Debt Rattle, March 26 2008: Back to the chopping block

One more time: look at existing home sales in this graph
And here's new home sales, down 29.8% since Feb '07

Ilargi: At one point last year, Meredith Whitney, after downgrading Citigroup, started receiving death threats. She’s not easily scared. Note that she clearly says this latest round of bad news on US banks will not be the last this year. “Since November, we have cut estimates for financials over 30 times, with no clear end in sight,”

It’s back to the chopping block

Just when you thought it was safe to take a look at the U.S. banking sector, Oppenheimer & Co. Inc. analyst Meredith Whitney is taking a cleaver to industry once more, cutting first quarter earnings estimates for a bunch of banks. “It’s back to the chopping block,” declares Ms. Whitney in a note outlining more doom and gloom for the industry despite the Federal Reserve’s recent injection of cash that appeared to have settled nerves on Wall Street.

Ms. Whitney is the bearish analyst whose downgrade of Citigroup Inc. last year led to a global sell-off of banking stocks. Now Oppenheimer is reducing first quarter earnings estimates by 84% on average for the U.S.banks to reflect more mortgage writedowns and higher charges on collateralized debt obligations and commercial mortgage backed securities.

Ms. Whitney forecasts Citigroup will record a per share loss of US$1.15 in the first quarter compared to her previous estimate of a loss of US$0.28. She rates Citigroup, Merrill Lynch & Co. and UBS AG “underperform,” and warns that earnings estimates could yet fall further.

“Since November, we have cut estimates for financials over 30 times, with no clear end in sight,” Ms. Whitney says. “As key mark-to-market indices trend lower, the housing market worsens, and the U.S. consumer comes under increasing pressure, we anticipate further downside to both estimates and stock prices.”

---

Ilargi: Here is the reason why I call the latest developments "nationalization", or the Bulgaria Model. In the end, it's your money that supports all the failed and doomed attempts at saving the bankers.

Taxpayers May Be Liable From Bear, Mortgage Rescue

Even as the Bush administration insists it won't risk public funds in a bailout, American taxpayers may already be liable for billions of dollars stemming from Federal Reserve and Treasury efforts to quell a financial crisis.
History suggests the Fed may not recover some of the almost $30 billion investment in illiquid mortgage securities it received from Bear Stearns Cos., said Joe Mason, a Drexel University professor who has written on banking crises.

Treasury's push to have Fannie Mae and Freddie Mac buy more mortgage bonds reduces the capital the government-chartered companies hold in reserve at a time when foreclosures and defaults are surging. Senators are promising to investigate. Officials "are playing with fire," said Allan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh. "With good luck, none of these liabilities will come due. We can't expect that good luck, and we haven't had it."

Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson were forced to respond after capital markets seized up and Bear Stearns faced a run by creditors. In an emergency action that jeopardizes the dividend it pays the Treasury, the Fed authorized a $29 billion loan against illiquid mortgage- and asset-backed securities from Bear Stearns that will be held in a Delaware corporation. JPMorgan Chase & Co. contributed $1 billion.[..]

"The fact that Treasury and Congress have been unwilling or unable to be proactive and provide a solution that involves putting taxpayer money at risk means that the Fed has had to take more measures itself, also putting taxpayer money at risk," said Laurence Meyer, a former Fed governor, and now vice chairman of Macroeconomic Advisers LLC in Washington.
The Treasury is counting on voluntary loan restructurings and $117 billion in tax rebates to support the economy through the worst housing recession in a quarter century.

The average recovery on failed bank assets is 40 cents on the dollar over a six-year period, according to Drexel's Mason, a former official at the Treasury's Office of the Comptroller of the Currency. Nobody knows if that historical benchmark will hold for the Fed portfolio because the assets haven't been disclosed, they have already been marked down and the Fed has 10 years to recover value.

"Over 10 years, you might eventually get your money back," said Janet Tavakoli, president of Tavakoli Structured Finance Inc. in Chicago. Still, "that isn't costless to the Fed, it isn't the same as holding Treasuries," she said. On some low-documentation loans, "you are going to be lucky to get 40 percent."

---

Lawmakers Probe Bear Purchase

Two key senators are demanding details of the last-minute sale of failing investment bank Bear Stearns to JP Morgan, and how the Federal Reserve Bank's backing for the deal could affect taxpayers.

Sen. Max Baucus, D-Mont., the Finance Committee chairman, and Sen. Charles E. Grassley of Iowa, the panel's top Republican, wrote Wednesday to executives of both firms, Treasury Secretary Henry M. Paulson and Fed Chairman Benjamin S. Bernanke seeking specifics of the transaction by week's end. They said they wanted answers on how taxpayers would fare under the deal, which the Fed helped broker and guarantee in an extraordinary move aimed at preventing a meltdown of the U.S. financial system.

The move was another sign that Congress, racing to deal with a housing mess that encapsulates voters' deep concerns about the economy, has placed the financial crisis at the top of the election-year agenda, with investigations and sweeping legislation likely to follow. "Americans are being asked to back a brand-new kind of transaction, to the tune of tens of billions of dollars," Baucus said in a statement. "Economic times are tight on Main Street as well as on Wall Street, and we have a responsibility to all taxpayers to review the details of this deal."

Grassley said, "Congress has a responsibility to look at whether the taxpayers will lose money here, what kind of precedent this sets for federal involvement when other firms over-extend themselves, how this will affect the marketplace in other direct and indirect ways, and whether top executives will come out better than the rank-and-file workers who weren't in the room negotiating the deal."

