Debt Rattle, April 16 2008: Witnessing madness

D'oh

Ilargi: I read yet another article this morning saying that the Fed is the lender of last resort in the US. That is not true, not anymore. The Fed’s plans, announced last week, that will see it borrow from the Treasury to keep its reserves above water, mean that the American taxpayer is now the lender of last resort. I don’t want to become a bore and repeat myself all the time, but this I will say again and again until it’s clear to everybody. A teutonic shift has taken place, and hardly a soul has noticed. That worries me.

If you haven’t read yesterday’s post The Fury of the Poor yet, please do so. I’ll keep posting relevant food and hunger articles. Today, we see countries halting exports of grains, to calm their own markets. The effect on importing countries could be devastating, and very soon.

As I said recently, we will see wars over this. I expect them to start this summer, if not earlier. The situation is ‘locked down’, there is no room to move. Production is largely controlled by multinationals, and reserves are already at record lows. One bad harvest anywhere in the world could set this powder keg ablaze. There's a new plant disease out there in Asia, the UG99 wheat fungus, that could do it.

In other joyful springtime tidings: While the total derivatives market grew an estimated 27% in 2007, credit derivatives beat that number, and by a mile and a half.

Outstanding contracts now total $62 trillion, up from $34.5 trillion a year ago!!

That is an 80% increase. That increase is twice the US GDP. That is an insane amount of money to carry into a casino.

In other words, the gambling increases and intensifies. The reason for that is the double or nothing crap table. And that table is reserved for addicts. Who will sell their mother to keep on gambling.

We are witnessing madness, whether we look at finance or at letting millions of people starve. Yes, it IS the same thing, you're right. Some people will say it's not madness, it's simply human nature. Maybe they're right. Maybe we're just complex amoebe, but driven by the same instincts. I for one see little proof of intelligence, or wisdom for that matter.

In any case, we need to realize that this is our own madness, our own nature, and pointing fingers only serves to try and wash our hands clean. I predict the insanity is at the very least highly contagious, and will spread, literally, like wildfire. It’ll be an extremely hot summer, climate change or not.


Credit Default Swaps and Bank Leverage

The Financial Times reports that that $45 trillion figure that most of us have been using for the size of the credit default swaps market is woefully dated. The International Swaps and Derivatives Association will announce today that outstanding contracts now total $62 trillion, up from $34.5 trillion a year ago.

Martin Mayer makes an interesting comment on the BSC debacle and leverage generally in this week's issue of Barrons:

In the OTC derivatives market, people who want to get out of their previous trades have to offset the obligations of that trade by creating a new instrument with a new counterparty. Take a credit-default swap, by which each party guarantees to accept the payout on a debt instrument held by the other party.

It's an insurance instrument, with some differences: The holder of the insured instrument can sell it, and the new owner becomes the beneficiary of the insurance. And the insurer may find someone who will accept a lower premium to take the burden of the insurance, allowing him to lay off his risk at an immediate profit.

The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous: $41 trillion face value of credit-default swaps... Once you begin to remove individual flower girls from the daisy chain of credit swaps, you don't know who will wind up with obligations they thought they had insured against and they can't meet.

For some months now, we've been pondering what happens to all of those net short credit default swap portfolios at dozens upon dozens of hedge funds that will be going out of business this year due to the Great Unwind. Hedge funds have no permanent capital, thus there are no assets available to support the defeasance of a book of net-short OTC derivatives positions should the fund be forced into involuntary liquidation.

In such a scenario, you can forget about netting; won't be nothing left to net, in or out of bankruptcy. And since the old habit of simply writing more CDS contracts is not available once the fund starts liquidating, we wonder if leading CDS dealers like JPMorgan won't be forced to take these trades back as hedge funds expire. What's the "fair value" of a book of short OTC derivative positions taken by a dealer in payment of other debts?

Indeed, if you think of BSC not as a broker dealer, but instead as a clearing customer of JPM, then the logic of the acquisition makes perfect sense. JPM could not let BSC go into Chapter 11 because doing so might have started a chain reaction among the OTC derivative counterparties of both firms.

Between JPM, BSC and BSC's customers there were three levels of leverage, making the ratio of Economic Capital to Tier One Risk Based Capital computed by The IRA Bank Monitor (4.7:1) for JPM at the top of the leverage pyramid seem entirely too generous! If you impute even a fraction of the downstream leverage residing with clearing customers to JPM, the giant bank's capital shortfall becomes alarming.

A bank holding company, after all, is thinly capitalized and in many ways was the precursor of the hedge fund model. On a parent-only basis, JPM's $314 billion asset balance sheet includes $200 billion representing investments in its subsidiary banks and non-bank units, supported by half as much equity and more than $200 billion in debt.

And remember that JPM's on-balance sheet capital does not even partially support the counterparty risk of its vast OTC derivatives businesses, thus the BSC acquisition was a "must do" deal for Mr. Dimon. Think of it this way: JPM is essentially an uncapitalized, $76 trillion OTC derivatives exchange with a $1.3 trillion asset bank appendage. By the way, we are working to include factors for OBS securitizations in the next iteration of our Economic Capital simulation in The IRA Bank Monitor. But you understand that Fed officials still believe, even today, that the US markets are not over-leveraged.

The story goes that shortly after Ben Bernanke was confirmed as Fed Chairman, he attended a dinner in New York attended by the heads of the major banks. All the big banksters were there. After dinner, Chairman Bernanke gave a speech and he at one point reportedly commented that the financial markets were "not very leveraged," causing audible laughter from the audience.

According to one attendee, Lehman Brothers CEO Dick Fuld eventually spoke up and, while declaiming any intention to disagree with Chairman Bernanke publicly, told the newly minted Fed chief that his comments about the degree of leverage in the financial markets were mistaken. JPM CEO Jamie Dimon, who also attended the dinner, was reported to second Fuld's comments.

Who would have thought that only several months later, Fuld and Dimon, both of whom are directors of the Federal Reserve Bank of New York BTW, would be calling upon Chairman Bernanke to rescue them from leveraged OTC swamp? Guess they're not laughing now - or are they?

