Debt Rattle, April 24 2008: Mania Psychology and Its Aftermath

Hunger line 1932

Ilargi: OUCH!!


New-home sales down 36.6%, prices fall 13.3%

Despite huge price declines, inventory on market rises to 27-year high

U.S. home builders have slashed their prices by a record amount, but sales still plunged by 8.5% to a 17-year low in March, the Commerce Department estimated Thursday. The decline in new-home sales to a seasonally adjusted annual rate of 526,000 was much weaker than the 577,000 pace expected by economists surveyed by MarketWatch. See Economic Calendar.

New-home sales are down 36.6% compared with a year ago and are down 62% from the peak in July 2005. February's sales pace was revised lower to 575,000 from 590,000. "There is little to support any claims that the housing market is stabilizing, let alone forming a bottom," wrote Richard Moody, chief economist for Mission Residential.

"The growing imbalance between housing demand and supply suggests continued construction cuts and price declines, and in turn, an extended period of sluggish economic growth," wrote Michelle Meyer, an economist for Lehman Bros. The figures likely overstate the number of sales because they don't account for canceled sales, which have ballooned. The report is based on contracts signed, not sales closed.

Perhaps the only ray of hope was data showing that inventories of unsold homes fell for the 12th consecutive month in March, an indication that builders are making some progress to get their inventories under control. However, with sales plunging even faster, the supply of homes on the market rose to 11 months, the most in 27 years. Inventories are likely understated as well because of canceled sales contracts.

The number of completed homes for sale fell for the third straight month to 189,000 after peaking in January at 198,000. Completed homes represent more than 40% of the total inventory, just off the record percentage set in February and an indication of how much speculation had taken over in the home building industry.

Most analysts believe it could take several more years to bring inventories back in line with fundamentals. Builders are competing against an influx of supply from foreclosed homes and homes being sold by distressed owners. Median sales prices for new homes have fallen 13.3% in the past year to $227,600, the biggest decline in 38 years.

---

An Overreaching United States

“Let Rome in Tiber melt...”

Rome did melt into the Tiber. The place was invaded by barbarians...the population sank from over a million to under 100,000. And when the city was “rediscovered” by tourists with a sense of history in the 17th century...there were goats grazing amid the ruins of the ancient city.

There are people who believe that power, progress, and wealth are always on a rising slope. Let them come to Rome! Roman property was a sell for a period of probably a thousand years...from the peak of Roman power, around 100 AD, down to its nadir, sometime after the Renaissance....

....No nation can stay on top of the world forever. But when you have no competition, you can’t rely on others to bring you down; you have to find ways to destroy yourself. For that job, America found just the men it needed just when it needed them most – Alan Greenspan and George W. Bush. What these two men accomplished is probably one of the greatest feats in human history. They took the richest, most powerful country the world has ever seen and, in the space of only five years, practically ruined it.

First, says the FT article, the soaring price of oil had the effect of transferring trillions of dollars from the biggest oil user – the United States – to the oil producers, notably the Arab states and its former enemy, Russia. Second, the federal government went from a budget surplus over $100 billion in 2000 to some of the largest government deficits ever recorded. Those, along with huge current account deficits equal to 6% of GDP, changed the United States from a chooser into a beggar – heavily reliant on foreign money.

The FT doesn’t mention it, but America’s spending spree had another important effect – it lit a fire under its new commercial rivals. Americans spent absurdly – which caused the Chinese to build factories, learn skills, and pile up a mountain of U.S. dollars.

Professor Paul Kennedy practically foretold all this when he noted that super-powers tended to “over-reach.” But even he couldn’t imagine how much of this over-reach would be caused by so few people in such a short period of time. Alan Greenspan reached for the stars in the early 2000s. His emergency-level Fed rates triggered an explosion of spending, borrowing and leveraging...which has now blown up in our faces. And the Bush Administration took on a war that has proved to be costly beyond anyone’s imagination. The total price of the war may come to $1 trillion or more – at a time when the United States already needs to borrow $2 billion per day.

Obviously, more prudent, more cautious leaders would have prevented these catastrophes. They would have read history...reduced expenses...raised interest rates...pulled back the troops...and saved money. But sensible leaders do not make history. Fools do. People reach for glory. Then, they over-reach.

---

Ilargi: China is entering a very dangerous phase. A huge amount of money has been lost in the stock markets, while food prices will keep rising. Unrest is the only possible next step. For instance, millions of small investors bought Petrochina when it was launched. They now lost 2/3 of their investment. That hurts. Total stock market losses are $2.5 trillion. That hurts.

China stock exchange investors suffer from spectacular bear market

China's stock market has lost half its value since October in one of the most spectacular bear markets of the last half century, eliminating $2.5 trillion (£1.25 trillion) of paper wealth. The Shanghai Composite briefly fell below the key psychological level of 3,000 yesterday, down 50pc from its peak. The near panic sales over recent weeks have caused heavy losses for millions of Chinese savers who jumped into the market at the top of the boom, but this has not had any appreciable effect on the broader economy so far.

Growth continued at a blistering rate of 10.6pc in the first quarter, despite the slowdown in North America and Southern Europe. Petrochina - briefly the world's first "trillion dollar company" after its partial float last year - is already a shadow of its former self, trading below its launch price. It has lost two thirds of its value. The company's first-quarter profit slumped 30pc on surging production costs.