The senators asked for, among other things, details on the assets the Fed took on in the deal, the names of those — including government agencies — who negotiated it, attorneys involved, and copies of all the relevant documents. The Fed agreed to provide an important multibillion financial lifeline for the transaction. In addition, in the broadest use of its lending authority since the 1930s, the central bank said it would let squeezed Wall Street investment houses go directly to the Fed for emergency loans. That has long been a privilege just for commercial banks.

The letter came as Paulson said the Bear Stearns takeover highlighted the need for stronger and clearer regulation of big financial institutions. He said Wednesday that he "fully supported" the Fed's action, but that it also raises important policy considerations about the oversight of investment houses.

---

Ilargi: After reading this latest report on Canada’s ABCP tragedy, I’d say it’s very hard for any judge to approve of the proposed deal.

The mother of all blanket immunity deals

Legal standoffs don't get much bigger than this. When the phone book-sized proposal to salvage $32-billion of asset-backed commercial paper (ABCP) landed in an Ontario court last week, there was only one passage that really mattered to investors. Near the bottom of page 127 was a demand that will make or break the impossibly big bailout.

In 38 crisp lines, the section outlines the terms of a Master Release Agreement. The agreement calls for investors to give up their rights to sue just about anyone linked to the shipwrecked notes. In exchange for the legal surrender, a cluster of foreign and domestic banks backing the stricken notes are giving up some monetary claims and offering to provide an additional $14-billion line of credit to bolster a new series of replacement notes.

By any measure, it is the largest legal release ever sought. It would protect any bank, broker, trust, sponsor, lawyer, adviser, consultant, credit rating agency and even public relations consultant linked to ABCP from any lawsuit “forever.” That means that any broker or bank that may have improperly sold the notes; any bank that may have shut off emergency lines of credit; or any ABCP sponsor or rating agency that may have been slow to sound the alarm will get Kevlar-strength protection from legal bullets.

The release comes with a clever bit of legal design work, known as a cram down, which means that all of the estimated 1,600 ABCP investors are barred from lawsuits if only a simple majority approve it. In other words, even if hundreds of investors vote against giving up their right to sue, the court will defer to the majority and prohibit all legal claims. Will it fly? Purdy Crawford, the Toronto lawyer leading the rescue operation, says investors have no choice. Without the legal releases, the banks won't co-operate and the rescue operation fails.

“Simply put, there can be no plan unless these releases are included and I believe that the benefits of the plan, taken as a whole, justify the releases,” Mr. Crawford said in a court affidavit last week. It's easy to understand why the banks and the other ABCP backers want the release. They walk away with a Get Out Of Jail Free pass and the comfort of knowing that billions of dollars of intricately linked financial instruments won't unravel and further devastate credit markets and balance sheets.

Furthermore, by calling for a sweeping release that protects virtually everyone connected to ABCP, the banks will be able to shield themselves from so-called third-party lawsuits. Third-party claims allow small players targeted in lawsuits to turn around and file claims against larger players, such as ABCP banks, as a way of tapping into bigger pools of liability insurance.

For example, when a pair of investors recently sued Vancouver's Canaccord Capital Inc. for allegedly improperly plunking ABCP into their portfolios, the brokerage responded by suing the bank, Bank of Nova Scotia, which was its dealer for the notes. Canaccord and Scotiabank have denied any wrongdoing.

For investors, the advantages of approving the restructuring are not so clear. The surest thing Mr. Crawford can say about the proposed bailout is that it represents “the art of the possible.” In other words, he and his advisers can't say for sure in these troubled times what the new investments contemplated under the plan will be worth. Nor have they been able to clarify how they are going to finance a new market for the new notes if investors need to sell. It doesn't help that some analysts are estimating that ABCP notes have lost more than 40 per cent of their value in recent months.

---

Small investors in ABCP retain legal advice from class action specialists

Small investors in asset-backed commercial paper have retained Juroviesky and Ricci LLP, a law firm noted for class action expertise. Holders of more than $33-billion worth of short-term notes which have been illiquid since August face a vote on a court-administered restructuring arranged by large institutional investors in the seized-up ABCP.

Lawyer Henry Juroviesky said Wednesday his goal is to negotiate a deal enabling small investors to sell their notes immediately for full value. Under the Companies' Creditors Arrangement Act proposal from the so-called Pan-Canadian investors committee headed by Bay Street lawyer Purdy Crawford, ABCP holders would receive restructured long-term notes which would ultimately be expected to provide all or most of their face value, but in the short term would likely trade at steep discounts.

Juroviesky and Ricci said it has been retained by investors Brian Hunter, Ted Mcfeely and a Facebook group of ABCP holders. The firm said it will be advised by Diane Urquhart, an independent investor advocate who has been harshly critical of the banks and others that sold ABCP to retail investors. Juroviesky said small clients — many already suffering “significant financial hardship — can't afford to wait until maturity to recover their holdings, as proposed by the Crawford committee.

Retail investors also are balking at the proposal's requirement that they give up all rights to sue the banks, brokers and others involved in the ABCP market collapse. “We will be looking to the institutional clients and other stakeholders in the Pan-Canadian committee arrangement that stand to benefit from the proposal, to assist our clients in making the arrangement a positive plan for them as well,” Mr. Juroviesky stated.

---

CIBC admits $25B in credit crunch exposure

Canadian Imperial Bank of Commerce has admitted the full extent of its exposure to monoline insurers in its book of non-subprime credit derivatives is a whopping $25-billion.