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The Economic Crisis Is No Longer Behind Us

Mack of Morgan Stanley and Fuld of Lehman have both expressed the opinion that the worst of the Wall St. earnings crisis may now be in the past. The head of UBS also thinks his bank's worst news is out. All of that is true until it isn't.

Word is spreading that Merrill Lynch may take write-offs of $6 billion to $8 billion for the last quarter. According to The Wall Street Journal, Merrill made bigger and bigger bets on the CDO market as 2007 went on. The net result, writes the paper, "would bring its total (write-downs} since October to more than $30 billion." That is a lot of money, even for Merrill Lynch.

The hardest news is not all out. If mortgages continue to default, and that number was up 57% in the last month, paper based on this lending could have further problems. The equity line of credit ARM market now totals $4 trillion. Other consumer loans will fail and a trying economy should bring down the value of LBO debt.

Looking forward in hope may give some short-term comfort to those who do not know any better. Insiders know something different. Credit default swaps rose 37% from the first half of last year to the second and hit $62.2 trillion. That is a lot of capital bet on negative news.

The low end of EPS estimates for banks and brokerages still reflects a deep pessimism about the system. If financial companies come in at or below those bleak numbers, share prices across the industry will fall and there will be more demand for new capital. That capital will ask for frighteningly favorable terms.

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In a bid to stem panic, grain exports halted

Some of the world's biggest grain exporters barred their farmers from selling in global markets yesterday, exacerbating the food price crisis for poorer nations that import their food and highlighting the failure of governments to nurture stronger rules for agricultural trade.

Rice and corn prices soared to records on U.S. markets and wheat jumped to its highest in a week after Kazakhstan, the world's fifth-largest wheat exporter, and Indonesia, a major rice producer, became the latest nations to impose export bans. The price increases further inflated global food costs that already had surged 48 per cent since the end of 2006.

The latest moves highlight the difficulty of solving a problem that has its roots in years of trade policy indecision, the push by richer nations to produce more fuel from food crops, growing demand from developing countries such as China, and Wall Street investors who see a money-making opportunity in surging commodity demand.

“Business as usual is no longer an option,” Paris-based UNESCO says in a sweeping report on the world agriculture system that was three years in the making and released yesterday. “There is a recognition that the mounting crisis in food security is of a different complexity and potentially different magnitude than the one of the 1960s.” Kazakhstan and Indonesia are trying to put a lid on food inflation to avoid the riots that have beset countries such as Egypt and Haiti.

While their policies may ease tensions at home, they threaten to make things worse for poorer countries that don't have the luxury of good agricultural land and temperate climates to feed their populations. “If a country is a net food exporter, or has sufficient production, and puts up restrictions, it could lead to lower prices in that country, but it takes food off the international market,” Jennifer Clapp, an expert in international governance at the University of Waterloo, said yesterday in an e-mail from a conference in Kansas City, Mo., dealing with international food aid.

Kazakhstan and Indonesia are hardly alone in seeking to prevent their farmers from trying to profit from sky-high international prices rather selling in local markets. Russia, Ukraine and Argentina are among other nations that have taken similar steps. Higher costs for oil and food burst the budget of the United Nation's World Food Program, forcing the UN to ask for an extra $500-million by May 1 to maintain programs that will feed 73 million people in 78 countries this year.

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Ilargi: Yup, these are the guys who hold 80% of all new US mortgages, on your tab. Nice feeling, right? Remember, Fannie and Freddie are private corporations, run for profit, with the implied guarantee from teh US government that any losses will be covered with taxpayer money. Or in different words: they have a license to gamble till they drop.

Attempting to Heal a Fractured Mortgage Market
Freddie's Woes Run Deep, Report Says

A federal regulator said yesterday that it has "significant supervisory concerns" about the conditions of Fannie Mae and Freddie Mac, two government-sponsored housing finance companies that own or guarantee trillions of dollars of mortgages. Both companies have suffered financially from the meltdown in the housing market and remain vulnerable to further declines, but Freddie Mac's problems run deeper, the regulator said.

Freddie Mac still has some ineffective internal controls, has invested in poorly underwritten loans and lacks "sufficient executive management depth," the Office of Federal Housing Enterprise Oversight said in an annual report to Congress. The regulator also raised questions about accounting decisions Freddie Mac made last year, saying they need further review. Those issues include Freddie Mac's approach to calculating the amount of money it should hold in reserve and other accounting choices that enabled the company to report a one-time gain of about $1 billion.

Under an accounting rule, Freddie Mac was able to book income from changes in the value of securities it held and was able to choose which securities to use that way, presenting the opportunity to cherry-pick. In an interview, OFHEO Director James B. Lockhart III said the agency was not challenging the accounting judgments Freddie Mac has already made but will be monitoring its approach going forward "to make sure there's a logical and ongoing methodology."

The Securities and Exchange Commission may look at the accounting issues as Freddie Mac seeks to register with the SEC this year, Lockhart said. At the end of last year, Fannie Mae and Freddie Mac had $4.8 billion and $15 billion of paper losses, respectively, that they had not counted against earnings, OFHEO said. The deferred losses involve what the companies regard as temporary declines in the value of mortgage-related investments, but determining whether the losses are permanent and therefore must be counted against earnings is a judgment call, OFHEO said.

"This is raising a yellow flag," Lockhart said. "Obviously, if we had a major issue with any of these they would have made a change," he said. The regulator's assessment came several years after twin accounting scandals prompted Fannie Mae and Freddie Mac to replace their top managers and begin overhauling the systems they use to track finances.

The government has been counting on Fannie Mae and Freddie Mac to help prop up the troubled mortgage market, and toward that end OFHEO last month agreed to let them operate with thinner financial cushions.

In announcing the decision, OFHEO emphasized the progress both companies had made in recovering from the accounting scandals. In the report released yesterday, OFHEO gave Fannie Mae more credit than Freddie Mac. Fannie Mae's internal controls range "from satisfactory to adequate," the regulator said.

