t a “rumor.” It was a tremor. Like those hints you get from the tectonic plates shortly before a large earthquake is about to happen. In an effort to help shore up firms such as Bear Stearns, on Tuesday, the U.S. Federal Reserve announced (undermining Mr. Greenberg’s earlier protestations), that it would now accept AAA mortgage-backed securities as collateral. This move was clearly designed to help Bear Stearns, the #2 U.S. underwriter of mortgage-backed securities, among other large independents (think Lehman Brothers).

The news of the $200 billion Term Auction facility drove North American financial shares higher on Tuesday, and Bear Stears recovered almost C$6 of its Monday swoon. But, it didn’t last. The very firms that do business with Bear didn’t change their view between Monday and Wednesday, and the ducks began to quack once again. By Thursday, the very reasons why the financial community had been starting to pull back their counterparty risk from Bear Stearns took hold. Overnight, the Federal Reserve stepped in, using J.P. Morgan (with assets of $1.6 trillion) as the funding conduit.

The moral is this. When it comes to financial stocks, there are no secrets. If a business is in trouble, it is very hard to hide it from the folks across the street. The industry is just too intertwined. The very people yakking about funding issues at Bear Stearns were the very ones who should have known there was trouble brewing - they are, after all, the people that trade with them all day. If they were nervous, it didn’t take a leap of faith to expect them to calm their own nerves…and yank the funding relationships.

The Fed underestimated the subprime crisis. Now it has raced unto the scene on its white horse, only to find out that market confidence in Bear Stearns may well be past the point of propping up. It’s not as though the signs weren’t there. As a result, a sale of BSC over this weekend is not out of the question. One thing’s for sure. Helicopter Ben’s critics will be at it again tomorrow.

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Ilargi: The Collection Agency has a different angle than me, but tells the same story: the Fed has already taken over, or nationalized, the bankrupt Primary Dealers. The PD's borrow temporary credit to pay off their permanent loans. Nice circle.

Pre-emptive warning of a major banking crisis

he TSLF will be a single-price auction, where accepted dealer bids will be awarded at the same fee rate, which shall be the lowest fee rate at which bids were accepted. Dealers may submit two bids for the basket of eligible Treasury general collateral announced at each auction. At the TSLF auction, each dealer aggregate award and each individual bid will be limited to no more than 20 percent of the offering amount.

The Desk will consult with the primary dealers on technical design features of the TSLF in the coming days and specific auction details may be adjusted based on these conversations, experience in the initial auctions and market conditions." Primary dealers (PD) get treasuries in exchange for other types of bonds they cannot use due to current credit market conditions.

There is however another factor that was pretty much ignored in the most recent developments. The Fed introduced a series of Permanent Open Market Operations, selling treasuries to PDs. So far there have been 2 POMO's (double the number for the whole of 2007), the first for $10bn and the latest for $15Bn. These are cash transactions; the Fed received $25Bn in cash and gave out Treasuries from the System Open Market Account (SOMA).

There can be little doubt that the current crisis is centered on the PDs and is directly related to a lack of usable collateral to enable PD borrowing to take place. That is, no one is willing to lend if the collateral is not AAA government debt. The Fed is attempting to relight lending by swapping usable collateral (treasuries) for other AAA/Aaa debt that is not at risk of downgrade.

If the Fed allowed free market forces to operate then the PDs would have to buy treasuries from the market to possess the collateral required to borrow. This is clearly beyond their ability as the losses realized from selling low and buying high would obliterate their balance sheets. The Fed has decided to meet the Bankers margin call.

You may ask "why didn't the PDs just buy the treasuries from the Fed?" A fine question that deserves a simple, observational answer. The Fed has conducted two 1 month TOMOs in recent days, lending out cash and taking mortgage backed collateral in exchange. The amount lent out is $30Bn. So to raise the cash to buy the treasuries from the POMO, the PDs borrowed from the TOMO. What does that tell us?

Quite simply the PDs have no cash reserves. They are bankrupt. When I mentioned in the recent Weekly Reports that the Fed had temporarily nationalized the Banks/Brokers, this is what I meant. The Fed is allowing PD assets to be moved off the balance sheet and into a new investment vehicle. The only difficulty is how do you make the make the words "Federal Reserve" and "Structured Investment Vehicles" into a new acronym?

