Friday, March 21, 2008

Debt Rattle, March 21 2008

Ilargi: As commodity prizes plunge the most in over 50 years, perhaps people will start to better understand why we talk about deflation, not inflation.

And I have to say I just love the term "mass media wear-out". They've done crisis for two months now, they need a new subject. Maybe that's one of the biggest dangers in here: the average attention span is way too short to follow what's winding up and down these days.

Fitch: It’s Not Over Yet, Not By a Long Shot
In a conference call held Thursday, Fitch Ratings said that the subprime crunch isn’t over — and is actually gaining speed, despite mass media wear-out on the subject. Glenn Costello, co-head of the U.S. RMBS group at Fitch, and Grant Bailey, director in RMBS surveillance, both said that home price declines are continuing to create significant problems in the mortgage market. “Loan modifications have not significantly reduced foreclosure efforts to date,” Costello said.

Roll rates for 2007 vintage subprime first liens are significantly higher than in previous vintages; those roll rates are provided in the graph to the right. Roll rates capture the number of loans moving from current to delinquent each month — and the graph shows that 2007 vintage loans are rolling into default at a greater than 4 percent rate. Per month. Every month. Consistently. And that only includes originations through the third quarter of last year, to boot.

That’s huge, for anyone outside of the industry that hasn’t seen this sort of data before, especially given how new these loans are. What’s worse, we’re not just looking at a subprime problem, as many HW readers already know. Below is a look at annualized default rates for Alt-A mortgages.

What should stand out to you is that the Q307 vintage was already above a 10 percent annualized monthly default rate by the end of December. Astounding. The culprit, of course, was an acceleration in housing price declines that put many borrowers upside down — and, given the incidence of fraud in most recent Alt-A vintages, a whole bunch of borrowers suddenly found themselves unable to refinance their way into another loan as lenders finally began to tighten their underwriting standards.

Commodity Prices Head for Biggest Weekly Decline Since 1956
Commodities plunged, heading for the biggest weekly decline in more than 50 years, on speculation a slowing global economy will curb demand for energy, metals and grains. The Reuters/Jefferies CRB Index of 19 commodities has tumbled 8.4 percent this week, which would mark the largest decline since at least 1956. After reaching records this week, gold plummeted more than $110 an ounce and crude oil tumbled $11 a barrel.

"We started to see a speculative frenzy in commodities," said Brian Hicks, who helps manage $1.5 billion at U.S. Global Investors Inc. in San Antonio. "Growth is going to be quite muted, and that does not bode well for commodities." The International Monetary Fund said this week that slowing global growth signals commodity demand will "soften."

Before this week, the weighted UBS Bloomberg Constant Maturity Commodity Index of 26 futures gained 20 percent in 2008, reaching a record on Feb. 29. The gauge climbed in each of the past six years, more than tripling in value. The rally may be coming to an end as the U.S., the world's largest economy, slips into a recession, damping global expansion, said Leonard Kaplan, president of Prospector Asset Management in Evanston, Illinois.

"Commodities were a bubble" that is now bursting, Kaplan said. "Prices will go lower than you can believe."

"Global-recession fears are causing selling pressure in all commodities," said James Mound, head analyst for, a commodities newsletter, in Palm Coast, Florida. "The markets are focusing on want-based items instead of need-based items." Investor demand for commodities led to a "buying orgy," Paul Touradji, founder of the $3.5 billion hedge fund Touradji Capital Management, told clients on March 10. Commodities "have all gone parabolically higher on frenzied money flow," he said.

Gold futures for April delivery fell $24.30, or 2.6 percent, to $921 an ounce on the Comex division of the New York Mercantile Exchange. The price reached a record $1,033.90 an ounce on March 17. The metal plunged $59 yesterday. The dollar has rebounded this week from a record against the euro and a 12-year low against the yen.

Crude-oil futures for May delivery fell $1.90, or 1.9 percent, to $100.64 a barrel on the Nymex. The price soared to a record $111.80 a barrel on March 17. Oil probably will fall toward $90 a barrel this spring as the slowing economy in the U.S. encourages traders to exit commodity markets, Goldman Sachs Group Inc. analysts including Jeffrey Currie said in a report today.

Commodity prices part speculative - IMF
The strength of commodities prices, such as crude oil, this year is explained in a large part by speculative factors such as investors piling into the new asset class and the weakness of the US dollar, the International Monetary Fund said on Thursday. The warning came as commodities prices fell across the board, with oil prices dropping below the $100 a barrel level, gold prices tumbling 10 per cent from their recent record above $1,000 a troy ounce and sharp falls in base metals and grains.

Commodities prices fell as investors, who have poured record amounts of money into raw materials so far this year, cut leverage and fled into cash and short-term US treasuries and bonds. The yield of the three-months US Treasury fell to a 50-year low of 0.56 per cent on Wednesday. John Reade, metals strategist at UBS in London, said: “It seems as if large-scale deleveraging is occurring across many asset classes and commodities – as profitable and recently fashionable trades – are being caught up in this trend.”

The fall in commodities prices, if sustained, could push down inflationary pressures both in developed and developing economies, analysts said. Until now, rising commodity prices have led to pressures on inflation, reducing central banks’ room of manoeuvre to insulate their economies from the impact of the credit squeeze.

The IMF said that the constellation of dollar depreciation and falling short-term real interest rates “has pushed up commodity prices through a number of channels, including by enhancing the attractiveness of commodities as an alternative asset.” “Overall, these financial factors seem to explain a large part of the increase in crude oil prices so far in 2008, as well as the rising prices of other commodities,” it said.