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Hedge Funds Need More Oversight, Transparency, Treasury Panels Say

Two committees appointed by the Treasury Department called yesterday for greater accountability within the secretive world of hedge funds and pressed fund managers to detail their investment activities, saying such moves would help the troubled financial markets. The two panels included senior executives of large hedge funds and major institutional investors such as pension funds. Under their proposals, hedge funds would set up independent bodies to oversee how fund managers are pricing hard-to-value financial investments and examine whether they are facing conflicts of interest.

The committees' report takes aim at complex financial instruments, which were at the core of the credit meltdown. Many hedge funds and investment firms were overly optimistic about the value of mortgage-related securities and then suffered massive losses when such assets began to plummet in price last year. Investors lost confidence in all kinds of debt securities and pulled out of the credit markets, virtually shutting them down. Several major hedge funds collapsed, further destabilizing the financial system.

Treasury Secretary Henry M. Paulson Jr. said the committees' report "sends a strong message that heightened vigilance is necessary." Speaking to reporters at the Treasury, he added, "Today's release reinforces our belief that a combination of robust market discipline and regulatory policies best protect investors and mitigate systemic risk." But the recommendations, keeping with a long-standing position of the Bush administration, did not seek regulatory oversight for hedge funds, which are large pools of private money that can be used for a wide range of investments.

Members of the panels said that the proposals were voluntary and acknowledged that they did not know how much it would cost to implement them. The two committees had separate but related tasks. The first, comprising managers who oversee 10 of the nation's largest hedge funds, developed a set of best practices for their industry. The other provided guidance for investors.

Eric Mindich, who chaired the first panel, is chief executive of Eton Park Capital Management, a $12 billion hedge fund. He said the 10 committee members committed themselves to the reports' proposals. He said he hoped other hedge funds would follow their example. "We agreed to do this not because anyone put a gun to our head but because we thought these recommendations are right and represented a step forward for the industry," he said in an interview.

Hedge fund managers must take more responsibility for their role in the markets because they have become such a significant force on Wall Street, Mindich added. Hedge funds manage about $2 trillion in assets and represent the majority of trading on major stock exchanges, he said.

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Blood On The Floor At WaMu

Washington Mutual investors have been bracing themselves for big losses and a change in management. Tuesday afternoon, they got what they were waiting for. After the close, Washington Mutual reported a first-quarter net loss of $1.1 billion, or $1.40 per diluted share, as it doubled its bad loan provisions to $3.5 billion.

In the year-earlier period, the Seattle, Wash.-based bank earned $784 million, or 86 cents per diluted share. Meanwhile, activist shareholders who were pushing to oust WaMu's finance committee chairwoman, Mary E. Pugh, had something to celebrate. The bank said Pugh had resigned from the board.

CtW Investment Group, part of the Change to Win federation of U.S. labor unions, has been leading an effort to hold Pugh and other executives accountable for not seeing the writing on the wall leading up to the mortgage meltdown.

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Ilargi: Yes, I’ve said it before: someone may take this G-7 openness demand serious. In 100 days banks may be forced to come clean somewhere in the world, or face severe sanctions. It’ll be a fun game to watch unfold.

Banks must come clean, says EU commissioner

The only way to restore confidence in global financial markets is for banks to come completely clean about their exposures, Charlie McCreevy, EU internal market commissioner, said today. McCreevy told guardian.co.uk: "There's no commercial paper market in Europe and it appears that last week's rate cut by the Bank of England made no difference at all because there's no confidence at all."

"What we need is a situation where every financial institution puts all its cards on the table so everybody can see clearly what they have and how they have valued things - and over a period of time that's the only way to put confidence back into the world." The Irish commissioner also highlighted the time it would take for banks to regain consumer and regulatory confidence. "This excessiveness built up over a long, long number of years and didn't happen just in the last six months. It would be lovely to think that would be finished in a couple of months but it will only wash itself out over a period of time."

His comments come as UBS, the European bank most savaged by the sub-prime crisis, came under fresh pressure over the appointment of Peter Kurer as chairman. Activist shareholder Olivant repeated its claim that Kurer does not represent a break from the past as he is an "insider" who served on its risk committee for several years. Kurer admitted to the Financial Times that it could take three years to restore UBS's battered reputation.

McCreevy, who oversees the European banking sector, has been reluctant to endorse tougher regulation in the wake of the sub-prime crisis but said changes would come in the medium to long term. "But no regulatory change will restore confidence overnight because if that were the case it would have been done."

But he also indicated he would bring forward proposals for stricter oversight of credit rating agencies later next month and planned to go ahead with his proposals for "colleges of supervisors" to watch over the EU's 46 cross-border banks, with one national regulator being assigned the role of lead supervisor. The idea is canvassed in proposals to beef up the EU's capital requirements directive published today and due to be finalised in October.

On rating agencies he said: "To be fair, some agencies have put forward their own proposals ... There will be changes, either voluntary or enforced, and I prefer voluntary but if it needs regulatory change I will not be afraid to do it."

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Ron Paul Sees Bailout Writing on the Wall

It saddens me to see the US being run by monkeys, who don't understand the sanctity of contracts, who don't understand moral hazard and who don't understand that destroying the US dollar is not good for America.

"I think that if there is something on the floor between now and November [that] will be construed as something to help people getting out of their mortgages, nobody will consider that the responsibility of government is to honor and respect contracts.

They are going to go and violate everybody's contracts and tell people, "Just because you [received] this loan and you can't pay it [back], we are going to change the rules."

But if you and I had a contract like that, we could see that that's not right. You owe me that money, or I want my house back. It's so vague now—who owns these mortgages—they figure, "Well, somebody in China owns these mortgages, so we won't honor the contract."

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US housing starts plunge 11.9 % to a 17-year low
Pace of building new homes down 36.5% on year-over-year basis

U.S. home builders started the fewest number of homes in 17 years, as housing starts plunged 11.9% to a seasonally adjusted annual rate of 947,000 in March, the Commerce Department reported Wednesday. March's rate was the lowest for housing starts since March 1991. Starts were down 36.5% compared with March 2007.