Right now the PDs are purely a front, emperors without clothes. Ben Bernanke is literally behind the curtain, pulling the levers. The problem for the Bernanke is the lack of levers, the SOMA is a finite resource, which I estimate to have $600Bn (ish) of usable collateral available. After using that resource the Fed would either have to buy newly issued treasuries from the US Government or issue its own bonds.

That would mean either the printing of new dollars to buy the treasuries or the invention of a new dollar derivative to use in the credit markets. Either choice has inherent risks to the dollars worth. Other new initiatives may well be viewed as panic moves, the goodwill of market participants may have been eroded to zero on this latest "boost" in the stock markets.

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Danes cry foul over aid for Northern Rock

Denmark’s biggest banks have written to the European commission to complain about the behaviour of the newly nationalised Northern Rock in the savings market.

In the first formal attack on Northern Rock’s conduct lodged with European authorities, the Danish banks claim the publicly owned bank enjoys an “unfair competitive advantage”. They also claim that the “extraordinary protection” afforded to Northern Rock’s customers from the British government could lead to a “distortion of competition” in the market. The criticisms are set out in a three-page letter that was sent to Neelie Kroes, the European competition commissioner, earlier this month.

The Danish complaint comes as Ron Sandler, Northern Rock’s chairman, prepares to file the bank’s business plan with the commission. The plan is expected to reveal that Northern Rock’s mortgage book could be shrunk to about half its current size. Northern Rock’s 6,000-strong workforce is also expecting to hear news of job cuts. Sandler has been working on a number of proposals to reduce job losses on Tyneside, including plans that would see the workforce administer mortgages on behalf of other lenders through out-sourcing agreements.

Pressure is mounting on Sandler to publish full accounts for Northern Rock, which were withheld before nationalisation. British bankers are increasingly concerned that Northern Rock’s government-backed status is allowing it to attract more than its fair share of the savings market. It is offering the highest rate in 11 of the 19 types of saving account monitored by the industry, according to banking sources.

A number of its products offer rates of 6.25%, a full 100 basis points higher than Bank rate. The British Bankers’ Association is pushing for Northern Rock’s savings products to have regulated interest rates, tied to those offered by competitors. The Building Societies Association (BSA) is considering lodging a complaint with the Office of Fair Trading over Northern Rock’s behaviour.

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Euro's Ascent Causes Concern for EU Leaders

European Union leaders expressed concern about their currency, which struck yet another record Friday against the dollar, though they remained optimistic that Europe would weather the current economic storm. In a rarity for a group that doesn't publicly discuss exchange rates, the EU's 27 nations said in a joint statement that, "Excessive volatility and disorderly movements in exchange rates are undesirable for economic growth."

(The euro hit an intraday record of $1.5688 on Friday, but eased back to $1.5671 at 4 p.m.) European exporters are being hurt because their goods are now more expensive for U.S. buyers. However, the strong euro may help alleviate the burden in dollar-priced oil imports. European Commission President Jose Manuel Barroso insisted that the region had a "stable currency."

He said governments were confident that the European Central Bank -- which sets borrowing costs for the euro currency zone -- was right to inject cash into lending markets in response to the current turmoil. The ECB has left interest rates unchanged since last June as tight credit conditions hold it back from trying to cool inflation. Yearly inflation in the euro zone last month was confirmed Friday at 3.3% -- the highest since the introduction of the euro in 1999.

"The European Central Bank has been responding to the financial turbulences through a timely provision of liquidity. This is evidence that the European Central Bank will do what is necessary to secure financial stability," Mr. Barroso said.
French President Nicolas Sarkozy said he was satisfied that leaders had expressed their worries about the currency-exchange situation. "It would have been unthinkable the summit would have remained silent on this," Mr. Sarkozy said.

He has been critical of the ECB for not heeding the concerns of politicians about growth-curbing interest rates. Mr. Barroso warned that the global financial crisis leaves little room for complacency. "Vigilance is called for," he said. "Transparency and enhanced cooperation between the regulators and the supervisors both at European and global level are crucial elements here."

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UK: Doors slam on mortgage deals

Banks that have long fought each other to win mortgage customers are now, unusually, taking steps to repel them. Some are withdrawing entire mortgage ranges with very little notice and many are increasing interest rates to levels that are demonstrably unattractive. Borrowers looking for new mortgages are being thrown into complete chaos as deals they have agreed with their broker disappear from the market just hours before applications were to be signed. Many are now facing unaffordable increases to mortgage payments.