In materials posted to the bank's Web site, CIBC said the portfolio is currently in the hole for about $885-million, and the underlying assets in this book is of much higher quality than its book of subprime investments. The bank issued the disclosure ahead of a speech by chief executive Gerry McCaughey, which is due to take place Wednesday afternoon at a banking conference in Montreal.

In his speech, which is also on CIBC's Web site, Mr. McCaughey is expected to say that volatile credit spreads are likely to lead to further writedowns in the second quarter. CIBC has already taken $4.2-billion of charges since the credit crunch began, which is more than any other Canadian bank. Earlier this year, CIBC was forced to raise $2.9-billion in emergency capital to shore up its balance sheet -- a move which steadied the bank, which now has the strongest Tier 1 capital ratio of any of the top 25 North American banks.

The lastest disclosure reveals the true extent of CIBC's dealings with monolines. It should ease frustration on Bay Street and Wall Street where analysts and investors had complained about the lack of details regarding the bank's book of non-subprime investments. In January, the Financial Post reported that the size of the book was estimated to be about $25-billion though a number of analysts had expressed frustration at knowing few details.

Following confirmation of the size of the book of investments, Blackmont analyst Brad Smith upgraded his rating on CIBC from "Sell" to "Hold" and also raised his target price for the bank's stock from $62.00 to $74.00. Mr. Smith said the disclosure shows the bank's exposure to the weakest monoline insurers is $6.5-billion, $3-billion lower than he had expected.

"While the risk of additional losses remains elevated, which may require additional equity, the disclosed exposures were not as severe as we had expected," Mr. Smith said. The underlying assets in the non-subprime book are mostly in North America and include collateralized loan obligations (CLOs), commercial mortgage-backed securities (CMBSs) and corporate loans.

---

American Banks Face Collapse

Central Banks have injected hundreds of billions of dollars of liquidity into the banking system since last August. Despite this, the financial position of US and investment banks continues to deteriorate. This conveys a serious message; banks are becoming increasingly insolvent. It is a message that few in equity markets seem to understand.

This loss of liquidity is a result of the market for securitised bank assets and syndicated loans drying up. So assets that were previously sold on for cash now have to be retained on balance sheet. The only buyer in the market now is the Fed. Bizarrely, many stock-market investors see these ever larger injections of liquidity as positive. Time and time again the market spikes up on their announcement.

The fact that banks NEED all this liquidity is a clear and unequivocal sign that banks are becoming increasingly insolvent and that the problems they face are getting worse. Indeed many would now be insolvent were it not for the support of Central Banks. If the ailing banks were seen in human terms, as a patient requiring increasingly large transfusions of blood to stay alive instead of capital, I wonder how many investors would conclude that the patient’s health was improving. One pint of blood on Monday, two on Tuesday, six on Friday. Is the patient’s health improving or are they dying?
 
The current situation in the US banking market is without precedent. Never before in a time of near full employment and record corporate profitability have we seen such huge levels of bad debts. By our own estimates bad debts in the US banking market are likely to rise to somewhere in the order of $300bn to $450bn. Other estimates set the figure much higher. This is important because the bad debts that have been incurred so far are entirely due to poor underwriting as opposed to a downturn in economic activity.

However, a downturn in economic activity is now occurring and, if the US economy is heading for recession as we forecast in 2007, it will give rise to a huge layer of additional bad debts. One that it simply cannot shoulder.  It is perfectly conceivable that bad debts may rise to somewhere in the order of $500bn. To put the scale of these losses into perspective the total equity of the US’s top 100 banks stood at $800bn at the end of the third quarter 2007. Losses of $500bn would wipe out 63% of their capital bases and leave many of them insolvent. 

---

Ilargi: Martin Wolf at FT puts it in big words. I think he's right in his main assessment, but not in his choice of words. While I think it's funny that he put the watershed, or "Game Over" moment one week later, March 14, than I did , March 7, he really should be clearer. "Liberization limit" my donkey, that's just beating around the shrub. We are witnessing the end of the capitalist, free market system. We truly have entered the Bulgaria Model, whether we like it or not.

The rescue of Bear Stearns marks liberalisation’s limit

Remember Friday March 14 2008: it was the day the dream of global free- market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Josef Ackermann, chief executive of Deutsche Bank, that “I no longer believe in the market’s self-healing power”. Deregulation has reached its limits.

Mine is not a judgment on whether the Fed was right to rescue Bear Stearns from bankruptcy. I do not know whether the risks justified the decisions not only to act as lender of last resort to an investment bank but to take credit risk on the Fed’s books. But the officials involved are serious people. They must have had reasons for their decisions. They can surely point to the dangers of the times – a crisis that Alan Greenspan, former chairman of the Federal Reserve, calls “the most wrenching since the end of the second world war” – and the role of Bear Stearns in these fragile markets.

Mine is more a judgment on the implications of the Fed’s decision. Put simply, Bear Stearns was deemed too systemically important to fail. This view was, it is true, reached in haste, at a time of crisis. But times of crisis are when new functions emerge, notably the practices associated with the lender-of-last-resort function of central banks, in the 19th century.

The implications of this decision are evident: there will have to be far greater regulation of such institutions. The Fed has provided a valuable form of insurance to the investment banks. Indeed, that is already evident from what has happened in the stock market since the rescue: the other big investment banks have enjoyed sizeable jumps in their share prices (see chart below). This is moral hazard made visible. The Fed decided that a money market “strike” against investment banks is the equivalent of a run on deposits in a commercial bank. It concluded that it must, for this reason, open the monetary spigots in favour of such institutions. Greater regulation must be on the way.