Also, building permits dropped 5.8% to 927,000 in March, 40.9% below the same month a year ago. The starts figure was much lower than expected on Wall Street, where economists were looking for a drop to 988,000 annualized units. The stunning drop in home construction indicates that there is still no end in sight to the housing downturn, with builders trying to reduce the excess inventory of unsold homes on the market.

"We think there is further room for declines into at least early summer," wrote Adam York, an economist for Wachovia, who said inventories should begin to fall slowly now that the pace of home completions is less than underlying demand.

"This report, while painful, implies healing in the sector,"(???> because at least builders aren't digging a deeper hole, wrote Robert Brusca, chief economist for FAO Economics. On Tuesday, the National Association of Home Builders forecast housing starts would fall 30% this year, compared with a previously estimated 27% drop, as the credit crisis persists.

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Ilargi: Britain will try to emulate the US every step of the way. The British pound will be hammered even more than the US dollar, and we have to start wondering how much longer there will even be sterling.

Bank of England set to act on mortgage crisis

The Bank of England is on the verge of taking action to address the increasing reluctance among mortgage lenders to lend money in the wake of the credit crunch. It is waiting for Government approval to take over mortgage loans that are sat on lenders' balance sheets, in order to increase liquidity in the money markets.

It is understood that the Bank would grant Government bonds in exchange for securities backed by UK mortgages. The plans coincide with Gordon Brown's trip to the US today, when he will meet banks on Wall Street a day after he welcomed proposals made by UK banks to help ease the credit crunch and confirmed that the Government remains in contact with the Bank of England to find a way through the crisis.

Mr Brown, who has seen his rating in opinion polls tumble as the credit crisis spreads to the wider economy in the UK, will also meet Federal Reserve chairman Ben Bernanke as part of his visit to the US. About 25 executives from Britain's high street lenders, investment banks, hedge funds and insurance companies yesterday attended a meeting with Mr Brown to offer suggestions on how to reopen the money markets.

Their principle request was that the Bank widen the collateral it will accept to include lesser quality mortgages and to make more longer-term funding available. The lenders hope such measures will help the inter-bank market, where the three-month London inter-bank offered rate (Libor) remained unchanged at 5.93pc yesterday - almost a whole percentage point above base of 5pc. Mortgage costs are rising despite recent interest rate cuts because wholesale markets are dislocated and funding remains near record highs.

In a statement released after the talks, the Prime Minister's spokesman said there would be further discussions in coming days, including a meeting between Chancellor Alistair Darling and mortgage lenders next week. Mr Brown said in an interview on Sky: "[We must] make sure that we can give people the confidence that mortgages will be safe and that we are in a position to steer the economy through difficult circumstances. We are doing everything in our power to make sure that we can underpin the housing market and the economy with greater confidence."

It is believed the Prime Minister would like assurances that any state help would be reciprocated by industry efforts to assist first time buyers. He also urged the banks to reveal the full extent of their sub-prime writedowns to remove counterparty concerns. Separately, the Bank carried out a planned £15bn auction of three-month money to help improve liquidity yesterday - at rates ranging from 4.91pc to 5.835pc. The auction was not oversubscribed, despite the shortage of three month funding, causing confusion among analysts.

Simon Ward, New Star economist, said the relatively low subscription rate reflected the fact that banks did not have enough securitised AAA mortgage paper and that they were unwilling to put up better quality assets in anticipation of a widening of the collateral allowed.

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Nothing Special With Treasuries as Fed Has Mortgages

The dollar isn't the only casualty of the Federal Reserve's rescue of seized-up credit markets. Bond traders are finding there is nothing special about Treasuries anymore, now that the Fed accepts substitutes for government securities as collateral -- having concluded it wasn't enough to reduce the benchmark interest rate for overnight bank loans six times since September.

As recently as March 21, Treasuries were in such demand that traders were willing to lend cash at rates 2 percentage points less than the Fed's target for overnight loans if they could obtain the securities as collateral. Now, the gap is back in line with the 0.06 percentage point average in the 10 years prior to August, when subprime mortgage losses spread.

The $6.3 trillion-a-day repurchase agreement, or repo, market is a barometer of sentiment because it's where firms finance trades. A narrowing of the spread between the so-called general-collateral and federal-funds rates may suggest declining demand for U.S. government debt. Treasuries have lost 0.8 percent on average since March 20, when the central bank expanded the type of debt it would take in return for the securities to include mortgage and commercial real estate bonds.

Since dealers typically use repurchase agreements to finance their holdings, movements in the rates affect the cost of holding the securities in inventory. Dealers last month increasingly let trades involving Treasuries go uncompleted because the cost to obtain the securities became too expensive.

Failures to deliver or receive Treasuries, known as fails, totaled $2.3 trillion in the week ended April 2, the highest since May 2004. Fails averaged $173.6 billion a week since July 1990, data on the New York Fed's Web site show. The general collateral rate increased to 2.25 percent on April 9, from 0.9 percent on March 20, according to data from Jersey City, New Jersey-based GovPX Inc., a unit of ICAP Plc, the world's largest inter-dealer broker. The Fed's target rate held constant at 2.25 percent during that period.

Banks and securities firms are still hoarding cash after racking up almost $250 billion of losses and writedowns since the start of 2007. The spread between the rate banks charge for three-month loans denominated in dollars and the overnight index swap rate, a measure of banks' willingness to lend, widened to 81 basis points today, or 0.81 percentage point, from 57 basis points on March 18. The low this year was 24 basis points on Jan. 24.

``Banks are still having to pay up to borrow,'' said Mark Amberson, the director of short-term investments and manager of the $7 billion Russell Money Fund at the Russell Investment Group in Tacoma, Washington. ``In this environment, which is dominated by fear and lack of trust, you are still seeing demand for government debt.''