It added that as global economic growth is widely expected to decline this year and in 2009, “prices of most commodities should eventually start easing.” However, it added that “unless there is a substantial global downturn, however, the extent of easing may be small, given the current tight balances in some commodity markets.” The IMF said that in all recent global downturns, commodity prices declined sharply, “suggesting a disconnect between commodity prices and the ongoing slowdown.”

Treasuries Rise, Bill Rates Plunge on Credit Market Losses
Treasuries rose and three-month bill rates plunged to the lowest level in almost 50 years on speculation credit market losses will widen, prompting investors to seek the relative safety of government debt. Bonds gained on concern the investment firm run by ex-Long- Term Capital Management LP chief John Meriwether is facing losses and Thornburg Mortgage Inc. may go bankrupt.

This week the Federal Reserve has cut interest rates, opened the so-called discount window to investment banks and arranged the sale of Bear Stearns Cos. to relieve market turmoil. "There's a whole flight-to-quality trade," said Joe Tully, managing director of the money-market desk in Newark, New Jersey, at Prudential Investment Management, who's betting $1 against a colleague that bill rates won't fall below zero. "The markets are totally skittish. They just want to be in bills."

Treasuries also gained as stocks retreated. The Standard & Poor's 500 Index, which surged the most in five years yesterday, fell 2.2 percent, while the Dow Jones Industrial Average lost 2.1 percent. "It's a capital preservation trade," said Michael Cloherty, an interest-rate strategist at Banc of America Securities LLC in New York. "The rationale is, `I'll buy a bill, I know that when the thing matures I'll get 100 cents on the dollar."'

The three-month London interbank offered rate, or Libor, for dollars rose for the first time in three weeks, indicating the Fed is struggling to instill confidence in money markets. The difference between what the government and companies pay for three-months loans, known as the TED spread, increased 32 basis points to 1.98 percentage points, the biggest gain since Jan. 22, when the Fed made an emergency cut in borrowing costs.

Freddie Mac and Fannie Mae to the Rescue
The Office of Federal Housing Enterprise Oversight, which oversees Freddie Mac and Fannie Mae, agreed to allow the two government-sponsored entities to reduce their mandatory cash cushion by a third. The plan is expected to free up $200 billion that will go to buying up more mortgages and mortgage securities.

This is the third consecutive step the government has taken to ensure the two firms will be able to take on more of the country’s bad mortgage debt. The first came when Congress raised the limits for the loans that Fannie and Freddie can buy or insure from $417,000 to $729,750. The second occurred March 1 when Fannie and Freddie were released from the combined $1.5 trillion cap on their mortgage investment holdings.

The initiatives taken recently by the government are controversial because it raises the risks the two companies will be allowed to take on. This in turn raises risks for taxpayers. Although Fannie and Freddie are publicly-traded companies, they enjoy the benefit of an implicit government guarantee. In other words, taxpayers will be expected to flip the bill if Fannie and Freddie ever fail. 

And the risk of failure is very real. In the fourth quarter of last year, the two GSEs were responsible for nearly 75 percent of the mortgage backed securities on the market. They are also losing money fast and expect to see more red ink in the future.
Fannie Mae posted a record $3.55 billion fourth quarter loss. Analysts believe the company’s credit losses will continue to rise this year and in 2009. Freddie Mac is in a similar position. The company reported a record $2.45 billion net loss during the same period.

James Lockhart, director of the Office of Federal Housing Enterprise Oversight, assured everyone at a news conference today that Freddie and Fannie are “safe and sound” and would remain that way. Until recently, Lockhart has been firmly against loosening regulations for Fannie Mae and Freddie Mac. There has been some speculation that his rapid change of heart stems from political and lobbyist pressure

Fed Lends $28.8 Billion, Adds Auction Collateral
The Federal Reserve, in its first extension of credit to non-banks since the Great Depression, lent $28.8 billion as of yesterday to the biggest securities firms to try to stabilize capital markets. In a separate announcement, the Fed expanded collateral eligible for its first auction of Treasuries March 27 to include bundled mortgage debt and securities linked to commercial real- estate loans. The value of the sale was set at $75 billion, part of a $200 billion facility unveiled last week.

The auctions and Wall Street's new loan facility are Fed Chairman Ben S. Bernanke's answer to a credit squeeze that's eroded U.S. economic growth and forced Bear Stearns Cos. to sell for $2 a share to JPMorgan Chase & Co. The recipients of the Fed's credit are getting cash and Treasury notes in exchange for securities tied to mortgages and other distressed debt.
"The Fed's pulling out all the stops here to add liquidity," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. "All these things are an attempt to bring down financing costs."

The central bank's Primary Dealer Credit Facility, announced March 16, allows Wall Street banks to borrow money overnight at a 2.5 percent interest rate, the same charged to commercial banks. The Fed bypassed its own emergency-lending policies and used broader authority in the Federal Reserve Act to give both kinds of companies the same borrowing costs. The central bank said the loans will be available for at least six months. The Fed's decision to be lender of last resort to the 20 primary dealers of government debt came two days after the Fed provided emergency financing to Bear Stearns through JPMorgan.