The nub of the problem is that banks do not have access to sufficient funds or administrative resources to meet high borrower demand. Funding through the wholesale markets has become prohibitively expensive and lenders increasingly are having to rely on the limited funds they receive from customer deposits. Some lenders have pulled out of the mortgage market altogether, while those still lending have scaled back their product ranges significantly. The high level of mortgage demand is being driven by the thousands of mortgage borrowers coming to the end of cheap fixed-rate deals each month.

“Any vaguely competitive mortgages are being snapped up very quickly by new buyers and those remortgaging,” said Melanie Bien at Savills Private Finance. “Once the funds have run out, lenders have been pulling the rates and have not always been able to give notice.” Scottish Widows Bank removed its entire range of tracker mortgages on Thursday, along with its five-year fixed rates. The bank, which is struggling to deal with a significant increase in new applications, told mortgage brokers it was unable to accept calls about new business for a week. It is due to relaunch its range on Tuesday at far higher rates.

Mortgage brokers say the speed at which top mortgage rates are disappearing is creating significant problems for borrowers. Ian Gray, senior mortgage manager at Clegg Gifford Private Clients, said: “Those coming off deals now are feeling a big shock as there has been a huge jump in mortgage rates.” He says some clients face monthly increases of up to £400. If they cannot afford the higher payments they might, in extreme cases, have to sell. Borrowers are also having to decide very quickly which mortgage to go for as some lenders are giving just a few hours’ warning when they are going to close a deal.

There are numerous examples of lenders pulling rates within 24 hours. One lender even backdated the end of the deal to the previous day. “The ridiculous thing was that at 3 o’clock in the afternoon the Scottish Widows deal was available,” said Mr Gray. “Forty-five minutes later the bank e-mailed to say it was being withdrawn at five that afternoon. That is not good practice.”

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UK lenders pull out of mortgage deals

Lenders are frantically withdrawing many of their mortgage offers – sometimes with less than an hour’s warning – as severe funding constraints mean that they are unable to meet demand for the most competitive deals. Brokers had as little as 10 minutes’ notice on Thursday when Scottish Widows removed the bulk of its mortgage range. Some borrowers have agreed mortgage deals only to see them disappear from the market just hours before completing their applications.

The root of the problem is unprecedented volatility in the mortgage markets. Three-month Libor – the rate at which banks lend to each other – yesterday climbed to 5.93 per cent, its highest level since the start of the year. “Certain lenders are pulling deals at extremely short notice,” said Paul Welch, managing director of Clegg Gifford Private Clients, the mortgage broker. “So few lenders are in the market now that those left just cannot cope with the business.”

According to Moneyfacts.co.uk, the comparison service, there are just 6,186 mortgages left in the market, less than half the number available at the end of August. The market for borrowers without a deposit has practically dried up. Only two major lenders – Mortgage Works, a division of Nationwide, and Abbey – are now offering 100 per cent loan-to-value mortgages. Mortgage Express, part of Bradford & Bingley, withdrew from this market earlier this week.

In the past lenders would typically have given at least a few days’ notice before they withdrew rates. But some are now choosing to give little or no notice so as to avoid a last-minute stampede from borrowers desperate to secure the best deal. Scottish Widows, which is part of Lloyds TSB, said it had withdrawn from the market for a few days because it was seeing “very high levels of applications”.

C&G, also part of Lloyds, announced yesterday morning that it was pulling a number of buy-to-let mortgage loans from brokers at the end of the day to prevent its levels of service from being flooded by new applications. Halifax, Mortgage Express, Bank of Scotland and Woolwich have also withdrawn rates at short notice in the past month.

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Small funds face credit squeeze as prime brokers withdraw financial support

London’s embattled hedge fund community is bracing for a spate of blow-ups in the wake of yesterday’s $16 billion (£7.9 billion) debt default by Carlyle Capital Corporation, the Dutch-listed affiliate of the American private equity group. Numerous small start-up credit hedge funds, managing between $10 million and $200 million of assets, are facing a funding squeeze, according to sources.

The prime brokers that provide credit liquidity to these funds are beginning to withdraw financial support or heavily increase their margin calls, they said. Several bigger credit funds with as much as $2 billion under management are also looking vulnerable, particularly if they are highly leveraged, according to other sources. “It’s basically any single-strategy hedge fund that is leveraged and invested in mortgage securities; it doesn’t matter whether it is AAA or sub-prime paper; these guys are at risk,” one London hedge fund manager said.