Former Fed Chairman Paul Volcker said Bernanke's decision to back the Bears Stearns buyout by providing guarantees on $28 billion of loans took the Fed ``to the very edge of its lawful and implied powers, transcending in the process certain long- embedded central banking principles.'' Volcker, chairman of the Fed from 1979 to 1987, made the comments in a speech to the Economic Club of New York on April 8.

Bernanke, who worked with Treasury Secretary Henry Paulson to broker the bailout, defended the move during testimony to Congress this month as necessary to prevent ``severe'' damage to financial markets. Fed and Treasury officials are considering ways to replenish the central bank's supply of U.S. bonds if needed to ensure the Fed can keep lending to Wall Street dealers. The Fed is selling some of its Treasuries to finance its lending programs.

Treasury bill, note and bond holdings at the Fed fell 21 percent to $560 billion on April 9 from $713 billion on March 5, said George Goncalves, chief Treasury and agency debt strategist at Morgan Stanley in New York. The firm is a primary dealer.
One option would be for the government to sell more debt and deposit the proceeds with the Fed, according to a Treasury official and two people at the central bank familiar with the proposal. The Fed would then use the cash to purchase Treasury notes, which it could lend to dealers.

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Ilargi: Libor is broken; banks don’t trust each other, and to a wider extent than you think. They don’t even trust each other to report correct rates anymore.

Libor's credibility is weakened: Credit Suisse

The London Interbank Offered Rate (LIBOR), hit by a breakdown in funding during the credit crisis, is likely to survive but with its “credibility severely weakened,” said Paul Calello, chief executive of the investment bank at Credit Suisse. “Continuing to base an enormous amount of derivative contracts on an index with credibility problems is a serious issue we must address,” he told the annual meeting of the International Swaps and Derivatives Association.

LIBOR is a daily reference rate published by the British Bankers Association based on the interest rates at which banks offer to lend unsecured funds to each other in ten major currencies in the London interbank market. It is a key global benchmark for short term interest rates and is used as the basis for settlement of interest rate contracts on many of the world's major futures and options exchanges.

It has become distorted due to the turmoil in the money markets, with banks becoming unwilling to lend to each other as they fear others may have hidden losses related to the U.S. subprime mortgage crisis. LIBOR was among a number of issues Mr. Calello highlighted in an appeal to the financial industry to come up with improvements to the derivatives market to combat risks to the entire financial system.

“Derivatives have now reached a sheer scale that clearly could affect the financial system at large ... and they need to be an integral and important part of the solution,” he said. “This new phenomenon of ‘too interconnected to fail' is now a permanent part of the financial system.” The ISDA said on Tuesday that outstanding credit derivatives now stood at $62.2-trillion (U.S.), up 37 per cent in the second half of 2007, continuing to grow at a strong pace despite the financial crisis.

As the U.S. Federal Reserve's intervention in aid of Bear Stearns showed, investment banks and non-regulated institutions are as crucial to the financial system as commercial banks, Mr. Calello said. Reported losses have reached hundreds of billions so far, and the banking system has replaced three-quarters of the writedowns with new capital, he said, but he expected more losses to come, not all at the banks.

On the LIBOR issue, the spread between LIBOR and the Overnight Index Swap (OIS) rate has widened to more than 100 basis points at times from about 12 basis points before the crisis started last June, Mr. Calello said. He expected to see strong growth in OIS transactions as a result of LIBOR's weakness, while the spread has shown no sign of returning to previous levels despite “virtually unlimited amounts of liquidity being injected into the system.” The industry needs to look at strengthening alternatives such as considering pushing the development of long-dated Overnight Index Swaps, he said.
During the crisis, the credit default swaps (CDS) market briefly traded as much on the basis of counterparty risk as underlying risk, he said.

“It has become clear that the CDS market had not sufficiently differentiated” between the two, he said. Firms need systems that can keep up with credit exposures, which can change hour by hour and with changes in counterparty exposures at times of stress, which can overwhelm collateralization agreements, he said. ISDA has already taken steps to head off problems with clearing and settlement since 2005. “Failing to do more now is not an option.”

The U.S. President's Working Group on Financial Markets is urging that standard CDS documentation include cash settlement provisions, he said. “ISDA must incorporate these protocols.” The Basel Committee Joint Forum has called for greater disclosure, he said. “ISDA knows the derivatives markets better than anyone, so who better to create uniform disclosure mechanisms?”

The industry needs to improve infrastructure to ensure timely settlement and trade resolution, more electronic trading, better valuing of risk and exposure no matter how fast the market is shifting, and transparent and accessible trade data, which “if we have to create an industry utility to do it, so be it.” Other markets have interoperability, automation, standardization and disclosure, “and it's past time for derivatives,” Mr. Calello said.

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Bankers Cast Doubt On Key Rate Amid Crisis

One of the most important barometers of the world's financial health could be sending false signals.
In a development that has implications for borrowers everywhere, from Russian oil producers to homeowners in Detroit, bankers and traders are expressing concerns that the London inter-bank offered rate, known as Libor, is becoming unreliable.

Libor plays a crucial role in the global financial system. Calculated every morning in London from information supplied by banks all over the world, it's a measure of the average interest rate at which banks make short-term loans to one another. Libor provides a key indicator of their health, rising when banks are in trouble. Its influence extends far beyond banking: The interest rates on trillions of dollars in corporate debt, home mortgages and financial contracts reset according to Libor.

In recent months, the financial crisis sparked by subprime-mortgage problems has jolted banks and sent Libor sharply upward. The growing suspicions about Libor's veracity suggest that banks' troubles could be worse than they're willing to admit.

The concern: Some banks don't want to report the high rates they're paying for short-term loans because they don't want to tip off the market that they're desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates. Fibbing by banks could mean that millions of borrowers around the world are paying artificially low rates on their loans. That's good for borrowers, but could be very bad for the banks and other financial institutions that lend to them.