The lobbies of Wall Street will, it is true, resist onerous regulation of capital requirements or liquidity, after this crisis is over. They may succeed. But, intellectually, their position is now untenable. Systemically important institutions must pay for any official protection they receive. Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large, must be restricted. This is not just a matter of simple justice (although it is that, too). It is also a matter of efficiency. An unregulated, but subsidised, casino will not allocate resources well. Moreover, that subsidisation does not now apply only to shareholders, but to all creditors. Its effect is to make the costs of funds unreasonably cheap. These grossly misaligned incentives must be tackled.

---

Iceland pushes rates to 15% as turmoil bites

Fears that Iceland could be the first country to fall victim of the global financial turmoil grew yesterday when its central bank abruptly increased interest rates 1.25 percentage points to 15 per cent in an attempt to restore confidence in its struggling currency and stave off a full- blown economic crisis. The bank said "deteriorating financial conditions in global markets" had contributed to the emergency move. Confidence in the krona, Iceland's currency, has been shattered this year because of perceived imbalances in the economy and fears the banking sector is in danger of collapse. The krona has weakened by 22 per cent against the euro so far this year.

The rapid weakening of the currency prompted the central bank to adopt unusually blunt language yesterday, warning if the decline was not reversed Iceland faced "spiralling increases in prices, wages and the price of foreign exchange". "Only time will tell if this works," Ingimundur Fridriksson, governor of the central bank, told the Financial Times. "We are a small, open economy and we are obviously affected by moves in the international economy."

Yesterday's move saw the krona gain as much as 6.3 per cent against the dollar, while the country's benchmark index of the 15-most traded stocks had its biggest gain in more than 15 years, rising 6.2 per cent. The bank last raised rates in November 2007 and said then it would leave them unchanged until the middle of this year, but was prepared to take extraordinary action if the krona depreciated severely. Inflation was 6.8 per cent in February and has outpaced the central bank's target of 2.5 per cent since 2004.

"It will be necessary to continue to pursue a very tight monetary policy in order to bring inflation and inflation expectations under control, and increase confidence in the krona,'' the central bank said. Thor Herbertsson, co-author of an influential report in 2006 on Iceland's economy with Fredric Mishkin, a member of the US Federal Reserve board, said Iceland could be thrust into crisis as a result of the global economic situation.

But at the same time as international investor confidence in Iceland has fallen sharply, policymakers and economists have tried to reassure markets by drawing attention to the country's economic fundamentals and the underlying strength of the banks.
Richard Portes, president of the Centre for Economic Policy Research, and the author of a respected report on Iceland's economy last year, has urged investors to pay more attention to the data. He says overheating is being tackled, with economic growth slowing, hitting 2.9 per cent in 2007 and zero this year.

He adds that Iceland's current account deficit - the source of many of the concerns about the economy - has narrowed from 26 per cent of GDP in 2006 to 16 per cent in 2007. He has also made clear that Iceland's banks are sound by international standards, with deposit ratios in line with international norms, high capital adequacy ratios by European standards and credible funding profiles. Finnur Oddsson, managing director of the Icelandic Chamber of Commerce, said: "The global turmoil is certainly hurting the financial sector, but the danger of things toppling over here is greatly exaggerated."

---

Citigroup slams Bank of England for risking damage to real economy

Citigroup has called for radical measures to end Britain's financial crisis, rebuking the Bank of England for moving too slowly to meet liquidity needs and waiting too long to head off an economic downturn. "The downside risks to UK growth are sufficiently severe that the Bank of England should now be adopting a more determined approach to easing financial market strains. Relative inaction has a cost," said the bank's chief UK economist, Michael Saunders.

The blunt criticisms come as Britain's interbank borrowing market began to sieze up again. Three-month LIBOR rates rose yesterday for the 11th session in a row to 5.995pc. "The UK money markets have become dysfunctional. Three-month money rates are up 50 basis points since mid-January. The Bank of England seemed to think that the problem would fade away of its own accord. Instead, it is getting worse," Mr Saunders said.

"They still seem to be concerned about moral hazard, but we are long past that. It is not a question of bailing out the City. We're faced with the threat of unnecessary damage to the real economy," he said. The Bank is in part hamstrung by its rigid anti-inflation mandate. Rising energy and food costs are likely to push inflation back over 3pc in coming months, making it very hard for the Monetary Policy Committee to justify pre-emptive measures to cushion the downturn. The US Federal Reserve has a broader licence to follow its instinct.

Citigroup said the Bank should adopt a slate of targeted measures proposed by Willem Buiter, a former MPC member. These include accep-ting a much broader range of collateral in exchange for loans, outright purchases of different kinds of private securities, and longer maturities for borrowing. These steps could alleviate financial strains without fuelling inflation.

Tim Bond, from Barclays Capital, echoed the concerns, fearing that the Bank has been left behind as the Fed and the European Central Bank opt for more expansive and creative measures to ease the crisis. "Britain risks being the odd man out. The reason why we had a bear raid on HBOS last week is because people question whether the Bank of England is there to backstop the system. We need a clear framework to restore confidence, " he said.

---

Bank of England's Mervyn King refuses to follow US Fed rate cuts

Mervyn King, the Governor of the Bank of England, has ruled out following the US Federal Reserve in making "aggressive" cuts to interest rates to stabilise the fragile economy. Speaking today before the cross-party Treasury Select Committee with other members of the Monetary Policy Committee, which is responsible for setting the UK interest rate, Mr King said that the bank would not follow the Fed by implementing a number of sharp reductions that have taken the key US borrowing cost to 2.25 per cent.