“The smaller players with $10 million or so of funds, guys who jumped out of the investment banks to set up on their own, are under the greatest pressure. They don’t have enough assets to generate proper alpha [sic] for their investors. They barely generate enough management fees to pay their wife’s shopping bill,” the source said. “They are not in a position to add assets because the banks don’t want to lend, so suddenly they don’t have a reason to exist any more.”

The default by Carlyle Capital Corporation, which was invested in AAA securities, represented the second shock wave in as many weeks to rip through the UK hedge fund market. It had already been reeling from the crisis at Peloton, which was forced to liquidate its $2 billion bond fund after failing to meet margin calls.

Like CCC, Peloton was invested in high-quality assets, whose credit quality had not been expected to fall in the wake of the collapse in values of sub-prime mortgage securities – loans extended to borrowers with patchy repayment histories. The CCC fund faced a similar double whammy. As well as the value of its assets sliding, it was hit by increased margin calls by its financing banks. Hedge fund experts said the problems at CCC underscored how prime brokers – the providers of liquidity to hedge funds – have been tightening their terms.

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A Wall Street Domino Theory

The volume of financial contracts that are not traded on any major exchanges has ballooned in recent years after the bailout of a big hedge fund, Long-Term Capital Management, in 1998. Now, much of the trading in derivative contracts tied to stocks and bonds takes place in unregulated transactions between financial institutions.Policy makers have been wrestling with questions about when and how they should provide assistance since the last major bailout of a tottering bank, Continental Illinois, in 1984. At the time, Continental was considered too big to fail without sending waves of losses through the financial system.

Regulators are facing an unprecedented and widespread deterioration in many markets. Last summer, the value of risky and exotic securities plummeted in value. Now, even top-rated securities once deemed as safe as Treasuries have hit the skids. Financial firms have written down more than $150 billion of their assets. Some analysts are predicting that losses in various credit markets will reach $600 billion. Bear Stearns was one of the first firms to experience a direct blow from the subprime mortgage crisis when two of its hedge funds collapsed because of the declining value of mortgage-backed securities.

It is also among the biggest firms in the prime brokerage business, or the financing of hedge funds. In recent weeks, nervous fund managers have scrambled to protect themselves. Robert Sloan, who is the managing partner at S3 Partners, a financing specialist that works with hedge funds, has shifted $25 billion out of Bear Stearns accounts in the last two months, he said. “The problem is the financing of the hedge fund industry is very concentrated and very brittle,” Mr. Sloan said. “If they go under, you will have thousands of funds frozen out,” he said, adding that everyone might then have to wait for a court to name a receiver before business could resume.

Hedge funds rely on Wall Street for a range of services from the humdrum, like holding their securities, to the critical, like providing loans they use to increase their bets. As Wall Street has buckled under multibillion-dollar write-downs, the firms have cut financing to hedge funds and asked the funds to put up more assets to back their borrowing, forcing managers to sell en masse. This has caused a series of hedge fund blowups, including Carlyle Capital, an affiliate of the powerful private equity firm Carlyle Group; Peloton Partners, a hedge fund founded by former Goldman Sachs traders; and Drake Capital, a blue-chip fund that has been struggling.

A manager at one hedge fund that uses Bear Stearns as its prime broker said his firm had been nervously watching the situation. The manager, speaking on the condition that he or his fund not be identified, said the fund had lined up backup firms that could clear its trades and keep its portfolio, though as of Friday afternoon it had not left Bear Stearns. Customer accounts at financial institutions are kept separate from banks’ and dealers’ own holdings to protect those funds if the broker has to seek bankruptcy protection.

But the bigger worry for hedge funds and others that do business with Bear Stearns is whether the firm will be able to honor its trades. Of particular concern are the insurance contracts known as credit default swaps in which one party agrees to guarantee interest and principal payments in case an issuer defaults on its bonds. Investors in such contracts with Bear Stearns are closely studying whether they can get out of them or have them transferred to a more stable firm.

Compounding the problem, some big investment banks this week stopped accepting trades that would expose them to Bear Stearns. Money market funds also reduced their holdings of short-term debt issued by Bear, according to industry officials. “You get to where people can’t trade with each other,” said James L. Melcher, president of Balestra Capital, a hedge fund based in New York. “If the Fed hadn’t acted this morning and Bear did default on its obligations, then that could have triggered a very widespread panic and potentially a collapse of the financial system.”