No specific evidence has emerged that banks have provided false information about borrowing rates, and it's possible that declines in lending volumes are making some Libor averages less reliable. But bankers and other market participants have quietly expressed concerns to the British Bankers' Association, which oversees Libor, about whether banks are reporting rates that reflect their true borrowing costs, according to a person familiar with the matter and to government documents. The BBA is now investigating to identify potential problems, the person says.

Questions about Libor were raised as far back as November, at a Bank of England meeting in which United Kingdom banks, the firms that process bank trades and central bank officials discussed the recent financial turmoil. According to minutes of the meeting, "several group members thought that Libor fixings had been lower than actual traded interbank rates through the period of stress." In a recent report, two economists at the Bank for International Settlements, a sort of central bank for central bankers, also expressed concerns that banks might report inaccurate rate quotes.

A spokesman for the BBA, John Ewan, said the trade group is monitoring the situation. "We want to ensure that our rates are as accurate as possible, so we are closely watching the rates banks contribute," Mr. Ewan said. "If it is deemed necessary, we will take action to preserve the reputation and standing in the market of our rates." Libor is expected to be on the agenda of a bankers' association board meeting on Wednesday.

In a recent research report on potential problems with Libor, Scott Peng, an interest-rate strategist at Citigroup Inc. in New York, wrote that "the long-term psychological and economic impacts this could have on the financial market are incalculable." Mr. Peng estimates that if banks provided accurate data about their borrowing costs, three-month Libor would be higher by as much as 0.3 percentage points.

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Ilargi: My assessment: Sarkozy is playing Berlusconi, to see what France can get out of this. For now, though, the French economy is not nearly as weak as Italy’s, and therefore its needs are very different. When push coems to shove, Sarkozy will vote with Germany and Holland, and be cozy in the EU Rich Club. Besides, nobody in Europe wants to be seen as too close a friend of the mobster Berlusconi, whose third term as prime minister was dubbed “The Godfather III” yesterday.

Berlusconi plans Paris-Rome axis to humble European Central Bank

Silvio Berlusconi's return to power in Italy is a nightmare come true for the European Central Bank, opening the way for a Rome-Paris axis with the political muscle to force a change in monetary policy. The billionaire politician has pledged an alliance with France's Nicolas Sarkozy aimed at humbling the bank and asserting the primacy of elected leaders over interest rates and the currency.

"A very strong euro is hurting Italy's economy. I will discuss intervening with the ECB with Sarkozy," he said.
The threat brought a sharp retort yesterday from the ECB's German governor and chief economist Jurgen Stark. "I would recommend to political leaders in Europe, newly elected and re-elected, to read the European law on the ECB," he said.

Mr Berlusconi - who is setting up a temporary office in Naples to tackle the city's long-running rubbish crisis - inherits an economy trapped in near slump conditions. The country has lost 40pc in unit labour cost competitiveness against Germany since 1995, largely due to anaemic productivity gains and an inflationary wage-bargaining culture. Yet it cannot use the old method of devaluation to claw back parity.

The International Monetary Fund forecasts growth of just 0.3pc in both 2008 and 2009, levels that are certain to cause a renewed rise in the country's national debt. Italian car sales plunged 18.8pc in March, and the Alpine lender Credito Valtellinese has just become the first European bank in living memory to miss a redemption on a callable bond - raising concerns of deeper troubles brewing in Italy's financial system.

Mr Sarkozy has repeatedly attacked the ECB's tight money policies, blaming it for causing the euro to surge 27pc in two years to a record $1.59 against the dollar. He says the ECB risks bankrupting Airbus and driving much of Europe's industry off-shore. Until now he has lacked the allies needed to impose his will.

"Politics is everything in EMU, and the re-election of Berlusconi represents a big shift in the political balance of power," said Bernard Connolly, global strategist at Banque AIG. "Spain will probably join France and Italy before too long, so you will have three of the big four eurozone countries in the same camp. They can set 'broad guidelines' for the ECB. It is a total misperception that the ECB should not be subject to political influence."

Article 111 of the Nice Treaty gives politicians power to set a fixed exchange rate for the euro (by unanimous vote), or to shape the exchange rate (by qualified majority vote). This power gives EU ministers an indirect means to force the ECB to cut interest rates. The treaty article has never been invoked but it hovers in EU affairs like Banquo's Ghost.

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Ilargi: And here is why The Godfather III is seen as a lame duck by the rest of the five families. Don’t underestimate the issue: countries like Italy, Greece, Spain and Ireland desperately need some relief, but they will not get it. The Euro zone is supposed to be one market, but it’s not even close.

Euro zone inflation's fresh record dashes any rate cut hopes

The rise in euro zone inflation to a record high has dashed any lingering hopes of European Central Bank (ECB) interest rate cuts in the near future to offset slowing growth, economists said. EU statistics arm Eurostat revised the bloc's harmonised index of consumer prices to a rise of 3.6 percent year-on-year in March from a provisional increase of 3.5 percent.

This rise in headline inflation to a new record since the launch of the euro in 1999 triggered a surge in the euro to a fresh high of $1.5966. 'The final euro zone consumer price inflation will go down like a lead balloon at the ECB and undermines already limited hopes of an interest rate cut in the near term,' Global Insight economist Howard Archer said.

'While inflation was pushed up once again by elevated energy and food prices, the ECB will be alarmed to see that core inflation, which excludes energy and unprocessed food prices, jumped to a six-year high of 2.7 percent in March from 2.4 percent in February,' Archer said. He said the figures are likely to strengthen the central bank's concerns that stubbornly high energy and food prices could lead to serious second-round effects.

'The ECB is particularly worried that pay settlements could move markedly higher across the euro zone, as a consequence of headline inflation rising to new highs and labour markets currently still tightening,' he said. UBS economist Sunil Kapadia was of the same view. 'Overall high inflation rates, indeed, rising inflation rates at all-time high levels, are not what the ECB wants to see at all,' Kapadia said. 'If inflation expectations rise significantly, or become entrenched at high levels, the ECB will not ease policy any time soon,' he said.