In contrast, the Bank of England has cut the UK interest rate only twice, to 5.25 per cent, since December. While Mr King conceded the Bank was more predisposed to lowering borrowing costs as lending in the financial markets continued to tighten, he said that inflation is expected to rise to 3 per cent before falling back to its 2 per cent target later on in the year, reducing the likelihood of steep interest rate cuts in the near term.

Mr King said that the Bank of England was still in talks with British banks about the best course of action to take in addressing liquidity problems in the financial sector. He said: "We are discussing with the banks how a longer-term resolution of the problem might be reached. It is too soon to say where those discussions will lead, but two principles would underlie any central bank role."

"First, the risk of losses on their lending should remain with banks’ shareholders. The banks neither need nor want the taxpayer to insure them against these losses." "Second, a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets."

---

Hoarding by banks stokes fear over crisis

Central banks' efforts to ease strains in the money markets are failing to stop financial institutions from hoarding cash, stoking fears that the recent respite in equity markets may not signal the end of the credit crisis. Banks' borrowing costs - a sign of their willingness to lend to each other - in the US, eurozone and the UK rose again even after the Federal Reserve's unprecedented activity in lending to retail and investment banks against weaker than usual collateral and similar action in Europe.

The continued friction in the money markets came even as stock markets were showing new signs of optimism in spite of fresh data from the US showing consumers at their most pessimistic for 35 years and house prices falling at the fastest rate on record. In London, where the Bank of England has faced criticism for not being as proactive as other central banks, the three-month Libor rate was set yesterday at 5.995 per cent, its highest of the year.

This is nearly 0.9 percentage points above the level investors demand for risk-free money, a spread nearly as high as that which led to central bank interventions in September and December. The European Central Bank allocated €216bn (£168bn) in seven-day funds in its regular weekly operation yesterday - some €50bn higher than the amount it estimated would have normally been needed - at an average rate of 4.28 per cent, which was the highest since late September.

The Fed's latest lending to banks under its Term Auction Facility was also in heavy demand, receiving bids for $88.9bn compared with the $50bn on offer, an excess of demand almost as great as the previous auction two weeks ago, before the collapse of Bear Stearns. But equity markets ignored the continued stresses in the plumbing of the financial system, partly in the hope that they were driven by liquidity hoarding at the end of the financial quarter.

---

JP Morgan Rolls the Fed of New York (and BSC)

The question to Fed of New York President Tim Geithner: Why was JPM involved in this transaction? Why not simply extend liquidity support to BSC as you now offer to every other primary dealer? As and when BSC shareholders litigate over this mess, Geithner et al may be forced to answer those questions in public. To us, even at $10 per share, the JPM buyout stinks to high heaven because of the conflicted role played by the Fed of New York. Does anyone believe that the Fed would force Lehman Brothers or Goldman Sachs into such a fire sale?

Indeed, it looks to us like the Fed of New York and BSC both got rolled by JPM CEO Jamie Dimon and his merry banksters. But the JPM crowd won't be laughing much longer. The same forces that pushed BSC into insolvency are working on JPM and the other money centers as you read these lines, but JPM first and foremost. Just look at the range of valuations included in JPM's disclosure to Canadian officials regarding price estimates for illiquid structured assets and you can see why JPM's Dimon has been so upbeat in recent months.

To understand the grim outlook for JPM, start the analysis with derivatives. Because of its huge market share in all manner of OTC derivatives, JPM represents a "super sample" of overall OTC market risk. In terms of total size vs the bank's balance sheet, JPM's derivatives book is more than 7 standard deviations above the large bank peer group.

Because of this huge OTC derivatives book, the $1.6 trillion asset bank can tolerate just a 15bp realized loss across its aggregate derivatives position before losing the equivalent of its regulatory Risk Based Capital (RBC). And much like the GSEs, JPM's positions are too big to hedge - despite what Mr. Dimon may say to the contrary about laying off his bank's risk. And note that we have not even mentioned subprime assets yet.[..]

Why do we take such a dim view of JPM and the US banking sector generally? First, because the US real estate market is not yet even close to the bottom. Second, the commercial real estate and corporate credit sectors are being dragged down by the same deflationary forces that are causing the US economy to slow dramatically. When you consider that US real estate markets and bank loan losses are unlikely to bottom before this time next year, you begin to understand our bearish outlook.

JPM has been lucky so far because its risk book is heavily weighted toward commercial rather than consumer risk, unlike our beleaguered friends at Citigroup. But like last week's debacle involving BSC, the fast deteriorating situation at C could provide a catalyst that takes JPM down a couple of notches in the next few months. We hear in the risk channel that the internal situation at C is going from bad to worse as veteran Citi bankers are in near-mutiny against the new, two-headed management team imposed by regulators.

Meanwhile, former CEO Chuck Prince, who is a consultant to C, is leading the discussions with regulators on behalf of the bank and is, in effect, acting as shadow chief executive of C. One insider predicts that the C annual meeting in several weeks time will be "very messy" and notes that acting Chairman Robert Rubin is nowhere to be seen. Keep in mind that C, JPM and many other large banks are still trying to get their arms around the full dimension of the risks facing their institutions, this even as bank loan default rates remain well-below long-term averages.

---

Fed Expands Role by Aiding JPMorgan's Purchase of Bear Stearns

The Federal Reserve further expanded its role as a backstop to Wall Street dealers, setting up a new company to manage and sell $30 billion of Bear Stearns Cos. assets. In disclosing terms of a financing arrangement to speed JPMorgan Chase & Co.'s purchase of Bear Stearns, the Fed said yesterday it hired BlackRock Inc. to oversee and sell the assets, which will be placed in a new company created by the central bank.