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The Boomers Break the Deal

In 2005 alone, there were 48% more housing transactions that occurred than should have been expected based on historical average sales per household. In large part this was caused by "investors," many of dubious financial strength, buying homes and condos on readily available credit with no real lending standards and no way to pay the loans if they were not able to sell them at a higher price.

As a result, there are now 3.5 million excess homes that need to be filled by qualified homeowners. Over time, due to growth in the population, the demand will eventually catch up, but that will be a process of several years. Housing prices will have to fall by another 15-20% or so to get to a place where homes become affordable to the marginal buyer. And that assumes rates can stay low.



Annual new and existing home sales are currently running at about 5.5 million. John Burns expect that will fall to about 4 million before we see the bottom of the market. Notice, in the above chart, the drop in sales after the increase in housing sales above the trend projection in the 70's. We have a long way to go to correct the recent bubble, and Burns's research suggests that we will get there sooner rather than later. But this means that home values will drop another 15% or more. Homeowners are going to see $5-6 trillion in home equity vanish in the next year.

By now, everyone knows that the subprime crisis started with non-existent lending standards which resulted in the large numbers of foreclosures we are seeing today. Those foreclosures will be rising throughout the year. We are not near anything like the top of the rising number of foreclosures. Ben Bernanke said last July that losses from the subprime would be in the $100 billion dollar range. True confession. I think I wrote six months earlier that it would be $200 billion. I point that out to make the point that I am an optimist by nature. The latest "bidding war" number for the amount of total losses is about $500 billion from Goldman Sachs, and a neat $1 trillion from uber-bear Nouriel Roubini.

Add in hundreds of billions from losses which are piling up in other credit markets and you can easily get to $1 trillion in losses which are going to have to be eaten by all sorts of financial institutions, without being all that pessimistic. Banks are being forced to reduce their loan and margin books in order to get the necessary capital required by regulatory authorities. Plus, credit is now more expensive as risk premiums rise from absurdly low levels in what more than one authority called a "new era of finance." Turns out it was just normal old era greed.

It is not just the mortgage market. It is commercial mortgages, safe municipal bonds, credit card debt, student loans and a host of credit that is under fire and cannot find a buyer at what should be a realistic price. We should not be surprised at the lack of liquidity in the credit markets. We have essentially vaporized 60% of the buyers of debt in the last six months.

The various alphabet of SIVs, CLOs, CDO, ABS, CMBS, and their kin that were the real shadow banking system are either gone or on life support. It took decades to build these structures and it is not realistic to think we can replace them in six months. This is going to take some time.

And time is what the Fed has bought this week by offering to take AAA mortgage paper and swap it for T-bills. They will start with $200 billion on offer. Remember you read it here first that that number will be increased and increased again. From the markets initial euphoric response, you would think the problems have been solved and banks will once again start lending. Sadly, this is probably not true.

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Woes at WaMu as rating agency issues downgrade

The Associated Press is reporting today that Moody’s Investors Service cut Washington Mutual’s credit rating and said the country’s largest savings and loan will need at least $4 billion more than it expected to cover bad mortgages in 2008.
Investors reacted by taking shares down $1.54, or 12.7 percent, to close at $10.59. Bloomberg reports that the stock is down 22.19 percent so far this year, and down 71.97 percent over the past 12 months.

Moody’s said its action reflects a “rapid deterioration” of the housing market, echoing the rationale behind another rate cut by Standard & Poor’s a week ago. Moody’s also downgraded WaMu’s senior unsecured rating to “Baa3” from “Baa2.” It also cut the bank’s long-term deposit rating to “Baa2” from “Baa1.” The new ratings are still considered investment grade, but reflect moderate credit risk - but another downgrade would put the ratings for the thrift into speculative grade, or “junk,” territory.

Olivia Riley, a WaMu spokeswoman, responded to the AP in an e-mailed statement. “WaMu has several funding sources in addition to the capital markets, including the Federal Home Loan Bank and deposits generated through our retail bank.”

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WaMu: Wasteful Accounting Measures Used

Friday’s announcement that the Federal Reserve and JP Morgan (JPM) were going to bail out failing Bear Stearns (BSC) is another sign that credit woes are far from over. Which by the way, is ironic because just Thursday, Standard & Poor came out suggesting that we were on the downhill slope of write-downs at the big banks! Talk about being wrong...and by just one day! Which begs the question: are the credit rating agencies retarded or just late to the party?