The Fed's weekly balance sheet released today showed other credit extensions, including loans to facilitate JPMorgan's purchase of Bear Stearns, averaged $5.5 billion a day for the week ended yesterday. The balance ended at zero, according to the Fed's weekly balance sheet. The zero balance on the Bear Stearns loans signals that the Fed has yet to extend the $30 billion in financing to JPMorgan in exchange for collateral that includes "less liquid" Bear assets. The $5.5 billion daily average of the JPMorgan-Bear Stearns loan indicates that a March 14 bridge loan, assuming it was paid off three days later, totaled about $13 billion.

Morgan Stanley and Goldman Sachs Group Inc. said yesterday that they borrowed to "test" the new lending facility. Lehman Brothers Holdings Inc. Chief Financial Officer Erin Callan said in a Bloomberg Television interview that the firm was using the lending window to "show some leadership." The Fed report today showed that the lending averaged $13.4 billion in the week ended yesterday.

Deflation Watch: US Short Term Rates Fall Below Japan's
Investors are so nervous that they are willing to take almost nothing in nominal terms, which is tantamount to a meaningful negative real return, to sit in the safety of three-month T-bills, which are now a mere 0.56%. One explanation is the large number of fails in the repo market, which as Alea reports, is "massive":What “Fails” mean:
If primary dealer A does not deliver a security to primary dealer B as scheduled, then dealer A reports a fail to deliver and dealer B reports a fail to receive. In contrast, if primary dealer A does not deliver a security to customer C, then dealer A reports a fail to deliver and the fail to receive is not reported. A settlement fail goes unreported if neither the buyer nor the seller is a primary dealer.

This is recent data to march 5th on settlement fails between primary dealers. Settlement fails are reported on a cumulative basis for each week, including nontrading days.

U.S. Treasury Securities (In Millions of Dollars)
Fails to Receive: 891,825
Change from Previous Week: 696,427
Fails to Deliver: 903,242
Change from Previous Week: 724,368

Not only is this the lowest level the rate has achieved since 1958, but as reader James Bianco of Bianco Research tells us, it puts US short rates below Japan's for the first time since 1993:

An article in the Wall Street Journal today with the rather misleading title, "Fed Fix Works For Now," says that the Fed is achieving some success in lowering mortgage bond yields. But the plunge in short rates and the rise in TED spreads says that much of the rest of the market is running for cover.

Treasuries' Scarcity Triggers Repo Market Failures
Surging demand for U.S. Treasuries is causing failures to deliver or receive government debt in the $6.3 trillion a day market for borrowing and lending to climb to the highest level in almost four years. Failures, an indication of scarcity, surged to $1.795 trillion in the week ended March 5, the highest since May 2004, and up from $374 billion the prior week. They have averaged $493.4 billion a week this year, compared with $359.6 billion over the last five years and $168.8 billion back through July 1990, according to Federal Reserve Bank of New York data.

Investors seeking the safety of government debt amid the loss of confidence in credit markets pushed rates on three-month bills today to 0.387 percent, the lowest level since 1954. Institutions worldwide have reported $195 billion in writedowns and losses related to subprime mortgages and collateralized debt obligations since the start of 2007, making firms reluctant to hold anything but Treasuries as collateral on loans.

"It shows you the kind of anxieties that are going on and the keen demand for Treasuries," said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. in New York. "The rise in fails tells us about the inability of dealers to obtain Treasury collateral."

In a repurchase agreement, or repo, a customer provides cash to a dealer in exchange for a bill, note or bond. The exchange is reversed the next day, with the customer receiving interest on the overnight loan. A Treasury security is termed on "special" when it is in such demand that owners can borrow cash against it at interest rates lower than the general collateral rate.

The Treasury Department cautioned dealers in January to guard against failing to settle in the Treasury repo market as interest rates fall. It cited periods of such failures to receive or deliver securities, known as 'fails' in the repo market, earlier in the decade when rates dropped.

The difference between the rate for borrowing and lending non-specific Treasury securities, or the general collateral rate, has averaged 63 basis points below the central bank's target rate for overnight loans this year. The spread has averaged about 8 basis points the past 10 years.

Mortgage Mess Hits Home For Nation's Small Builders
In the first wave of the housing crisis, homeowners across the U.S. lost their properties to foreclosure. Now, many of the nation's small and midsize home builders are on the ropes. Bill Whitlatch, longtime owner of one of the leading home builders here in northeast Ohio, is among the casualties. Three years ago, he borrowed from regional banks to start six developments in the Cleveland area. Soon the region's home market turned cold. Buyers vanished. Mr. Whitlatch drained his personal savings of $2 million to keep his company going.

It wasn't enough. In September, the company filed for bankruptcy protection. Now owing about $1 million to dozens of subcontractors, and $8 million in debt to his banks, Mr. Whitlatch is selling the family home he designed. "I couldn't come up with any more money, and I couldn't generate any more sales," says Mr. Whitlatch, a tall, 68-year-old grandfather who says he had planned on selling his company and retiring.

Though he and other local builders didn't know it at the time, Cleveland's housing slump was one of the first manifestations of a national slowdown. Now, plummeting home sales across the U.S. have left many builders with unsold inventory and land. Some are falling behind on interest payments, beginning to face foreclosures on developments and, like Mr. Whitlatch, sometimes reaching into their own pocket to keep operations going. Many smaller builders financed their developments with so-called recourse debt, which means that if they default, banks could seize homes, cars and other personal assets.

The U.S. government is now scrambling to contain the damage from the housing market's unraveling. On Wednesday, federal regulators cleared the way for mortgage-finance giants Fannie Mae and Freddie Mac to inject as much as $200 billion into the mortgage market, a credit-boosting move that could help builders' flagging sales. The relief may come too late for those like Mr. Whitlatch. "There are a lot of companies on the brink" of bankruptcy, says Ricardo Chance, a managing director at KPMG Corporate Finance LLC, who is helping troubled builders in the Midwest, Northeast and Arizona restructure their businesses.