Fed Chairman Ben S. Bernanke, trying to restore confidence to financial markets by averting a collapse of Bear Stearns, is pushing the central bank into new territory. Yesterday's announcement shows the Fed acting like a bank liquidator -- a role traditionally performed by the Federal Deposit Insurance Corp. -- for Bear Stearns, a firm whose main regulator is the Securities and Exchange Commission.

"Bernanke has taken the bit in his teeth," said Tom Schlesinger, executive director of the Financial Markets Center in Howardsville, Virginia. "I can think of nothing in recent or distant memory that remotely resembles what the Fed is doing here, certainly within the context of the central bank's operations."

The Fed last week agreed to help JPMorgan acquire Bear Stearns after a run on Bear, once the second-biggest underwriter of U.S. mortgage bonds. In an effort to shore up Wall Street's other firms, it also agreed to become lender of last resort to all 20 primary dealers in Treasury notes.

---

$10 bid for Bear Stearns may not be final word: UBS

Shares in Bear Stearns Cos Inc. fell below $11 on Tuesday, inching down ever so slowly to JP Morgan's new $10 offer for the beleaguered investment bank.  But while Tuesday's $10.94 closing price is a long way off Monday's $13.75 intraday high following JP Morgan's new bid, the current market value remains lofty enough to suggest the market is still waiting for the last word on the deal. 

UBS analyst Glenn Schorr, for one, thinks investors are still waiting for another bid to emerge, either from JP Morgan or another suitor – however unlikely that may be.   "At the current stock price, investors clearly believe another catalyst can drive the shares above the new $10 offer price," he said in a note to clients before markets opened Tuesday.

Although he believes the $10 per share offer is reasonable and will win the day eventually, he acknowledged the market's speculative nature around the situation, and added $1 of potential upside to the offer price and raised his price target of Bear Stearns shares to $11.

---

FDIC adds 140 workers to bank-failure division

Federal regulators will increase by 60% the number of workers who handle bank failures.

Anticipating a surge in troubled financial institutions, federal regulators will increase by 60% the number of workers who handle bank failures. The Federal Deposit Insurance Corp. wants to add 140 workers to bring staff levels to 360 workers in the division that handles bank failures, John Bovenzi, the agency's chief operating officer, said Tuesday.
"We want to make sure that we're prepared," Bovenzi said, adding that most of the hires will be temporary and based in Dallas.

There have been five bank failures since February 2007 following an uneventful more than two-year stretch. The last time the agency was hit hard with failures was during the 1990-1991 recession, when 502 banks failed in three years.
Analysts see casualties rising, but don't believe they will reach early-1990s levels. Gerard Cassidy, managing director of bank equity research at RBC Capital Markets, projects 150 U.S. bank failures over the next three years, with the highest concentration coming from states such as California and Florida where an overheated real estate market is in a fast freeze.

To cushion against losses from bad loans, banks likely will raise additional capital and cut dividends this year, said Tony Davis, a senior bank analyst with Stifel Nicolaus & Co. Inc. However, he said, "we're not looking at a massive number of bank failures." The FDIC provides insurance for deposits up to $100,000. While depositors typically have quick access to their bank accounts on the next business day after a bank closure, winding down a failed bank's operations can take years to finish. That process can include selling off real estate, investments and dealing with lawsuits.

There are 76 banks on the FDIC's "problem institutions" list, which would equate to about 10 expected bank failures this year, though FDIC officials declined to make projections. Historically, about six banks fail per year on average, FDIC officials said. Since 1981, total failures per year averaged about 13% of the number of institutions that started the year on the agency's list of banks with weak financial conditions.

The FDIC's chairman, Sheila Bair, has said that banks that were cautious about their lending should be able to weather the economic downturn, but cautioned that those that weren't so careful won't be so lucky. Analysts warn of lurking weaknesses, especially in smaller banks with a high concentration of real estate construction loans. 

---

Writedowns put Deutsche Bank profit at risk

Germany's biggest bank Deutsche Bank warned on Wednesday that credit market aftershocks could hit its 2008 profits, sending its shares down. In its annual report the bank highlighted the hurdles it faces this year from disruptions in the markets for leveraged finance and structured credit, previously big money spinners that have ground to a halt as credit market turmoil spread.

Deutsche is aiming for pretax profit of €8.4-billion this year but Chief Executive Josef Ackermann warned last month that 2008 would be “challenging for our capital-markets related business”, adding he would give ample notice if Deutsche looked likely to miss its targets. Analysts have been cutting their expectations for Deutsche Bank's earnings this year, with underlying pretax profit seen at 7.1 billion euros, according to the average of 15 forecasts compiled by Reuters Estimates.

“The pretax goal was already assumed as non-achievable,” JP Morgan said in a note to clients. “We believe consensus has to come down further,” it said, predicting pretax profit of 6.6 billion euros this year. Deutsche said business had slowed in a weakening economy, especially in areas most directly affected by the credit crisis, such as leveraged finance for corporate takeovers, where it has over 36 billion euros of exposure and expects more writedowns.

“Compensating for these negative effects on our profitability through performance in our other businesses may not be feasible, particularly if assumptions for continuing, albeit slower, economic growth in 2008 are not correct and less favourable economic conditions prevail,” it said. “These circumstances would likely adversely affect our ability to achieve our pretax profitability objective,” it said on Wednesday, days before the end of its first quarter. Deutsche also detailed billions of euros in exposure to other risky investments such as residential and commercial mortgage-backed securities and other structured finance products.