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UBS Slashes Shareholder Payout After Scotching Cash Dividend; Needs Years to Recover Reputation

UBS AG Wednesday disclosed a steep cut in its payout to shareholders, after scotching a cash dividend amid $37 billion in write-downs so far on dud mortgage securities. The Zurich-based bank said shareholders will receive one entitlement for every UBS share held as a dividend for 2007, when UBS posted a net loss of 4.38 billion Swiss francs ($4.34 billion). Twenty of the entitlements, which can be traded, translate into one new UBS share.

The stock dividend, which represents 1.69 francs at current market prices, marks a dramatic cut in payout to shareholders. For 2006, when UBS posted a full-year profit of 12.26 billion francs, the bank paid 2.20 francs a share and launched a share buyback of up to 16 billion francs. UBS, which in recent years has given shareholders cash payouts, was forced to cancel its cash dividend in December after steeping itself in hefty subprime losses.

The write-downs have caused most of UBS's top management to lose their jobs, including Chairman Marcel Ospel, and will tip UBS to a second consecutive quarterly loss when the bank posts first-quarter earnings May 6. In addition to striking its dividend, UBS was forced to shore up capital with a cash injection from the Singapore government's fund and an unnamed Middle East investor. The bank also recently disclosed a capital increase of 15 billion francs.

UBS shares have slumped 36% so far this year, underperforming by far the Dow Jones Stoxx bank index, which has slipped 17%. Shares rose slightly in morning trading Wednesday, rising 1% to 34.06 francs.

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Deutsche Bank Earnings Estimates Cut by Merrill Lynch Analysts

Deutsche Bank AG, Germany's biggest bank, had its earnings estimates lowered by analysts at Merrill Lynch & Co. after announcing further writedowns.

The Frankfurt-based bank may report 4.8 billion euros ($7.6 billion) in pretax profit this year, including a loss of 310 million euros in the first quarter, analysts including Stuart Graham at Merrill in London wrote in a note to investors today.

Deutsche Bank said on April 1 it will write down 2.5 billion euros of loans and asset-backed securities in the first quarter and said conditions had become ``significantly more challenging.''

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China logs 10.6% growth in first quarter

China shrugged off atrocious winter weather and a global credit crunch to post surprisingly strong economic growth of 10.6 per cent for the first quarter. The outcome will be welcome to global policy makers, who are looking to big emerging markets such as China to take up some of the slack in the world economy as the United States teeters on the brink of recession.

Annual gross domestic product growth dropped from 11.2 per cent in the final quarter of 2007, the National Bureau of Statistics said on Wednesday, but it beat market forecasts of 10 per cent despite a drive by the central bank to rein in lending. With consumer price inflation remaining high at 8.3 per cent in the year to March, albeit down from near-12-year highs of 8.7 per cent in February, economists said Beijing would be wary of relaxing policy despite fears for China's export prospects.

“The headline GDP number was slightly on the strong side and, given that we had the snowstorm and tightening measures in the first quarter, this will give reason for the government to continue with its tightening bias,” said Kelvin Lau, an economist at Standard Chartered Bank in Hong Kong. In fact, there was an immediate response, the central bank announcing an increase of 0.5 percentage point in big banks' reserve requirements to 16 per cent from April 25. It was the 16th increase since the middle of 2006.

The economic data showed inflation remained largely confined to food, which cost 21 per cent more in the first quarter than a year earlier. Consumer prices were up 8.0 per cent overall, but only 1.2 per cent excluding food. Economists, however, said price pressures were building up: annual factory-gate inflation leapt to 8.0 per cent in the year to March from 6.6 per cent in February.

“We believe it is crucial to maintain the tightening policy stance to anchor rising inflation expectations. It is still too early for the government to claim victory for their inflation battle,” Hong Liang and Yu Song with Goldman Sachs said in a note to clients.

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Median price of SoCal homes plunged 24 pct to 4-year low

Southern California home values plummeted 24 percent during March, leaving prices at an almost four-year low amid the real estate market's deepening distress. The median price of homes sold in a six-county region stood at $385,000 in March, a sobering turnaround from the previous year when values had reached a record $505,000, according to data released Tuesday by DataQuick Information Services.

Southern California homes haven't sold for so little since April 2004 when the region's median price stood at $380,000.
The median price represents the point where half the homes sell for more and half sell for less. Tuesday's report covered Los Angeles, Orange, Riverside, San Bernardino, San Diego and Ventura counties - a region that once ranked among the nation's hottest real estate markets as lenders aggressively lowered their rates and standards for qualifying for home loans.

As it turned out, many borrowers couldn't afford their mortgages after they adjusted upward from temporarily low rates. That has led to a wave of foreclosures that is prompting lenders to sell Southern California homes at sharp discounts and depressing the value of neighboring properties. More than a third of the Southern California homes sold last month had been through a foreclosures at some point during the past year, according to DataQuick.

Riverside and San Bernardino counties - a rapidly growing region known as the Inland Empire - was particularly hard hit.
Foreclosures accounted for 56 percent of the sales in Riverside County, where the median price of a home fell 27 percent to $306,250. The erosion was even worse in San Bernardino County, where the median home price plunged 28 percent to $265,000.

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Ilargi: Hello again, Bob Shaw!

Potash Producers Raise Chinese Prices to a Record

Potash Corp. of Saskatchewan Inc., the world's largest maker of crop nutrients, and Russia's OAO Uralkali raised prices for Chinese deliveries by $400 a metric ton amid booming food demand. Canadian trading company Canpotex Ltd., which markets potash on behalf of North American producers, agreed to the price increase with Chinese customers, Saskatoon, Saskatchewan-based Potash Corp. said today in a statement. Uralkali also said today in a statement it agreed to the gain.

The accord ``shows that even China as the biggest net importer has had zero negotiation power'' with producers, Deutsche Bank AG said in a note to clients today. Farmers are using more fertilizers to boost yields as the population grows and the amount of arable land available for cultivation shrinks. The world has a 1.2 million-ton potash production shortfall, Uralkali said last week. Potash protects crops from dryness and disease.