On Friday, S&P lowered WaMu's (WM) debt rating. Was this perhaps due to the fact that Jamie Dimon had his hands full dealing with a broken Bear Stearns? Mr. Dimon is probably the only executive with the banking sensibility to deal with Bear. His acumen is noted by the Fed's willingness to back the deal without capital risk to JP Morgan. We know Dimon is sitting on a pile of cash, and that he has been eyeing possible acquisitions. We also know that WaMu has been mentioned as a possible target by JP Morgan. Other rumors circulating suggest private equity involvement or a foreign interloper (bank) on the prowl for an opportunity to have a footprint in the US (especially on the west coast).

But, with Jamie's attention focused on saving the world (literally), what are WAMU's prospects? As money managers, we get paid to know what's going on in the market (or at least try). WaMu is one of those stocks that has always bothered me, even when it was flourishing and paying a fat dividend.

The thick 10-k theory: Back in the old days, financial statements came in the mail. My desk was piled with this stuff, and at home could occasionally be found in the bathroom near the pile of well-thumbed Mad Magazines. After CEO Killinger took the reigns at WaMu, their financial reports got a bit more thicker each year. Of course, acquistions accounted for most of the footnotes, but it was the 3-4 pages of contingincy descriptions related to these acquistions which left me so uneasy.

We used to refer to WaMu's explanations as a "rainy day" fund, given the rosy outlooks and accretive estimates to earnings, etc. I will say this about Killinger; he was great at acquiring deposit growth, which provided assets to build the higher margin mortgage side of revenues. But, he failed miserably as an operator. The company under Killinger's control botched hedging and interest rate changes often. Apparently, the juicy dividend helped investors forgive management for the operational blunders.

And, as credit reamined cheap, WaMu, like Countrywide (CFC), abandoned the conforming guidelines of Freddie Mac (FRE) / Fannie Mae (FNM) lending practices in favor of their own risk models and assumptions. Well, the rest is history. Countrywide is prone and supplicating, with Bank America (BAC) sniffing indifferently. But WaMu, an elephant by comparison, has more to lose. The dividend was slashed and the stock trades near 11, down some 80+ % from its highs. Considering the incredible and consistant misteps by Killinger and co., you have to ask yourself some hard questions.

How much crap do these guys have on their books, and what would somebody pay for the franchise? I pity any potential white knight who tackles the task of due diligence. They will undoubtedly need lots of bleach to get the dirt out.

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Currency surge adds to Japan’s woes

The Japanese government was on Thursday no closer to resolving a crisis over the leadership of the Bank of Japan as a surging yen threatened to aggravate an already worsening economic climate. The yen surged through the Y100 to the dollar milestone for the first time in 12 years. Accompanying that was more bickering between the government and opposition Democratic Party of Japan over who should take the helm at the central bank when the current governor steps down next Wednesday.

The ruling Liberal Democratic party won the approval of the lower house of Japan’s parliament on Thursday for the government’s nominee to head the central bank, Toshiro Muto, and its two candidates for deputy governor. But that did nothing to clarify who will lead the central bank as Muto has already been vetoed by the upper house, which the DPJ has controlled since elections last July. The DPJ’s rejection of Mr Muto and the LDP’s refusal to consider an alternative, has increased the prospect that the BoJ will be without a governor unless the two sides can come to an agreement in the next few days.

The uncertainty over the leadership of the BoJ comes as the global economy faces the risk of a serious downturn. “This is the second largest economy in the world. We need a governor,” says John Richards, head of research at Royal Bank of Scotland in Tokyo. In practice, the BoJ can function without a governor. Both houses of parliament have now approved Masaaki Shirakawa as BoJ deputy governor and he would likely become acting governor if a replacement for Mr Fukui was not in place.

Most BoJ watchers agree that the lack of a governor will not seriously affect monetary policy decisions. For one thing, “there is no real monetary policy issue pending,” says Mr Richards. Having raised interest rates twice, to a still historically low 0.5 per cent, the BoJ had been prevented from making further moves by a weakening economy at home and looming slowdown in global markets. Nevertheless, as the yen’s relentless surge against the dollar further undermines an economy that many believe is already in recession the lack of a governor will make it difficult for the central bank to make any bold policy decisions, economist warn.