Builders' problems are now threatening losses for small and medium-size regional banks. Muscled out of the mortgage business by large national lenders, many of these banks flocked to construction lending as the housing market boomed. Though these institutions were generally less exposed to the subprime-backed securities that have generated billions of dollars in losses for national banks, they are the front-line casualties when builders and developers can't make their payments.

Delinquencies on loans to build single-family houses reached 7.5% of the value of all such loans in the fourth quarter, up from 2.1% a year earlier, according to Foresight Analytics, an economic and real-estate research firm. There's likely more pain ahead. The Commerce Department reported this week that permits for new housing construction, a barometer of future building activity, fell 7.8% in February to the lowest level in 16 years. Also this week, the Federal Deposit Insurance Corp. said it had "increased [its] overall concern" about banks with high concentrations of construction loans, particularly those for residential developments, its strongest warning to date about these banks.

Paul Krugman Wonders If He Is Dumb. I Say: "No!!"
He writes:
Fed funds question (seriously wonkish, and possibly dumb too): The target Fed funds rate is now 2.25%. Everyone expects it to be reduced further; Citi economists predict that it will be down to 1% by mid-year. But I have a possibly naive question: can the Fed really cut the Fed funds rate that far?... The Fed actually conducts monetary policy through open-market operations in Treasuries: the FOMC tells the open-market desk to buy or sell Treasuries from banks until the Fed funds rate is close to the target. Normally this puts Treasury interest rates close to the Fed funds rate, since one short-term loan to a very safe customer is a lot like another.

But right now Treasury interest rates are much, much lower than the Fed funds rate -- around half a percent on both 1-month and 3-month bills. Weirdness like negative rates on repos aside (I'm still trying to wrap my mind around that one), basically the Fed can only drive Treasury rates down by about another half-point -- which would still seem to leave Fed funds well above 1%.

How is it possible for the Fed funds rate to be higher than the Treasury rates? Well, one interpretation is that banks don't trust each other.... Fed fund loans, after all, are unsecured. In other words, the Fed funds rate may be more like LIBOR than the Treasury rate -- and it may be being held up by a premium similar to the TED spread.

Am I being really stupid here? Or is it possible that the fear factor will soon make it impossible for the Fed even to achieve its target on the interest rate it supposedly controls?

No, this is not stupid. As Clouse and Elmendorf (1997) write: "Because funds-market trading is typically not collateralized, the funds rate can also differ across borrowers according to their perceived riskiness." This has in fact been happening since last August--what the (average) fed funds rate is on any given day depends on who is doing the borrowing.

Ilargi: Paul de Grauwe at Financial Times has the solution: simply keep assets in your books at fantasy prices. that way you can’t lose. One of many "experts" who see the mess and the dangers, but have no clue what to do.

Act now to stop the markets’ vicious circle
The credit crisis has produced an avalanche of problems and also of explanations. Some observers have stressed that it is mainly a solvency crisis; others that it is mainly a liquidity crisis. It is increasingly clear that it is both. Liquidity and solvency problems are so intertwined that trying to decide whether it is one or the other is counterproductive. When a hedge fund today is hit by a withdrawal (a liquidity problem) and is forced to sell assets, the price of its assets declines and a solvency problem is created.

The liquidity and solvency problems of that hedge fund in turn are likely to lead other investors to withdraw (again a liquidity problem) leading to further price declines (solvency). This interconnection between liquidity and solvency problems is em?bedded in the activities of banks and financial institutions that fund long-term investments with short-term loans. Withdrawals trigger solvency problems, which in turn become signals for further withdrawals, creating liquidity problems.

There is a clear market failure here. Markets are fantastic instruments to co-ordinate economic activities without the need of a planner. Under normal circumstances markets co-ordinate these activities towards a “good” equilibrium that increases welfare. Once in a while they can also co-ordinate activities towards a “bad” equilibrium that reduces welfare. Banks, hedge funds and other financial institutions that borrow short and lend long contribute to welfare when withdrawals are random and independent from each other.

The economy is then in a good equilibrium. Occasionally, as a result of bad news or foolish behaviour of some of these institutions, lenders withdraw their funds, thereby creating (or aggravating) solvency problems, which in turn lead to further withdrawals. The market then starts to co-ordinate lenders into massive withdrawals, leading to massive solvency problems at financial institutions that, without the withdrawals, would have been perfectly all right.

This perverse co-ordination by the market (some will call it a vicious circle) is made worse by “marking to market” (valuing assets at market rates). The practice forces banks to take a loss on their balance sheets on assets that are caught by the liquidity-solvency spiral. They are forced to do so even if these assets are sound. Thus marking to market today accelerates the downward spiral.

Marking to market, which was generalised as an accounting procedure in the 1990s, was influenced by the idea that financial markets are efficient. In this view markets provide the best method to put a correct value on financial assets. Markets are wiser than the judgment of individual bankers or accountants, it was said. That is right under normal circumstances, but not today, when markets are clearly driving towards a bad equilibrium. Markets are not always right.