Crashing stock prices are usually a warning signal that the broader economy is heading into a sharp downturn, but it is unclear whether this market lore has much value in Shanghai. Charles Dumas, global strategist at Lombard Street Research, said China's local exchanges were completely artificial. "There's no breadth to the market because nobody is allowed in from the outside, so it has violent swings up and down," he said. "Still, China is entering an unpleasant quadrant of the economic cycle where it has to cut back growth to stop inflation accelerating."

The central bank raised interest rates six times last year, although its main tool for controlling overheating is to keep nudging up reserve requirements. Beijing has also quickened the pace of yuan revaluation, allowing the currency to rise 10pc against the dollar over the past year. A report by UBS said Chinese exporters had so far proved immune to the US slowdown. China's 35pc share of the US market for light manufacturing goods and electronics has held steady this year. Its share of the EU market has been growing by leaps and bounds to 40pc.

Profit margins have remained steady at 8pc to 10pc, even for textiles, suggesting that exporters have been able to pass on price increases. Food costs make up roughly a third of China's inflation index, so the spiralling cost of rice, corn, poultry and milk is playing havoc with price stability. The inflation rate is nearing levels that set off urban riots in the late 1980s and caused workers to come out in sympathy with the students in the Tiananmen Square protest

---

China's "mad bull" market unlikely to be revived

The mad bull isn't coming back. A 9.3 percent leap by China's stock market on Thursday, after the trading tax was cut, recalled the heights of the stock frenzy of 2006 and 2007, when millions of Chinese poured into the market for the first time in one of history's great equity bull runs. But this time, there are signs that China's legion of individual investors has learned a painful lesson about risk during a market slide which halved share prices over the past six months.

The public trading halls of several Shanghai brokerages on Thursday contained little of the euphoria seen during last year's steep uptrend, dubbed the market's "mad bull" phase by local media. "I sold half my shares and mutual funds today. I only see this as a short-term rebound, not the start of an uptrend," a retiree in his 60s, who identified himself as Wu, said at a Shanghai Securities branch in the city's financial district.

Wu said he had the equivalent of several thousand dollars of his savings in stocks, and would end up roughly breaking even on his investments. "A rally of several days isn't enough to compensate you for the pain of having the value of your stocks halved," he said. The feelings of people like Wu suggest any continued rally by China's stock market will not be as fevered or extend nearly as far as last year's bull run, analysts said.

"The market is unlikely to see the mad and bold speculation that we had last year," said Zhang Qi, analyst at Haitong Securities. "Investors have really learned a lesson."

---

Libor to Rise as Banks Stay Wary, Derivatives Signal; More TAF Needed

Interest-rate derivatives are signaling that the rate banks charge for loans in dollars in London may rise further as financial institutions remain reluctant to lend. The difference between the rate of three-month loans in London relative to the overnight index swap rate, known as the Libor-OIS spread, is 87 basis points. The gap reached 90 basis points on April 21, the widest since Dec. 12.

The London interbank offered rate, or Libor, for dollars had climbed to a seven-week high amid speculation the global credit crunch prompted lenders to manipulate the rate to prevent their borrowing costs from escalating. The British Bankers' Association said last week it will speed up a review of the process by which money-market rates are set daily and ban any member providing misleading quotes.

"The correction in Libor has not completely happened,'' said Bulent Baygun, head of interest-rate strategy in New York at BNP Paribas Securities Corp., a unit of France's largest bank. "Given the dynamics that have persisted in the past few weeks, it looks like there could be a little bit more room for an increase.'' Three-month Libor for dollars has advanced 19 basis points to 2.91 percent since April 16. It dropped 1 basis point today, the first decline since April 14.

The three-month Libor-OIS spread was as narrow as 24 basis points on Jan. 24 and reached as high as 106 basis points on Dec. 4. A basis point is 0.01 of a percentage point. The OIS rate signals what traders' expect the overnight federal funds rate to average over the time period of the swap. The dominance of European banks among the 16 members the BBA uses daily to set Libor may skew borrowing costs for U.S. lenders and prompt the need for alternative index based in the U.S., Scott Peng head of U.S. rates strategy in New York at Citigroup Global Markets Inc., wrote in a report last week.

The persistence of banks' need for cash and increase in Libor rates has triggered speculation that the Federal Reserve will increase, for the third time, the amount it loans through its Term Auction Facility, which is known as TAF. The Fed has auctioned a total of $360 billion in temporary funds through TAF since its debut in December. This month, both TAF auctions were for $50 billion each in 28-day loans.

---

Ilargi: England stands on the edge of a very black hole. And I can't see how they could manage to stay clear of that gravity pull. It looks really bad. And the housing crash hasn't even started yet. That crash is inevitable, simply because prices are far too high. Still, hundreds of billions of pounds are squandered, gambled away, on attempts to prevent the crash, the by far worst possible choice. And yes, I suspect that Gordon Brown knows that very well. The man who sold England's gold at the worst-ever time, when prices were below basement level, is now dragging the British economy down to uncharted lows.

Goldman Sachs warns on gilt market after Bank of England's bail-out

Goldman Sachs has advised clients to take out "short" positions on British 30-year Gilts before a rash of new issues by the Government floods the bond market. The closely watched US investment bank said it was concerned about the "heavy supply of longer-dated paper" likely to weigh on the price of British sovereign debt. The bank has closed its "short" positions on the pound after raking in bumper profits on the precipitous slide in sterling since the Northern Rock debacle.