“It will be difficult for the Policy Board to make major decisions . . . until the new governor is in place,” says Robert Feldman, chief economist at Morgan Stanley in Tokyo. Perhaps more worrying is that the BoJ will find it more difficult to move aggressively in response to the impact of global problems on the Japanese economy and what the central bank can do about them, economists say. “In the current global turmoil, the BoJ is potentially a very, very powerful player on the global stage and not to have a governor at the helm is irresponsible,” says Mr Richards.

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N.Y. action to let the air out of inflated appraisals

You've heard the charges: Real estate price declines under way around the country are partly the result of systemic over-valuations of homes -- much at the behest of loan officers illegally influencing or threatening appraisers to "hit the number" needed to close the deal. But if an extraordinary legal settlement has its intended effect, that system will change radically. Some details:

*Most lenders won't be able to fund mortgages without guaranteeing that the underlying property valuations are free of influence or pressure and fully conform to a new national code for appraisals.
*Appraisers and consumers will have complaint hot lines to report prohibited forms of interference by loan officers, realty agents and others.
*Lenders with in-house appraisal staffs or financial interests in appraisal-management companies won't be allowed to use valuations generated by them if they want to sell loans into the secondary mortgage market.
*Mortgage brokers, who originate 50 to 60 percent of home loans, will be cut out of the appraiser selection process.
*National oversight of home appraisals will be turned over to a new Independent Valuation Protection Institute that will monitor appraisals and automated valuations, receive and mediate complaints or forward them to federal and state regulators.

These and other changes are in a settlement among the two congressionally chartered mortgage investors -- Fannie Mae and Freddie Mac -- the attorney general of New York, and the federal agency that oversees Fannie and Freddie. Terms, scheduled to take effect Jan. 1, are open to comment from the mortgage industry and public. But the core quality standards for appraisals are in effect for loans delivered to Fannie or Freddie. What's the big deal, you might ask. Aren't accurate appraisals in everybody's interest? Absolutely. But in several ways, the agreement is unprecedented.

Using a 1921 securities fraud law in his state, New York Atty. Gen. Andrew M. Cuomo brokered an agreement that transcends state governments -- and could touch almost every home-mortgage transaction nationwide. Late last year, Cuomo began an investigation of potential appraisal fraud in the portfolios of Fannie Mae and Freddie Mac. With what he considered evidence of appraisal problems generated by a suit involving a major seller of loans to Fannie and Freddie -- Washington Mutual Inc. -- Cuomo began negotiations with the agencies and their federal regulator, the Office of Federal Housing Enterprise Oversight.

Cuomo never announced what, if anything, he found amiss at Fannie and Freddie. In the agreement, both denied wrongdoing. First American Corp.'s eAppraiseIT subsidiary, accused by Cuomo of inflating appraisals under pressure from Washington Mutual, also denied wrongdoing, as has WaMu. But Fannie and Freddie agreed to overhaul their appraisal standards and practices, signed on to a detailed home valuation code of conduct covering all mortgage activities and committed to pay $24 million over the next five years to create and staff the institute that will oversee appraisals nationwide.

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De-leveraging

In our opinion, you should never have all of your money in one place for any reason — stocks, bonds, cash, or one particular sector — let alone a single stock. The money we manage is not designed for the best single theoretical bet on the future, but rather a plan that provides consistency of strategy and execution in a changing world. We take this process very personally, as we know the stakes are high.

We simply cannot, and will not, make bets that you cannot afford to take. Hedge funds, on the other hand, are designed with a singular purpose the majority of the time. They try to find niches of a market that are unjustly depressed or simply overlooked. Then they “bet the house.” The investors give them $1 of collateral, then borrow the additional $9 and away they go!

The hedge fund world massively underperformed the S&P 500 last year — yes, there were big winners, big losers, but in general they were down about 15 percent for the year. One way to read the tea leaves then is to understand that the group of the smartest, most sophisticated, and most trained for market uncertainty, simply didn’t understand what was going on in the market place. You would be right to draw that conclusion, but you need to go back and understand part of the leverage issue, as access to credit dried up over night.

The hedge fund managers would buy — or sell; as they can and often do, the markets short- their investments with capital provided by the investors and the leverage provided by the banks. If the market went against them they would simply get more investment dollars and more loans to secure their investments. This worked fine as long as there was always access to new investors and more loans. When the loans dried up, a process known as de-leveraging began to take place.

Remember, the funds are in very tight niches or tight trades as we call them. If the value of the collateral — the investment — went down because the market went the wrong way, then the bank would require more collateral or a reduction in the loan out to the fund. If no new investors could be found then the fund would have to sell assets regardless of the market conditions. Welcome to the last week of February and the first week of March.