U.S., Abu Dhabi, Singapore Agree on Wealth Fund Rules
U.S. Treasury Secretary Henry Paulson and the sovereign wealth funds of Abu Dhabi and Singapore agreed to adopt rules for greater disclosure and to ensure their investments are for economic, not "geopolitical," purposes. Paulson and officials from the two countries said there's a "common interest in an open and stable international financial system," according to a joint statement after talks in Washington. A set of "best practices will create strong incentive among SWFs and investment-recipient countries to hold themselves to high standards."

The U.S. is pushing the government-run funds and their target countries to agree to guidelines being drafted by the International Monetary Fund and the Organization for Economic Cooperation and Development. Paulson's efforts are aimed in part to head off protectionist sentiment in Congress against foreign investors.

"Singapore and UAE have long-established, well-respected funds and are showing real leadership by joining with us today," Paulson said in the statement. "The U.S. welcomes sovereign wealth fund investment and looks forward to continuing to work with these two countries and others to support the initiatives under way at the IMF and OECD."

The Treasury chief has expressed concern that a lack of transparency by the funds could spark a rise in U.S. protectionism. The European Commission last month called for an international accord to limit the political influence of the state-owned capital pools, which have grown in number to about 40, managing between $2 trillion and $3 trillion.

The three countries today agreed that all investments must be based only on commercial grounds, and the funds should increase the disclosure of information and make sure they have strong risk management and governance controls. They also agreed that countries that receive investment shouldn't set up protectionist barriers and have consistent, non-discriminatory investment rules.

Prospects fading for deep Fed cuts
U.S. short-term interest rate futures dropped sharply in Thursday's short trading session, cutting back on the implied outlook for Federal Reserve rate cuts at the April and June policy meetings.

The sell-off reflected a factory survey from the Philadelphia Federal Reserve that was not as weak as feared and a sharp rally in U.S. stock markets. Major equity indices were up about 2 percent in afternoon trading.
Futures ended the week suggesting the federal funds rate will fall no lower than 1.75 percent in the Federal Open Market Committee's current cycle of rate cuts.

"A less aggressive policy path is expected relative to what we've seen from the Fed in recent months," said strategists at Action Economics. "There's considerable uncertainty over what the FOMC might do next."
The implied prospects for the Fed to slash its benchmark lending rate by another one-half percentage point in April FFK8 to 1.75 percent, dipped to 40 percent from 82 percent late on Wednesday.

A one-quarter point rate cut, which would take the funds rate to 2 percent, is still fully priced. The FOMC has lowered benchmark lending rates by 3 full points since mid-September, to 2.25 percent from 5.25 percent. Futures now show only an 78 percent chance that the Fed will lower its benchmark lending rate to 1.75 percent by June FFN8 after fully pricing such a move on Wednesday.

Japan Risks Loss of Stature With No One at BOJ Helm
For the first time since World War II, Japan is left without a central-bank governor, the clearest example of how its government has been losing its grip on economic policy just as a global financial crisis deepens.
Japan's parliament yesterday voted down Koji Tanami, the government's second nominee for governor of the Bank of Japan, the same day that Gov. Toshihiko Fukui ended his five-year term.

The rejection came after Prime Minister Yasuo Fukuda's government failed to convince a powerful opposition party that controls the upper house of Parliament -- a chamber that can veto nominations for top BOJ posts. It wasn't immediately clear how long the vacancy would continue. Some analysts said it could take days or weeks before a third candidate is named. Mr. Fukuda didn't unveil a plan.

Before leaving office Wednesday, Mr. Fukui named Masaaki Shirakawa, a former senior BOJ official and one of two newly elected deputy governors, as acting head of the BOJ until a new governor is elected. Kiyohiko Nishimura, a policy-board member and a University of Tokyo economist, was elected as deputy governor.

Economists say the BOJ will still be able to conduct monetary policy without a hitch, as its policy board will function. But the lack of a central-bank chief in the world's second-largest economy could harm investor confidence, especially when turmoil in the financial markets is putting policy makers and financial regulators on high alert around the world.

Concerns of a U.S. recession have mounted in the past week amid signs that problems in the residential-mortgage sector are harming consumer sentiment. Worries about a recession sent the dollar to a 13-year low against the yen last week, and the currency fluctuations threaten to hurt Japanese exporters and lead to a slowdown in Japan's economy.
"We really want the government to understand this kind of political situation is clearly having a negative impact on the economy," Fujio Cho, chairman of Toyota Motor Corp., said at a news conference yesterday.

Social Security's running out of time
One of Washington's rites of spring is almost upon us. It's the wonks' version of the Cherry Blossom Festival - the release of the annual Social Security trustees' report showing the health of our nation's biggest social program. Each year the report touches off a debate, mostly misguided, about Social Security's financial status. Given the political environment this year, you can expect more heat than usual when the report comes out. But you're unlikely to see much light.

So let me try to illuminate things for you. Forget all the talk you'll hear about how Social Security is okay until 2040 or thereabouts. That is, as we'll soon see, utter nonsense. The real problem starts only a decade or so from now, when Social Security begins to take in less cash than it spends.

How can I say that, given Social Security's $2.3 trillion (and growing) trust fund? It's because the fund owns nothing but Treasury securities. Normally, of course, Treasury securities are the safest thing you can hold in a retirement account. But Social Security's Treasuries won't help cover the program's cash shortfall, because Social Security is part of the federal government. Having one arm of the government (Social Security) own IOUs from another arm (the Treasury) doesn't help the government as a whole cover its bills.

Here's why the trust fund has no financial value. Say that Social Security calls the Treasury sometime in 2017 and says it needs to cash in $20 billion of securities to cover benefit checks. The only way for the Treasury to get that money is for the rest of the government to spend $20 billion less than it otherwise would (fat chance!), collect more in taxes (ditto), or borrow $20 billion more (which is what would happen).