Goldmans' quiet move adds to worries that foreign investors may begin to shun British bonds as Prime Minister Gordon Brown pushes through a liquidity deal to kick-start the lending system. Yields on the benchmark 10-year Gilt surged from 4.43pc to 4.71pc last week, one of the sharpest moves in recent years. They are now 67 basis points above German Bunds, and 88 basis points above US Treasuries.It is hard to untangle how much of this jump stems from renewed inflation fears, and how much from concerns that the British state may be taking on massive liabilities from the crumbling housing market.

The UK already has the worst fiscal profile of any major country in Europe or North America, with a budget deficit topping 3pc of GDP at the peak of the cycle. Marc Ostwald, a bond expert at Insinger de Beaufort, said Gilt issuance was set rise to £72bn this year from £58.4bn in 2007, even before the decision to let the Bank of England to swap mortgage collateral for AAA Gilts. Mr Ostwald said: "British finances are in a parlous state. It is more than likely that the deficit will reach 4pc or 5pc of GDP, and it could be far worse if things go pear-shaped.

What is shocking is how fast the picture is deteriorating.Our overall debt could reach levels above 60pc of GDP.” The Bank’s three-year swap arrangement will almost certainly see a flood of new Gilt issues. The Bank has just £3bn on its books, tiny compared to the Federal Reserve’s $800bn (£404bn). The Treasury will have to step in with new issues. The Debt Management Office has already announced plans to add £15bn to the Gilt stock, prompting talk it is preparing for the lifeboat operation.

The banks have roughly £35bn of mortgage securities frozen on their books, says Lehman Brothers and these are likely to swapped for Gilts. Goldman is offsetting its bet against Gilts with a “long” position on one-year money market rates, known as Sonia (Sterling Overnight Interbank Rate). The assumption is that the Government’s plan will cut Sonia spreads from their current stratospheric levels. “Gilt bears” say UK bonds will lose some of the safe-haven appeal they have enjoyed since the credit crunch began. As the panic subsides, the underlying realities of the British budget may draw closer scrutiny.

Capital Economics has warned a hard landing for the economy could have a “catastrophic impact” on UK public accounts. “A recession as deep as the early 1990s could push borrowing up to £150bn per annum,” it said. This dire scenario is less likely now under the Treasury rescue. Even so, there are rising risks. The bond vigilantes who hold UK debt are not captive British pension funds. Foreigners own £166bn of Gilts, making Britain vulnerable to a sudden loss in confidence. The Northern Rock bail-out has already added £100bn to the UK national debt, at least in nominal terms.

---

City of London hit with 'Code Red' by Moody's

The office rental market in London's historic Square Mile has been issued a "code red" rating by Moody's, as the slowdown in banking industry hits demand for space. The ratings agency downgraded the City's office market to red, or already under "imminent stress", from a yellow rating where it was "on the cusp of imbalance and therefore fragile".

In a report on the European commercial property markets, Moody's said London's financial district was now seeing the fastest growing vacancy rates across Europe, and faces a greater risk from over-supply next year. Rod Bowers and Jeroen Heijdeman, who wrote the report, said: "The London City market continues to maintain the strongest negative demand-supply relationship - increasing from -1.1pc to -5.4pc. The negative demand-supply relations is anticipated to impact vacancy levels in the near future."

Outside the Square Mile, London's Docklands - which includes the Canary Wharf financial district - faces the prospect of no new demand this year, according to Moody's. The area has also been downgraded, from a green rating - described as basically sound over the near term - to a yellow. Meanwhile, the West End continues to outperform other London sub-markets - despite also being taken down a peg to yellow - remaining the strongest area for office rents across the Capital.

With Continental Europe outperforming all UK markets, Mr Bowers and Mr Heijdeman said: "This could be due to the greater exposure to financial services companies in the UK, which has been most noted in the City and Docklands markets. These markets saw their scores decline by 60pc and 40pc respectively as banking sector job cuts and the restructuring of financial organisations has caused a decline in forecast take-up levels for 2008."

Moody's said it "will very carefully scrutinise the sustainability of current rents" in the City. The red alert for the City comes as Credit Suisse plans to lay off up to 150 people from its investment bank in London - the first of a wave of an expected wider cull. Merrill Lynch is to axe 350 jobs, while UBS is reported to be letting 900 employees go.

---

Bank of England's dilemma: A house price crash or soaring inflation

Which would you rather face: a recession and house price crash or years of soaring seventies-style inflation? Two options; one nasty dilemma for the Bank of England. In particularly stark and simple terms, this is the question tearing a major split through the Monetary Policy Committee, which decides interest rates.

This is the debate which will determine how painful the coming months are for families throughout the country, and could set the UK on the road to either another boom in house prices or, at the other extreme, a dismal Japan-style depression. Oh and in case you had already made your mind up, I should add there is probably no correct answer. You might have guessed as much already from news yesterday of a highly unusual three-way split in the MPC's interest rate meeting this month.

Though the Committee ultimately opted to cut rates a quarter percentage point to 5 per cent, one of the members called for a dramatic half percentage point cut; another two said the Bank should not have reduced borrowing costs at all. The news has sent yet another shiver through both the City and the high street. If the very institution in control of the economy can't agree on what it should be doing, how much faith can we have that it will help drag us out of this increasingly uncomfortable credit crunch?