---

Corporate liquidity begins to dry up

The credit crunch is taking a toll on corporate liquidity, as the soaring cost of debt—for both commercial paper and private placements—pinches the balance sheets of all but the most highly rated non-financial companies. Cash and short-term investments of non-financial companies dropped by $250 billion in the second half of 2007, the first decline in the nine years that consultancy Treasury Strategies has been tracking the data.

Corporate liquidity had risen steadily, from $3.9 trillion in 1999 to $5.5 trillion in June 2007. But at the end of last year, it had fallen to $5.25 trillion, a 5% drop. The findings are part of a survey of 135 corporate treasurers conducted by Treasury Strategies between July 1, 2007, and Jan. 1, 2008. Treasury Strategies then adjusted that data with findings from its annual survey of 600 corporate treasurers.

Anthony J. Carfang, a co-founder of Treasury Strategies, attributes much of the drop to a decline in commercial paper issuance. Many companies issue commercial paper not just to finance operations but to bolster the cash on their balance sheet. “As companies have tightened up, they’re shrinking balance sheets just a little bit by borrowing less,” Mr. Carfang said. “A lot of companies had been directly issuing commercial paper because it was easy to do, and keeping a little cash cushion as a result.”

But when the credit crunch began, it became expensive for all but the most highly rated companies to issue paper. As a result, he said, cash balances dropped. For non-financial issuers of 30-day A2/P2 commercial paper, spreads jumped as high as 150 basis points in the second half of 2007, according to Federal Reserve data. Prior to that, spreads had hovered around 15 basis points for much of the last five years.

Commercial paper has become so expensive for some firms that they can’t issue it at all. Last week, commercial financier CIT Group reported it needed to tap $7.3 billion in unsecured credit lines because it was unable to raise money by selling commercial paper.

---

Medicare Running Out of Funds, Requiring Changes

Spending on Medicare, the U.S. health-care program for the elderly, will reach a legal limit by 2014, requiring the next president to propose changes. The report issued today is the second consecutive year that Medicare's trustees have pulled the so-called trigger, a law mandating that the president introduce legislation the following year to protect the program's financing.

President George W. Bush proposed in February that wealthier seniors pay higher premiums for Medicare's prescription drug benefit to increase revenue. Bush's plan, which Democrats in Congress dismissed as insufficient, was required by the trustees' report of 2007. Because of the new report, Bush's successor will have to offer proposals next year. The trustees also urged action to shore up Social Security, the government's retirement program.

"As the baby boom generation moves into retirement, these programs face progressively larger financial challenges," said Treasury Secretary Henry Paulson, one of the trustees, in a news conference. "The Medicare program poses a far greater financial challenge than Social Security." The trustees, all members of the Bush administration, offered projections for Medicare and Social Security similar to those in last year's report. They again estimated that Medicare's hospital fund will be exhausted by 2019, although earlier in that year than previously predicted, and that Social Security will run out of assets by 2041.

Medicare's Part A benefit, which includes payments for hospitals and is covered by the trust fund, constituted almost half the program's spending in 2006. Medicare's financing is made more precarious because of "overpayments" to private insurers that provide benefits, Representative Pete Stark, a California Democrat, said in an e- mailed statement. Insurance companies, including UnitedHealth Group Inc., are paid on average 13 percent more through the Medicare Advantage program than it costs Medicare to provide the same benefits directly.

---

Paulson: Social Security fix needed

Treasury Secretary says program is 'financially unsustainable.' Trustee report says government will have to pay back what it owes starting in 2017.

Treasury Secretary Henry Paulson, saying that Social Security is "financially unsustainable," called Tuesday for quick action to keep the system strong and released a report detailing the program's funding shortfalls. The federal government will have to start paying back what it owes the Social Security trust fund in 2017 so the program can continue paying 100% of benefits. By 2041, if the system is left unchanged, Social Security will only be able to pay out 78% of benefits promised to future retirees.

Those are two key estimates in the Social Security and Medicare trustees' 2008 annual report. Shoring up Social Security is one of the main economic issues that will face the next president. Most proposals involve raising taxes or reducing benefits. Democrats typically have opposed benefit reductions while Republicans have opposed tax increases.

"This year's Social Security Report again demonstrates that the Social Security program is financially unsustainable and requires reform," Paulson said at a briefing. "The sooner we take action ... the less drastic needed changes will be." For years, the Social Security program has been taking in more in payroll taxes from existing workers than it needed to fund benefits. The government borrowed that surplus and promised to pay it back with interest by issuing special issue bonds to the program.

But the proceeds from those bonds are finite, which is why the trustees estimate that the trust fund will run dry by 2041. Without that cushion, Social Security would only be able to pay out the money it collects in payroll taxes. Demographics are a major reason for the funding shortfall. The number of workers, compared to retirees, has begun to shrink.

That means the system will produce a smaller surplus, then none at all, and eventually it won't be able to pay out all benefits promised to future retirees. Last year, the trustees also estimated that the government would need to start paying back the program in 2017, and that the Social Security trust fund would be exhausted by 2041.

Currently, the first $102,000 of wages are subject to the 12.4% payroll tax that funds Social Security. Typically, half the tax is paid by workers, and the other half is paid by employers. To keep the system solvent over the next 75 years, the trustees estimated that the Social Security payroll tax rate would need to increase to 14.1%, up from the current 12.4%. Or lawmakers could bring it into balance by cutting benefits by 12%.