Potash Corp. said shipments to China will be limited to 1 million tons this year. It didn't disclose the price it will sell at. China imports 8 million tons a year, according to Deutsche. India contracted potash deliveries last month at $625 a ton and the latest increase for China means it will pay $650, according to Deutsche and Troika Dialog estimates.

Global consumption may grow by an average of 5 percent a year, according to Uralkali, Russia's second-largest producer. The soil nutrient may reach $1,000 a ton ``rather fast'' because of the supply shortage, Oleg Petrov, Uralkali's head of sales, said Apr. 14.

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Global warming rage lets global hunger grow

We drive, they starve. The mass diversion of the North American grain harvest into ethanol plants for fuel is reaching its political and moral limits. "The reality is that people are dying already," said Jacques Diouf, of the UN's Food and Agriculture Organization (FAO). "Naturally people won't be sitting dying of starvation, they will react," he said.

The UN says it takes 232kg of corn to fill a 50-litre car tank with ethanol. That is enough to feed a child for a year. Last week, the UN predicted "massacres" unless the biofuel policy is halted. We are all part of this drama whether we fill up with petrol or ethanol. The substitution effect across global markets makes the two morally identical.

Mr Diouf says world grain stocks have fallen to a quarter-century low of 5m tonnes, rations for eight to 12 weeks. America - the world's food superpower - will divert 18pc of its grain output for ethanol this year, chiefly to break dependency on oil imports. It has a 45pc biofuel target for corn by 2015. Argentina, Canada, and Eastern Europe are joining the race.

The EU has targeted a 5.75pc biofuel share by 2010, though that may change. Europe's farm ministers are to debate a measure this week ensuring "absolute priority" for food output. "The world food situation is very serious: we have seen riots in Egypt, Cameroon, Haiti and Burkina Faso," said Mr Diouf. "There is a risk that this unrest will spread in countries where 50pc to 60pc of income goes to food," he said. Haiti's government fell over the weekend following rice and bean riots. Five died.

The global food bill has risen 57pc in the last year. Soaring freight rates make it worse. The cost of food "on the table" has jumped by 74pc in poor countries that rely on imports, according to the FAO. Roughly 100m people are tipping over the survival line. The import ratio for grains is: Eritrea (88pc), Sierra Leone (85pc), Niger (81pc), Liberia (75pc), Botswana (72pc), Haiti (67pc), and Bangladesh (65pc). This Malthusian crunch has been building for a long time. We are adding 73m mouths a year. The global population will grow from 6.5bn to 9.5bn before peaking near mid-century.

Asia's bourgeoisie is switching to an animal-based diet. If they follow the Japanese, protein-intake will rise by nine times. It takes 8.3 grams of corn feed to produce a 1g of beef, or 3.1g for pork. China's meat demand has risen to 50kg per capita from 20kg in 1980, but this has been gradual. The FAO insists that this dietary shift is "not the cause of the sudden food price spike that began in 2005".

Hedge funds played their part in the violent rise in spot prices early this year. To that extent they can be held responsible for the death of African and Asian children. Tougher margin rules on the commodity exchanges might have stopped the racket. Capitalism must police itself, or be policed. Even so, the funds closed their killer "long" trades in early March, causing a brief 20pc mini-crash in grains. The speculators are now neutral on the COMEX casino in New York.

What about the California state retirement fund (Calpers), the Norwegian Petroleum fund, the Dutch pension giants, et al, pushing a wall of money into the $200bn commodity index funds? They have undoubtedly bid up the futures contracts, but the FAO says this has no durable effect on food prices. These index funds never take delivery of grains. All they do is distort the shape of the maturities curve years ahead, allowing farmers to lock in eye-watering prices. That should cause more planting.

Is there any more land? Yes, in Russia, Ukraine, and Kazakhstan, where acreage planted has fallen 12pc since Soviet days. Existing grain yields are 2.4 tonnes per hectare in Ukraine, 1.8 in Russia, and 1.11 in Kazakhstan, com-pared with 6.39 in the US. Investment would do wonders here. But the structure is chaotic.
Brazil has the world's biggest reserves of "potential arable land" with 483m hectares (it currently cultivates 67m), and Colombia has 62m - both offering biannual harvests. The catch is obvious. "The idea that you cut down rainforest to actually grow biofuels seems profoundly stupid," said Professor John Beddington, Britain's chief scientific adviser.

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Judge extends protection for ABCP through May

An Ontario Superior Court judge has agreed to extend the bankruptcy protection that's covering Canada's $32-billion third-party asset-backed commercial paper market until the end of May. Lawyers told Justice Colin Campbell that the extension is necessary because a vote on the plan to fix this market is scheduled for April 25, and the court would have to hold a sanction hearing after that date.

The committee that's working to salvage this market, led by Toronto lawyer Purdy Crawford, has warned that the sector could collapse if court protection were lifted before the market is fixed. Meanwhile, Justice Campbell spoke toughly to a lawyer who said he wants permission to examine an executive from National Bank and an official from DBRS, as well as permission to carve out a new class of investors.

The requests came from Allan Sternberg, a lawyer representing Montreal businessman Hy Bloom, whose companies are holding frozen ABCP and who is suing National Bank in Quebec Superior Court. “We are rapidly running into a position where the relief that you are seeking...is going to go past the vote time,” Justice Campbell said. Mr. Sternberg's request to reclassify investors “would fundamentally change a plan that's been worked on for six months,” the judge said. “I'm very reluctant to see the court have to get involved,” he added.

“Maybe you better go back and look at the consequences if this plan fails,” he told Mr. Sternberg. “It is absolutely essential for thousands of Canadians that we get this plan done.” Justice Campbell said he doesn't know that he has the authority to compel officials from National Bank and DBRS, and suggested Mr. Bloom should try to deal with some of his issues in the Quebec Superior Court. Mr. Sternberg noted that if the restructuring plan for the ABCP sector passes, Mr. Bloom's lawsuit against National Bank would fall by the wayside because of blanket legal releases the plan grants to all of the major players who created or sold ABCP

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