That economists can't agree with each other is nothing new: this notoriously indecisive species is a cause for perennial frustration among politicians. Indeed, Margaret Thatcher used her self-penned Yes, Minister appearance to call for their abolition ("All of them, Prime Minister?" "Yes, all of them. They never agree on anything..."). But while it has always been the case that asking nine economists their opinion elicits ten answers, rarely has the split on the MPC been so deep - nor has it come at such a perilous time for the economy

---

Northern Rock shareholders lodge £2bn compensation claim

Small shareholders seeking £2bn in compensation following the nationalisation of Northern Rock have applied for a judicial review into the terms of the Government's takeover of the troubled lender that they allege are "deliberately rigged" to give them nothing. Under the nationalisation, the Government said it would appoint an independent valuer to determine the value of the business and thus how much its 150,000 shareholders should receive in compensation.

Roger Lawson, head of the UK Shareholders Association, which is representing smaller Northern Rock shareholders, said it decided to move ahead with its judicial review application after the Government rejected its complaints about the conditions of the valuation process.

The Government set out clear parameters by which the valuer must evaluate Northern Rock: one, that it was unable to continue as a going concern, and two, to value it as a group in administration. Mr Lawson said they were tantamount to assigning the company a value of zero. He said: "They have set completely artificial terms of reference to avoid paying any money."

According to the last set of accounts, published earlier this month, Northern Rock was shown to have a net asset value of about £3.20 per share. On this basis, said Mr Lawson, "we'd be looking at a price of higher than £5 per share [about £2bn]. That's nothing compared to what they'll be able to sell this business for in a couple years." A key part of shareholders' case is that at the time of Northern Rock's decision to call on the Bank of England's lending facilities, it was a perfectly solvent bank.

---

Lehman warns that oil boom will deflate

The roaring oil boom of the last few months may be on its last legs as economic growth slows hard across the world and a clutch new refineries come into operation, Lehman Brothers has warned in a hard-hitting report. “Supply is outpacing demand growth,” said Michael Waldron, the US bank’s oil strategist.
“Inventories have been building since the beginning of the year. We have pretty significant projects starting soon in Saudi Arabia, and large off-shore fields in Nigeria,” he said.

The Saudi Khursaniya field has just opened with 500,000 barrels a day (b/d) of production, and the new Khurais field will start next year with a further 1.2m b/d. The Saudis have pledged to spend $90bn (£45bn) on their oil industry over the next five years, lifting capacity to 12.5m b/d by the end of 2009. US crude prices retreated yesterday from their all-time high of $119.90 a barrel earlier this week. The latest spike was driven by fears that the 'Forties Pipeline’ from the North Sea might be closed as a knock-on effect from threatened strike action at Scotland’s Grangemouth oil refinery.

Lehman Brothers said the price of oil had been pushed to inflated levels by a $40bn inflow into commodity index funds this year, much of it coming from Mid-East sovereign wealth funds. The petro-investors may have second thoughts about gaining “double exposure” to commodity prices. “Financial flows have been the marginal driver of prices since the onset of the credit crunch. Investors are using oil as a hedge against inflation and a falling dollar,” said Mr Widmer.

The index effect has lifted prices by $20 to $30 a barrel. This could reverse sharply once the dollar starts to stabilize against the euro, since the euro/dollar exchange has become the proxy watched by oil traders for signals. A dollar recovery may be on the cards after the G7 powers issued a statement condemning big moves in currencies as a threat to financial and economic stability, choosing the exact wording used before the joint intervention by central banks in September 2000. A clutch of new refineries will add almost 8m b/d of new capacity by 2010, including a 600,000 b/d plant opening this year in India.

The cost of oil field machinery and rig maintenance has at last levelled after three years of galloping inflation. Drilling costs have even started to fall in the United States, while deep-water rig-rates have stopped rising after jumping fourfold from 2004 to 2007. These are all time-honoured signs that the cycle may have topped. Ominously for oil bulls, the underlying value of oil company reserves has slipped slightly over the last two years, failing to “confirm” the huge rise in spot oil prices. The divergence is a warning sign.

---

How Mania Psychology Trumped Swiss Banking

An old joke about European stereotypes goes like this --

In Heaven: the cooks are French,
the policemen are English,
the mechanics are German,
the lovers are Italian,
and the bankers are Swiss.

In Hell: the cooks are English,
the policemen are German,
the mechanics are French,
the lovers are Swiss,
and the bankers are Italian.

My space here is limited, so let's overlook the line about hellishly bad lovers and consider instead the reputation the Swiss enjoy as divinely gifted bankers. As always, there's a reason for the stereotype. Probably the most recognized case-in-point is UBS, the Swiss bank with $3 t-t-trillion under management. Yes, that makes it the world's largest manager of private wealth.

Although UBS has acquired other distinguished money management firms over the years (including Dillon Read, S.G. Warburg, and PaineWebber), its Swiss banking pedigree dates to 1747. The three keys which comprise the UBS logo stand for confidence, security, and discretion.

Alas, UBS has recently had to report another dollar figure that stands out as "the largest" among lenders: namely, some $38 billion in total writedowns since the subprime debacle began in summer 2007. According to The New York Times, that cumulative loss has effectively "destroyed all the profit that the bank generated since 2004." The greater insult to injury for UBS shareholders is the 56% price decline the company's stock has suffered in the past 12 months.