The hedge funds found themselves in a pickle. The value of the assets they bought are going down, thus they had to sell their assets to get capital and that simply drove the price down even further. The spiral begins. Making matters even worse is that investors in hedge funds have to tell the managers ahead of time if they want to pull their money out during the open windows — usually twice a year, sometimes only once.

When an investor notifies the manager of their intent to withdraw their money, the hedge fund can no longer use their capital as part of the collateral to secure the loan, thereby creating even more deleveraging and more selling into the spiral.

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Vive La France - the Road to Hyperinflation

According to the Fed, its new plan does not amount to buying mortgages but simply accepting them as collateral for 28-day loans. However, will the Fed really return these ticking time bombs to their true owners in 28 days, inciting the very collapse its actions were originally designed to postpone? Why does the Fed believe that the mortgages will be marketable next month; or the month after that?

Nor can we believe that such "loans" will be restricted to only $200 billion. Bear Stearns and Carlyle are certainly not alone in massive exposure to bad debt. Given the unprecedented leverage that many of the biggest financial firms used to play in this market, there will be many more failures to come. Does the Fed stand ready to bail out all comers? Based on this course of action, the Fed, or more precisely American citizens, will end up with trillions, not billions, of such securities on its books.

The problem with these mortgages (other than the borrowers lacking any means or desire to repay them) is that the underlying collateral is worth a fraction of the face amount. With recent foreclosure recovery rates amounting to less than 50 cents on the dollar, it is no wonder that no one wants them. The real estate bubble allowed borrowers to leverage themselves to the hilt using inflated home values as collateral. However, now that the bubble has burst, mortgage balances far exceed current property values. It is a trillion dollar time bomb that no one can possibly defuse.

Paper dollars are technically Federal Reserve Notes, which means they are liabilities of the Fed. When it puts newly minted notes into circulation it does so by buying assets, usually U.S. treasuries, which it then holds on its balance sheet to offset that liability. By swapping treasuries for mortgages, the Fed effectively alters the compilation of its balance sheet and the backing of its notes.

However, backing paper money with mortgages is nothing new. The French tried it in the late 18th Century, and it lead to hyperinflation. Assignats, which were first issued in 1790 to help finance the French revolution, were backed by mortgages on confiscated church properties. Although the stolen underlying collateral did have some value, the revolutionaries saw no reason to limit how many Assignats were printed, which resulted in massive depreciation. Within three years, price controls were introduced and failure to accept Assignats, initially an offence subject to six years in prison, was made a capital crime. By 1799 the currency was completely worthless.

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Subprime bubbly

It is, as they say, a bit of a moment. Here we are in the grip of this puzzling and profound financial crisis. Yet the Champagne region of northern France, unable to meet surging demand for its bubbly, thinks now is just the time to expand the acreage of land it allows to produce this sparkling index of excess. Counterintuitive, n’est-ce pas?

Well, there is a growing taste for bubbly in the newly affluent emerging markets of China, Russia and India – not to mention a Titanic spirit, as well as appetite for fizz, in the City and other beleaguered financial centres. There is, in fact, quite a good fit with the zeitgeist. The fizziest bits of champagne folklore bear uncanny similarity to the foggiest bits of modern finance.

Champagne came about through an accident of secondary fermentation, attributed to divine intervention by its discoverer, Dom Pierre Perignon, the Benedictine monk who – in a flourish of modern marketing – is supposed to have summoned his brothers saying: “Come quickly! I am tasting stars.” More prosaically, champagne was invented to disguise otherwise almost undrinkable wine. In that respect, it resembles the way dodgy mortgages were repackaged as CDOs and onsold as securities with an entirely different flavour. Just like secondary fermentation: it is all in the blending.

Indeed, the stamp of spurious sophistication of the CDO is rather like the snobbish cachet of the AOC – or should that now read appellation d’origine décontrôlée? The Champagne vineyards should look carefully at the bankers and hedge funds, not just as clients but as a cautionary tale of what happens when you debase the currency.

For 80 years the Champenois, as petulant as they are pétillant, have insisted that only the fruit of their 80,000 hectares could be considered champagne, fending off upstarts from Catalan Cava to Crémant d’Alsace. They should beware of following in the slipstream of the financial alchemists, less the new bubbly ends up getting all champagne downgraded to subprime.

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