The spend-less, collect-more, and borrow-more options are exactly what they would be if there were no trust fund. Thus, the trust fund doesn't make it any easier for the government to cover Social Security's cash shortfalls than if there were no trust fund.

Social Security's negative cash flow becomes so horrendous - hundreds of billions of dollars a year - that our nation's twenty- and thirtysomethings aren't going to let the government cover it, regardless of how many Treasuries the trust fund holds. So forget about 2039 or whenever. Start worrying about 2016 or 2017.

Washington Revisits Financial Regulation
The credit-market turmoil has sparked a broad rethinking of how Washington regulates financial institutions, giving momentum to several ideas once thought politically unfeasible. One central issue: What to do with the Federal Reserve, which is taking on more responsibility for the stability of financial markets. Last week, the central bank set a precedent by agreeing to lend funds to investment banks.

Crises often have led to big changes in Washington regulation. The Great Depression spawned the Federal Deposit Insurance Corp. The savings-and-loan crisis of the late 1980s produced the Office of Thrift Supervision, the Office of Federal Housing Enterprise Oversight and the Federal Housing Finance Board.

In a speech, House Financial Services Committee Chairman Rep. Barney Frank (D., Mass.) said Thursday that policy makers should consider giving a regulator the authority to monitor risks that threaten the broad financial system. Rep. Frank said this power could be given to the Fed, and he said the entity would supervise risks across all financial markets "regardless of corporate form." Such an idea would more closely align supervision of big Wall Street investment banks and their huge commercial-bank counterparts, which operate under different regulatory frameworks.

"You have two different types of institutions competing with each other but under different rules," Rep. Frank said in an interview. "It's the function, not the form, that's important." While such a change would threaten the turf of some Washington regulators, officials at the Treasury Department already have been considering a similar restructuring.

Senior Treasury Department officials have spent months drawing up a blueprint for financial-market regulation that also includes a new vision for the central bank's role. The Treasury plan, which has been submitted to the White House for review, could propose moving the Fed out of day-to-day supervision of state-chartered banks, people familiar with it said. Instead, the Fed would be given a more sweeping responsibility to monitor financial-market stability

Auction-Rate Market Shrinks By $21 Billion as Borrowers Escape
Municipal borrowers from Wisconsin to California plan to pull at least $21 billion of bonds out of the auction-rate market by May 1 to escape soaring costs, according to data compiled by Bloomberg. The amount is more than what was sold in any one year before 2002, the data show.

About 69 percent of auctions in a market that also includes debt of student lenders and closed-end mutual funds failed to attract enough buyers this week, resulting in interest rates as high as 14 percent. Borrowers are converting to fixed-rate bonds and other forms of variable-rate securities, after investors pulled back from debt backed by downgraded insurers and dealers stopped acting as buyers of last resort.

Yields on municipal auction debt are almost twice what they were in January on average, based on a Securities Industry and Financial Markets Association index. "The issuers couldn't pay those punitive auction rates and remain solvent after the market effectively shut down," said Mike Pietronico, chief executive officer of Miller Tabak Asset Management, a municipal-bond investment advisory unit at New York-based trading firm Miller Tabak & Co.

The average rate on long-term bonds with rates determined at auctions every seven days was 6.41 percent March 12, based on the latest public data from Sifma. That's down from a record 6.89 percent in February, though still higher than every other reading in the two-year-old index that averaged 3.60 percent through January of this year.

The use of auction bonds by states, cities and other municipal borrowers exploded in 2002, when sales doubled to $25 billion from $12 billion the previous year, data compiled by Thomson Financial show. Sales peaked at $42 billion in 2004 before subsiding to $39 billion in 2007. The $21 billion total represents auction bonds to be called, or bought back, on dates from February through the first day of May, according to data compiled by Bloomberg from an original list of $211 billion of the debt.

How far away is US recession
So that's it  then. We're all agreed. "This is clearly the worst financial problem we've had since the Great Depression," as Joseph Stiglitz told a radio show in New Zealand on Wednesday morning, where he's attending a conference. The Nobel laureate lined up behind Countrywide Financial (July '07), Wells Fargo (Nov. '07), former Treasury advisor Nouriel Roubini (Dec. '07), the National Association of Homebuilders (March '08) and pretty much everyone else in saying this is as bad as it gets.

As in, well, the worst ever – like finding nothing besides Of Mice & Men to order from Amazon, and nothing but Seabiscuit to rent at Blockbusters. The men now pulling the Fed's monetary levers sure agree. And while Ben Bernanke might see the shadow of depression where the rest of us glimpse a shade of recession, liquidating the mal-investments of 2002-2007 is certainly hurting. Imagine the US Treasury paid your wages each month; you'd jump to increase the money supply every chance you got, too. See, it's the only way to stop the Nazis taking over. Or the Commies.

Or maybe even – oh, horror! – the Clintons...

"Involuntary unemployment," as John F.Kennedy put it, way back in 1960, "is the most dramatic sign and disheartening consequence of under-utilization...We cannot afford to settle for any prescribed level of unemployment." Barely a generation after the worst recession in US history, backing labor over capital like this – and thereby nabbing labor's far weightier vote – meant JFK got to kick Richard Nixon around at the ballot box.