All this and more was on the mind of some 4,200 of those shareholders, who assembled this week in Bern, Switzerland for UBS's annual shareholder meeting. Sentiment at the gathering was described as "raucous" (which to my mind suggests that if the crowd was anything but mostly Swiss, their emotional state may well have incited an all-out, chair-throwing spasm of violence). Shareholders received assurances that UBS's top executives and board would be repopulated by bankers with more conservative instincts; they were also told that the firm was very sorry and wouldn't do it anymore.

Assurances aside, the plight at UBS begs the question: How could a revered institution -- which represents a centuries-old tradition of "confidence, security, and discretion" in banking -- become a case study in irresponsible asset management?

Put simply, the answer is: Tradition is no match for psychology, especially mania psychology.

---

Credit Suisse hit by further $5-billion writedown

Credit Suisse notched up a further 5.3 billion Swiss francs ($5.26-billion U.S.) of credit-linked writedowns but its core rich clients kept their money at the bank unlike those of rival UBS.

Markets had stabilized in April but Credit Suisse was not counting on an improvement yet, it said on Thursday, and it was hard to say whether there would be any further writedowns on its risky investments.

“In this crisis, a number of times people have seen a light at the end of the tunnel and it has ended up being a train coming down the tracks,” chief executive Brady Dougan told reporters on a conference call.

Credit Suisse has been hit by the credit crisis to a much lesser degree than its larger rival UBS, Europe's largest casualty of the crisis, which on Wednesday said it would cut back its investment bank after heavy writedowns.

---

Bear Stearns Buy-Out... 100% Fraud

On or prior to March 13, 2008, an additional request was made of the options exchanges to open more March and April put series with very low exercise prices.

These new March put options would have just five days of trading to expiration. The exchanges accommodated their requests, knowing that the intentions of the requesters were to buy puts. They indeed bought massive amounts of puts. For example the March 20 puts traded nearly 50,000 contracts (i.e. contracts to sell 5 million shares at 20). The March 15s traded 9600, the March 10s traded 13,000 and the March 5s traded 6300 all on March 14 (the first day of trading of the new March series).

The introduction of those far-out-of-the-money put series in the April and March months immediately before the crash provided a vehicle whereby extreme leverage was available to the insiders. In other words if an insider had $100,000 and he knew that Morgan would buy Bear Stearns at 2, he could make 5-10 times more on the $100,000 by buying the newly introduced March puts. This is so because the soon to expire far out-of-the-money puts were far cheaper than the July or October out-of-the-money puts. And that is why the illegal inside traders requested the exchanges to introduce the far out-of-the-moneys just days before the crash.

But this scenario has serious implications. This means that the deal was already arranged on March 10 or before. That contradicts the scenario that is promoted by SEC Chairman Cox, Fed Boss Bernanke, Bear CEO Schwartz, Jamie Dimon of J.P. Morgan (who sits on the board of directors for the New York Federal Reserve Bank) and others that false rumors undermined the confidence in Bear Stearns making the company crash, notwithstanding their adequate liquiduty days before.

I would say that the deal was arranged months before but the final terms and times were not determined until maybe March 7-8, 2008.

On March 14, 2008, the April 17.5s, the 15s, the 12.5s and the 10s traded 15,000 contracts combined. Each put gives the right to sell 100 shares. So for example, these 15,000 April puts gave the purchaser(s) the right to sell 1.5 million shares at prices between 10 and 17.5. Those purchasers expected to make profits on 1.5 million shares because they knew the deal was coming at $2.00.

That is the only plausible explanation for anyone to buy puts with five days of life remaining with strike prices far below the maket price.

So there were requests, during the period of March 10-13, to the exchanges to open the March and April series for buying massive amounts of extremely out-of-the-money puts, which were accommodated by the options exchanges. Did the Exchanges aid and abet the insider trading scheme?

---

SEC Examining Whether Credit-Raters Changed Policies

The U.S. Securities and Exchange Commission is probing whether credit-rating companies changed the way they graded debt as the market for products tied to subprime mortgages boomed earlier this decade, its chairman said.

``The volume of the structured-finance deals that were brought to the credit-rating agencies increased substantially from 2004 to 2006,'' SEC Chairman Christopher Cox told the Senate Banking Committee today. The regulator is looking at whether the companies ``adapted their rating approaches in this environment,'' Cox said.

The SEC, in response to subprime losses, may restrict companies such as Moody's Investors Service and Standard & Poor's from doing consulting work and may ban them from grading securities they helped design, Cox said. Lawmakers asked whether raters have inherent conflicts, because they're paid to evaluate debt by the same Wall Street firms who sell it.

Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, asked whether the companies ``give ratings that are overly optimistic in order to obtain more business.''

---

Ambac Shares Tumble 43%; $1.66 Billion Loss Posted

Ambac stock fell 43% to $3.46 on the New York Stock Exchange, its lowest close, after the company said it lost $1.66 billion, or $11.69 a share, in the quarter.

The loss was nearly eight times worse than analysts had expected and some said the company's financial situation put it at risk of being downgraded by the major credit-rating firms. Bond insurers such as Ambac and its biggest rival,MBIA Inc., have relied on their triple-A ratings selling insurance on new bonds.