---

US consumer optimism at Watergate low

Consumer expectations in America have plummeted to their lowest level since the Watergate crisis and the oil embargo in 1973, while US house prices are now falling at the fastest pace since records began. The Case-Shiller index of home prices in the 20 largest US cities fell 10.7pc in January from a year earlier, with drops of 19.3pc in both Miami and Las Vegas. The price falls have already left nine million Americans facing negative equity in their houses.

Separately, the US Conference Board released a string of grim figures showing that the financial crisis of the last eight months has suddenly spilt over into the broader economy, causing a plunge in consumer confidence index from 76.4 in February to 64.5 in March. The most shocking data was for the "Expectations Index". It crashed to a level last seen in December 1973, when the noose was tightening on the Nixon presidency and the 'Great Inflation' had begun to accelerate out of control. The Yom Kippur War two months earlier had led to an Arab oil embargo of the West.

"Obviously, this is a recession signal," said Lynn Franco, the Board's research director. "People are faced with rising gasoline and food prices, and the credit crunch has made it much harder to get a home equity loan." The data comes as a cold shower after the euphoria following the Federal Reserve's rescue of Bear Stearns and the US banking system. It is a reminder that the US economy faces a long stint of hard labour to purge the excesses of the property boom. Americans have scant reserves to tide them through.

The savings rate fell below zero last year for the first time since the 1930s and mortgage debt is now greater than total home equity for the first time ever. David Blitzer, who puts together the Case-Shiller index for Standard & Poor's, said house prices were now in a vicious downward spiral. Wall Street took the day's grim news in its stride, and there was little change in the Dow Jones index in late trading.

---

Subprime woes threaten Japan real-estate boom

Foreign investor-driven trusts holding massive unrealized losses

The transformation of Japanese real estate into a financial product has helped to draw investments from abroad and underpin higher land prices, but the same forces are poised to deflate the market, according to a published report. While real estate investment trusts, or REITs, have played a key role in the surge in property values, their holdings, purchased for 6.9 trillion yen ($69 billion), carry a much lower market value of roughly 4 trillion yen, business daily Nikkei said on its Web site in a report dated Tuesday.

The nearly 3 trillion yen in unrealized losses underscore the sector's potential weakness, the report said. REITs are like stock mutual funds in that they are shares of a portfolio of properties. But they're also like bonds, with dividend yields generated by rental income from the properties in the portfolio. Tokyo's official land prices climbed for a second straight year in 2007. However, the subprime mortgage fallout has weakened the investment capabilities of hedge funds and other purchasers of Japanese property.

Financial institutions are also growing more cautious about funding such transactions. Foreign lenders have tightened screening of nonrecourse loans, a major financing conduit in real estate investments. Lending by foreign banks has plunged more than 1 trillion yen compared with 18 months ago, the Nikkei said, without citing its source for the figures

---

Our Financial House of Cards

When a bank fails, unless it is immediately taken over by another, still-solvent bank, its outstanding checking deposits lose the character of money and assume that of a security in default. That is, instead of being able to be spent, as the virtual equivalent of currency, they are reduced to the status of a claim to an uncertain sum of money to be paid at an unspecified time in the future, i.e., after the assets of the bank have been liquidated and the proceeds distributed to the various parties judged to have legitimate claims to them. Thus, what had been spendable as the equivalent of currency suddenly becomes no more spendable than any other security in default.

This change in the status of a bank's checking deposits constitutes a fully equivalent reduction in the quantity of money in the economic system. Thus, for example, if a bank were to fail with outstanding checking deposits of $100 billion, say, and not be taken over immediately by another, still-solvent bank, the quantity of money in the economic system would also immediately fall by $100 billion.

As a result of this fact, bank failures have the potential greatly to accelerate and deepen the descent into deflation and economic depression. For they represent much larger, more sudden reductions in the quantity of money and volume of spending in the economic system. And, just like lesser reductions, their effect, unless somehow checked or counteracted, is to launch a vicious circle of contraction and deflation. The period 1929–1933 provides the leading historical example.

In 1929, the quantity of money in the United States was approximately $26 billion and the gross national product (GNP/GDP) of the country, which provides an approximate measure of consumer spending, was $103 billion. By 1933, following wave after wave of bank failures, the quantity of money had fallen to approximately $19 billion and the GNP to less than $56 billion. The failure of wage rates and prices to fall to anywhere near the same extent resulted in mass unemployment.

---

Massive Antarctic ice shelf on verge of breakup

Some 220 square miles of ice has collapsed in Antarctica and an ice shelf about seven times the size of Manhattan is "hanging by a thread," the British Antarctic Survey said Tuesday, blaming global warming.

"We are in for a lot more events like this," said professor Ted Scambos, a glaciologist at the National Snow and Ice Data Center at the University of Colorado at Boulder. Scambos alerted the British Antarctic Survey after he noticed part of the Wilkins ice shelf disintegrating on February 28, when he was looking at NASA satellite images. Late February marks the end of summer at the South Pole and is the time when such events are most likely, he said.

"The amazing thing was, we saw it within hours of it beginning, in between the morning and the afternoon pictures of that day," Scambos said of the large chunk that broke away on February 28. The Wilkins ice shelf lost about 6 percent of its surface a decade ago, the British Antarctic Survey said in a statement on its Web site Another 220 square miles -- including the chunk that Scambos spotted -- had splintered from the ice shelf as of March 8, the group said.

"As of mid-March, only a narrow strip of shelf ice was protecting several thousand kilometers of potential further breakup," the group said. Scambos' center put the size of the threatened shelf at about 5,282 square miles, comparable to the state of Connecticut, or about half the area of Scotland.

---