When his turn at the top finally came round at the end of the '60s, Tricky Dicky didn't forget the kicking. In fact, "I [already] knew from bitter experience how, in both 1954 and 1958, slumps which hit bottom early in October contributed to substantial Republican losses in the House and Senate," as Nixon himself wrote in 1962. So come December of 1968, when Herbert Stein first met with Nixon as head of his Council of Economic Advisors – and he asked Stein to name the biggest problem they faced – "I started with inflation," said the economist.

"[Nixon] agreed, but immediately warned me that we must not raise unemployment," Stein was to recall nearly 15 years later. "I didn't at the time realize how deep this feeling was or how serious its implications would be..." Fast forward to the brink of Easter '08, and the "serious implication" of the Great Depression once again today is the cost of not acting to prevent it. Or so everyone says.

And I mean everyone...

HBOS: Malicious traders in the City try to topple the Halifax bank
Stock market manipulators yesterday tried to bring down one of Britain’s biggest banks by spreading false rumours through the City. The Bank of England was forced to issue an unprecedented denial that HBOS was in trouble. The Financial Services Authority (FSA) said that it would pursue traders guilty of “market abuse” by spreading untrue claims that banks were on the brink of collapse. The authorities believe that the fear and uncertainty in financial markets are allowing unscrupulous traders to make multimillion-pound profits by whipping up hysteria about the stability of big banks.

Yesterday’s drama began at about 8.30am when rumours started spreading through London’s stock market that HBOS, which owns Halifax, the UK’s biggest mortgage lender, and Bank of Scotland, was about to become another Northern Rock and that it had begged the Bank of England for a multi-billion-pound emergency loan. Within 20 minutes HBOS’s shares had plunged by more than 17 per cent as investors dumped their stakes. An hour later, the Bank of England announced that no bank needed emergency funding, while the FSA issued a statement warning investors to stop spreading false accusations.

It is feared that short-sellers — investors who use falling share prices to make money — were deliberately spooking the market in order to profit from plunging stocks in a practice called trash ’n’ cash. Rumours that the American investment bank Bear Stearns was short of cash contributed to its near-collapse last week after its lenders were scared into demanding that it repay them immediately. The warning to speculators came as it emerged that the American financial watchdog was investigating similar activity in the trading of shares of Bear Stearns and Lehman Brothers, another US investment bank heavily exposed to risky American mortgage business.

Andy Hornby, the HBOS chief executive, vehemently denied that the bank needed an emergency loan. He said: “It’s categorically untrue that we’ve approached any central bank for funding.”

Small noteholder stokes revolt against ABCP deal
The man behind a Facebook group for individual holders of roughly $400-million of frozen asset-backed commercial paper has begun soliciting support for a plan that would see their investments returned in full or a proposed restructuring of the notes scuppered altogether. Brian Hunter, a Calgary-based engineer with more than $600,000 tied up in illiquid ABCP, wants all small noteholders to band together to demand their money back from the banks that created the securities in exchange for supporting a controversial rescue of the $32-billion market.

As part of a bankruptcy protection process, all noteholders will get the chance to vote on the restructuring at the end of April. Despite the fact that the bulk of the value of the paper is controlled by a handful of big institutions the success of the restructuring will depend on retail investors such as Mr. Hunter. "It would seem like cheap insurance for any group that wants the restructuring to proceed to get the [retail investors] onside," Mr. Hunter wrote on his web site, shortly after an Ontario court granted bankruptcy protection to 20 ABCP trusts that are part of a beleaguered rescue effort known as the Montreal proposal.

"If I worked at the Caisse [de dépôt et placement du Québec] and wanted to ensure I kept my job, got my bonus next year and ended happily pensioned off, I wouldn't be taking any risk." Mr. Hunter said investors should vote for the deal only if the institutions agree to buy back their stalled notes with interest. The current restructuring proposal calls for noteholders to receive new term paper maturing in 7 or 8 years that are expected to trade at significant discounts to their original value.

In most bankruptcies the biggest creditors typically have the most clout, but in this case small investors have the advantage. That's because in order for the restructuring to get the court's blessing, it must win support from more than 50% of noteholders by number. That means votes cast by even the smallest investor carry the same weight as the big guys. "Retail investors now have the determining vote and we think that's as it should be," said David Weiner, a spokesman for the investors committee overseeing the restructuring. "But if they choose to reject the plan, the outcome is the unravelling" of the market.

BMO restructures two ABCP trusts
Bank of Montreal says it has successfully restructured two asset-backed commercial-paper trusts known as Apex and Sitka that had threatened to cost the bank further writedowns. "We are very pleased with the agreement to restructure," said Tom Milroy, the head of BMO Capital Markets. "This was a complex deal that was achieved through the efforts of both the investors and the swap counterparties."

The bank has already taken $210-million in charges related to the two trusts. BMO had warned more losses would follow if it could not restructure the trusts, although the bank insisted there is still "underlying economic value" in the assets of the trusts. Those writedowns will now not be necessary, the bank said. The bank has provided additional funding and extended the terms of the two trusts.

BMO's stock price closed Wednesday at $42.10, down more than 42% from its twelve month high. On Monday, it closed at a low of $39.15 as investors punished the bank because of its exposure to the credit crunch. Last month, the bank reported net income for the first quarter of 2008 fell 27% or $93-million from the previous year.

BMO took $490-million of writedowns in the first quarter and announced it has agreed to provide more than $12-billion in funding to two structured investment vehicles (SIVs) that have been hit by the credit crunch.