Ratings firm Standard & Poor's wasn't surprised. Ambac's results are "not going to have an impact on our rating," said Dick Smith, an S&P analyst, adding that the results are "within" S&P's projections.

The big surprise in the earnings came from the $1 billion in loss provisions on mortgage securities, as opposed to more complex collateralized debt obligations that were already under stress. The company also had mark-to-market losses on credit default swaps of $1.7 billion.

Chairman and Chief Executive Michael Callen said, "While we realize that these are disappointing credit results, we continue to believe that the capital raised and strategic business actions taken during the quarter will enable us to get beyond this credit market."

Of its $1.73 billion in mark-to-market losses, Ambac said it expects to realize $940.4 million in estimated credit impairment, which means it expects to pay out that much on its guarantees.

---

Ambac: Deteriorating Bonds Could Be A Sign Of Fraud

Bond insurer Ambac Financial Group Inc. (ABK) has hired outside legal and forensic experts to examine 17 of its financial guarantee transactions and may seek to cancel the contracts if the experts uncover evidence of fraud, David Wallis, Ambac's chief risk officer, said Wednesday....

.... "If they can demonstrate there was fraud, they don't pay" is the general legal standard for such contracts, Gregory Hindy, a partner with Newark law firm McCarter & English LLP told Dow Jones Newswires Wednesday.

Hindy said that such lawsuits in the bond insurance industry are rare but that he expects to see more of them in coming months.

To get out of a contract, the insurer would have to make the case that "had these been accurately described," the insurer would not have entered the contract.

In recent months, Security Capital Assurance (SCA) has sought to cancel seven financial guaranty contracts it wrote for Merrill Lynch, and FGIC Corp. sued to cancel $1.7 billion in financial guarantee contracts it wrote for IKB Deutsche Industriebank (IKB.XE) of Dusseldorf, Germany.

During its first-quarter conference call last week, investment bank Merrill Lynch said it had canceled $1.1 billion in contracts with MBIA Corp. (MBI) and was working to resolve its conflict with Security Capital Assurance.

---

Investors sidestep the little guys for safer havens

Small-capitalization stocks have been known to generate big returns. But ever since the credit crisis erupted last summer, the only thing small caps have done is get even smaller.

And that trend could continue this year as increasingly risk-averse investors flee to the perceived safety of large-cap stocks and money market funds, according to a report by Scotia Capital. It's a sobering read, particularly for investors who may be looking to small caps to put some sizzle back in their portfolios. Instead, they may end up getting burned.

From July 19 – the day equity markets peaked last year – through the first quarter of this year, the S&P/TSX SmallCap index plunged 20 per cent. That's more than double the decline of 8.7 per cent for the S&P/TSX composite index.

Canada is part of a global trend; in the first quarter, the average drop in small-cap indexes around the world was 12.4 per cent, with Hong Kong faring the worst, down 25.5.

Scotia Capital analysts Anthony Zicha, Mark Neville and George Doumet offer several reasons why the underperformance of small caps may continue.

For one thing, the credit crunch has raised the cost of capital for companies, and the pain is especially acute for smaller firms that may not have the deep pockets of their larger rivals. (Scotia Capital defines small-cap stocks as those with a market capitalization of less than $1.5-billion.)

For another, with economic growth slowing and corporate profits shrinking – particularly south of the border – many investors are looking for safer places to park their money. In January and February, investors yanked $1.89-billion out of Canadian equity mutual funds, including $328.7-million from small- and mid-cap funds, and poured more than $8-billion into money market funds.

---

Stretched buyers fuel boom in housing

Canada may not have the sizable subprime market of the U.S., but the engine behind the country's housing boom has been increasingly leveraged first-time buyers.

Legions of first-timers are adding years of extra mortgage payments so they can buy a house, or putting little or no money into a down payment, a Re/Max survey revealed yesterday. Nearly two-thirds of buyers in major centres now favour extended amortization periods of up to 40 years, while putting little or no money down was prevalent in 38 per cent of regional markets surveyed across Canada.

The country's real estate industry has played down any similarities to the U.S. when it comes to subprime borrowers. But as new segments of the Canadian population enter the market, the findings raise questions about what's been driving soaring house prices in recent years.

"The reason we think the market has been staying hotter much longer than anyone anticipated was because of these newer amortization mortgages," said Craig Alexander at Toronto-Dominion Bank....

...."Innovative financing has become key to home ownership in today's environment," yesterday's report said. "Entry-level purchasers are adjusting their expectations by sacrificing size, location, and even long-term financial freedom to overcome challenges such as rising prices and serious supply issues."

Policy changes help explain why so many people have been entering the market. Ottawa extended the maximum amortization period to up to 40 years from 25 years in 2006. In the same year, Canada Mortgage and Housing Corp. began providing insurance to lenders for interest-only mortgages.

Mr. Alexander figures that as many as 70 per cent of first-time buyers are opting for longer amortizations. "It's a double-edged sword. It brings down your monthly payments. But it will actually double the amount of interest you pay over the lifetime of the loan."

---

Lenders Slow to Address Florida Mortgage Defaults

The failure of the lenders to address their issues with defaults is compounding the inventory problem to the point where we will see a tidal wave of inventory hit the market.

“Buyers now realize lenders are going to take weeks or months to review and respond to offers that often reflect market value but fall short of covering the balance on the mortgage, ” Morgan writes. “Such “short sales” should be the easiest way for lenders to move inventory at market prices — but the lenders have not faced reality. And now, most buyers who have had experience with short sales no longer want to look at short-sale properties because of the long and convoluted process. Instead of using this tool to realize market values, the lenders are dumping property into below-market foreclosure auctions, which then creates another new downward spiral for prices.”

“Lenders’ failure to address these issues has forced more defaults, which lead to skyrocketing foreclosure rates. Defaults and foreclosures mean huge expenses for the lender, and significantly lower values. And it gets worse for lenders. In the most extreme examples, lenders cannot foreclose because the documents have not followed the mortgage.”

---

The Impending Mortgage Crisis

Option ARMs allow for the choice of the size of the payment. Homedebtors can choose to pay an amortizing payment (such that their mortgage balance is reduced), an interest-only payment, or a negative-amortizing payment, where their mortgage balance increases. Recent data from Countrywide (CFC) indicates that 71% of borrowers with option ARMs are only making the minimum, negative-amortizing payment. Option ARMs have provisions such that when the mortgage balance exceeds the original mortgage by 10% to 15%, the loan converts into a fully self-amortizing loan. Considering that many of these loans were made over the last few years (beginning in 2005), we should start to see a number of recasts. When a mortgage recasts, the payment size can easily double or triple. Those who could afford their payments before will no longer be able to do so.

Option ARMs are highly prevalent, especially in the most bubbly markets. The coming crisis will be caused by option ARM recasts, falling prices, and banks’ increasing reluctance to lend. The crisis will manifest itself in people simply walking away from houses where their mortgage is worth more than the house. Considering how many people have used home equity loans to remove equity, how many have had negative amortization in their loans, and considering how small down payments became over the last few years, very few homeowners will be left with equity in their houses. Economy.com currently estimates that nine million households have negative equity. That figure could easily double or triple as house prices fall by another 20% to 30%.

The assumption on the part of mortgage lenders, regulators, and housing market optimists is that as long as people can afford to pay their mortgages, they will. But homedebtors faced with 20% to 30% negative equity will be much better off going through foreclosure than they will paying off their debts. Helping them is the fact that in a number of states, purchase money mortgages are non-recourse debt, meaning that banks cannot sue to recover the money they lose. The sheer number of foreclosures will mean that banks will not have the manpower to go after domedebtors even when they want to do so.

The rising tide of foreclosures caused by people walking away from houses in which they have negative equity will act as part of a positive-feedback loop to increase the rate of price declines. The housing market is not getting better anytime soon and it will soon get much, much worse.

---

The Bottom Is Up Ahead

To figure out where things are in this crisis, and where they are headed, it's important to understand how we got in this mess. Let me posit two possibilities.

One explanation is that we got here because mortgage bankers and brokers were sleazy, investment bankers were greedy for fees, banks were incompetent, rating agencies were compromised, and regulators either were blinded by deregulatory ideology or chose to look the other way.

Obviously, there is a good deal of truth in all of that. And if you accept that as the basic story, then you might well think that the crisis will be over as soon as the bad loans are acknowledged and written off, the banks are recapitalized, and new rules are put in place to make sure it never happens again.

But what if that isn't the whole story? What if, for the better part of a decade, the United States had been living way beyond its means, consuming more than it produced and investing more than it saved? What if China and Taiwan and Saudi Arabia and even Japan were willing to finance that trade deficit on easy terms because it allowed them to peg their currencies to the dollar in a way that generated higher job creation and economic growth in their home markets? And what if this mutually advantageous imbalance in trade and investment flows wound up creating a huge supply of cheap dollar-denominated credit that virtually invited the bankers and brokers and rating agencies and private-equity firms in U.S. markets to throw caution to the wind and make ill-advised lending and investing decisions?

Not only is this a plausible explanation, but I think it is the underlying story. And if that is the case -- if the story of the credit bubble and its bursting is more fundamentally about macroeconomic imbalances than microeconomic failures -- that has very different implications for where we go from here.

For what it means is that things won't be "fixed" simply by having the financial sector write off its losses and bad loans and promise to do a better job next time with risk management. Rather, it will require a reduction in the overall standard of living in the United States so that the country as a whole begins to live within its means.

---

The Homeownership Ideologues

However, homeownership should not be viewed as an end in itself. One of the reasons millions of families face foreclosure and/or the loss of their life's savings is the ideologues of homeownership continued to promote homeownership even when it was clear buying a home would be financially detrimental.

Recognizing the risks of homeownership in a bubble wasn't a matter of rocket science - it was simple arithmetic. The ratio of house sale prices to annual rent soared past 20 to 1 in the bubble markets, approaching 30 to 1 in the most inflated markets.

If a homeowner takes out a 7 percent mortgage (very low for a subprime buyer), pays 1 percent of the value in property tax each year, and another 1 percent for insurance and maintenance, then ownership costs are equal to 9 percent of the sale price. If the house sells for 20 times annual rent, then this family is paying 80 percent more in housing costs as homeowners each year than they would pay as renters. If the house was selling for 25 times the annual rent, then the family would be paying 125 percent more as homeowners than they would as renterFor low- and moderate-income families who are struggling to make ends meet and pay for necessities like health care and child care, how are we helping them by having them pay 80 percent to 125 percent more than necessary for their housing costs? Oh, yeah, but they will accumulate equity in their home.