Citigroup analyst Shannon Cowherd said investors should anticipate continued volatility at BMO in a note issued before the announcement about Apex and Sitka. Ms. Cowherd reduced her target price for the bank's stock from $54.00 to $43.00.


nick said...

Deflation of oil prices with peak oil looming seems hard to fathom. World demand would increase quite a bit if oil crashed. There's still a lot of cash, wealth, and growth in Asia.

Ilargi said...


If you read these comments here:

I saw that your reference to The Automatic Earth was rudely deleted at The Oil Drum, just like that happened yesterday, more than once, to Ozonehole.

I'm sorry to see that they have stooped to that kind of toddler's behavior. It gives you an idea of the respect and value these folks attach to their readers, as well as to their former contributors.

shargash said...

I went into EIA's database and pulled WTI crude spot prices from 1985 to now and plotted them. It's hard to see any correlation between economic downturns and oil prices.

Oil prices were pretty high in 1985, when the EIA data starts. They didn't bottom out till late 1986, when the economy was in a robust recovery from the '82 recession. In the '91-'92 recession, oil prices stayed flat-to-slightly elevated. They dipped a bit by 1994, but that was pretty much past the recession. Oil prices did dip in Oct 2001 after 9/11, but they recovered completely by April or May. It wasn't until oil prices had recovered that the recession really got under way.

Now, I don't think this means that economic activity has nothing to do with oil prices. I think it means that other factors tend to be more important than (US) economic activity.

It is true that this economic downturn is going to be nastier than any of the others within the EIA's data set. On the other hand, it is also true that we're coming up against oil depletion.

To some extent I see it as a race between economic collapse and depletion. If the collapse happens soon (i.e. this year), then oil prices could drop. If the collapse happens in late '09 or later, then I think depletion wins.

I think there's a similar dynamic with food. Unless we reduce the population, or reduce the number of calories consumed per capita, it is doing to be hard for food supplies to keep up with demand, given the stresses of climate change, topsoil erosion, water shortages, and fertilizer shortages (and none of those issues are driven by economic activity, at least not in the timeframes we're talking).

Greyzone said...

To simplify what Shargash said...

Prices rise and fall in response to changes in supply and demand. Such changes in price have NOTHING to do with inflation and/or deflation.

Prices also generally tend to rise during monetary inflations and generally fall during monetary deflations. This is why it is important to have a better definition of inflation than just rising prices!!! Rising prices can be caused by supply or demand changes. That is NOT inflation.

Nick, you appear to be confusing the reasons for the changes in oil's price. Oil has increased in price not only due to monetary inflation but also due to structural supply problems that have been ongoing for nearly 4 years now. Even if the monetary inflation is completely replaced by monetary deflation, the supply problems remain. Thus, the only way that prices can decline long term for oil is if demand collapses drastically - total economic collapse.

So, as long as industrial civilization continues running and as long as the supply of oil is roughly fixed (or worse, begins to decline), there will be upward pressure on oil prices that has nothing whatsoever to do with inflation or deflation.

The point that Stoneleigh and ilargi have been making all along is that the ongoing economic dislocation may very well become so large as to cause such a huge drop in demand. If we get that, then yes, oil prices will fall a long ways but until that occurs, price changes like this week are just minor corrections in an overall bull market (as Stoneleigh has repeatedly observed).

Here's another thought for you - if oil production has truly peaked and begins to decline, then demand has to decline faster than production or you still have upwards pressure on prices! (And note that in such a world many other things would increase in price as well while many more things would fall to almost zero value because those things would have zero survival value.)

CrystalRadio said...

I don't know if you are talking 'depression' Greyzone, but on the line of 'You can't get blood out of a stone' wouldn't the lack of available dollars during a depression put great pressure on the price of oil to drop, likely much faster than any drop in production?

Myself I would wait to see how things fall out, before holding investments in oil, till I was sure of a bottom. Then of course It would be drunken sailor on a spree time:)

nick said...

grezone, I am not confusing anything. I mentioned both supply (peak oil) and demand (growth in Asia) as factors in keeping oil prices up.

Musashi said...

You have to look at it as a series of parallel and simultaneous races.

Currency depreciation
Oil demand and supply
Geopolitical adjustments

Each factor affects, in this case the price of oil, by some percentage that may drive the price one way or another. Just add them up. They may even offset each other.

Applies to everything.

Problem is that now we have market interventions and very unstable geo politics, can't really trade anything this way unless you are in and out real quick and without leaving the screens.

IRX says most real money isn't even doing that anymore.

I guess our neighbors are unhappy because their agenda's are being steamrolled by events as predicted.

Musashi said...


Is another factor.
For oil producers, not pumping is a form of investment.
We park money in short term treasuries, Putin el al park it by not pumping.

Investment banks are corrupt?
Use the $$ to build petrochemical complexes and retain the added profit from finished product that used to go to the multi nationals.

To what extent this is true is anyones guess, but not considering it as a possibility is stupid.

nick said...

Good point musashi. I think OPEC said they would pump less if oil goes below low-90s or so (can't remember the exact range).

JWhitland said...

We're not in a credit crisis; we just experienced a "Gullibility Crisis". Way too many gullible borrowers, and gullible lenders. Not enough people who were willing to sit this one out.

CrystalRadio said...

Hi Musashi thanks for that link, good one! And ain't that (one year) graph of (^IRX) a hoot! Reminds me of a particularely bad day in the boudoir:(

About:real money isn't even doing that anymore.... and no more is mine and most especially since the Ides of March when the Bear cried "and you too, Morgan!"