Right, the housing bubble will keep inflating indefinitely. Maybe the ideologues of homeownership thought housing prices would just keep rising forever, but this was an unbelievably stupid thing to believe.

---

Bank of England Splits Three Ways in Rate-Cut Vote

Governor Mervyn King says the central bank faces a ``difficult balancing act'' as it tries to damp inflation while thawing the frozen mortgage market shore up the slumping housing market. The split highlights the discord on the panel about the pace of further interest-rate cuts after three since December.

``The minutes suggest to us that eight of the nine members remained in favor of a gradual approach to policy easing, reflecting the negative outlook for inflation for this year,'' said Nick Kounis, an economist at Fortis Bank NV in Amsterdam and a former U.K. Treasury official. ``The BOE's next move will be a 25-basis point reduction in June.''

The pound was little changed against the dollar, trading at $1.9995 as of 12:13 p.m. in London. U.K. mortgage approvals fell 46 percent in March from a year earlier, the biggest drop since September 1997, the British Bankers' Association said today in a separate report.

---

World Vision cuts aid for 1.5 million people due to rising food costs

World Vision says soaring food costs will force it to cut 1.5 million people from the roster of 7.5 million it fed last year, one-third of them children who rely on the organization's aid to survive.

"The hungry are resourceful, they'll do what they have to, but it's going to take human life, there's no question about that," World Vision Canada president Dave Toycen told CBC News on Wednesday.

About 572,000 of those who will not receive food support are children who depend on that nourishment to thrive, Toycen said. While children funded by World Vision's sponsor-parent program will continue to receive aid, he said they could still be affected by an overall food shortage in their community.

"Well, at this point [people will] do like the hungry always do.… If they were getting two meals a day, now they'll cut back to one meal a day or, in some cases, they won't eat every day."

---

Japan Inflation Likely Quickened to Fastest in Decade

Japan's consumer prices probably rose at the fastest pace in a decade as companies foisted higher costs of energy and grains onto consumers to protect profits.

Core consumer prices, which exclude fruit, fish and vegetables, climbed 1.2 percent in March from a year earlier, quickening from 1 percent in February, according to the median estimate of 39 economists surveyed by Bloomberg....

....Japanese companies including Yamazaki Baking Co. and Asahi Breweries Ltd. raised prices of beer, bread and noodles this year to pay for more expensive materials.

Wholesale prices rose at the fastest pace in 27 years in March. Crude oil prices have doubled in three years. Wheat surged 71 percent in the past year, prompting the government to raise prices of the grain 30 percent this month.

Oil-related products contributed two-thirds of the increase in inflation in February. Food was responsible for a quarter of the gains.

---

Potash profit soars on world food demand

Fertilizer giant Potash Corporation of Saskatchewan Inc. has tallied another record quarter amidst soaring worldwide demand as farmers strive to boost crop yields – and it has boosted its growth forecasts for the balance of the year.

The Saskatoon company said Thursday that it had a profit of $566-million (U.S.) in the three months ended March 31, compared with $198-million a year earlier, as revenue leaped to $1.89-billion from $1.15-billion.

This translated to $1.74 a share, up 181 per cent from 62 cents a year earlier and beat analysts' predictions, which ranged from $1.31 a share to $1.65. It also was 50 per cent higher than the previous record of $1.16 a share the company set in the fourth quarter. The leap came as world food demand pushed prices for potash, phosphate and nitrogen to new heights.

“Another record quarter for our company reflects the ongoing growth in global demand for food and the fertilizers that are essential to maximizing crop production,” Potash Corp. president and chief executive officer Bill Doyle said in a news release.

---

From Wal-Mart quotas to a 'frenzy' in Vancouver, Asia's rice crisis goes global

Vancouver's Western Rice Mills Ltd. has been importing rice from Thailand for years and sending it to grocery stores and restaurants across Canada. But yesterday the Thai shipments stopped, leaving the company scrambling to find supplies.

"We've never seen anything like this in the history of this company," said Lawry Poupart, controller at the company, which supplies major chains including Safeway and Save-On-Foods. "Everybody is precariously watching what's happening in the world."

Rice has been hit by a convergence of factors recently, including increased demand from developing countries and weakened supplies due to poor crop yields, rising input costs and limited growing areas. World rice stocks are at 20-year lows and riots have broken out in some countries where rice is a staple. While global rice production is expected to rise by nearly 2 per cent this year, demand will still outstrip supply, according to the Food and Agriculture Organization of the United Nations.

Compounding the problem were recent moves by two big rice producers, India and Vietnam, to restrict exports in order to preserve ample supply at home. Thailand, the world's largest producer, has also restricted some exports, although the country's Prime Minister vowed yesterday not to cut exports or distort prices....

....The global rice crisis is also starting to have an impact on North America.

Sam's Club stores, a division of Wal-Mart Stores Inc., has began restricting the amount of rice customers can buy at outlets across the United States.

"We are limiting the sale of jasmine, basmati and long-grain white rice to four bags per member visit," said company spokeswoman Kristy Reed. "We are working with our suppliers to address this matter to ensure we are in stock, and we are asking for our members' co-operation and patience. At this time, we are not restricting purchase amounts of flour or oil."

Karin Campbell, a spokeswoman for Wal-Mart Canada, said similar restrictions were not in place in Canada.

Costco Wholesale Corp. said it has seen a spike in rice purchases at some stores in the U.S, but so far it has not introduced limits on purchases.

---