Debt Rattle, April 4 2008

New York Times, Dec. 12 1930

Ilargi: As financial troubles in Europe grow, calls for transparency get louder. Since the EU has a common central bank, the ECB, that is not really a lender of last resort, and the national central banks have limited powers, transparency may be the only way to stop the bleeding before the patient succumbs.

In the case of Spain, it may already be too late. All the more reason to stop the infection from spreading. For the UK, 2008 will be an annus horribilus. And while it still has its own central bank and currency, cross-border trade ensures that when the UK hits a full depression, the continent will feel a strong downward pull.

But if Europe chooses to do "hit the open road", there will be consequences for Wall Street, and the US economy, as well. Much of the US banking system has been propped up by opaqueness: as long as there is no demand for mark-to market-numbers for all sorts of assets, we can all keep pretending they are worth whatever is convenient. That would become impossible, since most securities and derivatives are traded globally. Nowhere left to hide.

This could lead to a hostile cross-Atlantic environment.


Foreign banks flee Spanish property debt

International banks are scrambling to sell their holdings of Spanish mortgage debt at a steep discount, fearing that the country may be sliding into the worst economic downturn in its modern history.

A blizzard of grim data has soured the mood, capped yesterday by a plunge in PMI purchasing managers' index to an all-time low of 40.9. Car sales fell 28pc in March, and even Madrid's legendary tapas bars seem to have lost their late-night sparkle.

Inmobiliaria Colonial - once the country's biggest property group --is in emergency talks with banks after Dubai's Investment Corporation pulled out of a rescue deal. Developer Martinsa Fadesa is struggling to restructure €5bn of debt to stave off insolvency. Traders says the market price for Spanish mortgage securities has begun to slide abruptly, replicating the pattern seen in the US last year.

Large French and German funds and insurers appear to be liqudiating assets in a pre-emptive move, afraid being caught yet again in a violent downturn. Ismael Clemente, head of Deutsche Bank's property arm RREEF in Spain, told a panel of experts in Madrid that foreign banks were now dumping Spansih mortgaged debt at a 40pc discount.

Mikel Echavarren, director of the property consultancy Irea, said Spain's housing market was far weaker than the official statitics suggest, warning that prices could fall 20pc to 25pc. "All kinds of ploys have been used to disguise the true extent of the price falls, which we think are 5pc to 7pc already. Buyers have totally abandoned the market. We've had a wave of negative sales as people pull out of commitments already made," he said.

"We have a very worrying situation. The developers simply cannot refinance their debts. We need to cut interest rates by 2pc, which is obviously not going to happen," he said, adding that the crash could be sharper than the property crisis in the early 1990s. Santiago Baena, head of Spain's estate agents lobby API, said the downturn had already forced 40,000 agents to close their doors, laying off 120,000 staff.

The Bank of Spain said default rates would rise but insisted that the Spanish banking system remains in good health, without much exposure to the US subprime debacle. The loan-to-value ratio on mortgages was kept to 70pc - although a report in Germany's Die Welt newspaper today alleges that false pricing was often used to circumvent the rule.

The authorities said that a crisis comparable to the early 1990s (when bad debts reached 13.1pc) would erode the capital base of the banking system by 63pc, a manageable level. The developers owe €290bn to the banks and lenders, known as'cajas". The government is preparing a €20bn spending blitz on high speed railways and other mega-projects to cushion the downturn. Spain's trump card is a budget surplus of 2pc of GDP last year, leaving it ample scope for fiscal stimulus - in sharp contrast to Italy, France, and Britain.

The root cause of the crisis is in a sense Europe's monetary union. The euro effect halved Spain's interest rates almost overnight. Rates then fell below Spain's inflation rate for several years, fuelling an explosive credit boom. The country's current account deficit has reached 10pc of GDP, the highest of any major economy.

The process has now kicked into reverse. Mortgage rates - priced off three-month Euribor - have nearly doubled since late 2005. David Owen, Europe economists at Drsedner Kleinwort, said Spain was waking up to the reality that there will be no quick-fix. "They are no longer arguing about whether there will be a recessoin, but about how deep it will be," he said. "Spain is no longer able to set monteary policy for its own needs. It could face zero-growth for five years," he said.

---

Banks urged by EU to disclose "toxic products"

Banks should step forward with all their problem investments in order to restore confidence into financial markets, the European Union's top financial regulator said on Friday. "It would give confidence to the market if everybody was pretty certain that all these institutions had all of their toxic products on the table," EU Internal Market Commissioner, Charlie McCreevy told reporters.

"Nobody can say with certainty if all of this is out in the wash at the present time," said McCreevy. What McCreevy calls toxic products are securitised products underpinned by home loans in the United States. As those loans defaulted, the market dried up and their value plunged, forcing many banks to write-down billions of dollars in losses.

Banks fear more write downs are likely and are therefore loathe to lend money to each other, thereby continuing the credit squeeze on the interbank money market. McCreevy was speaking on the sidelines of a meeting of EU finance ministers and central bankers who were due to sign an agreement to increase cooperation in supervision of the bloc's 40 or so big cross-border banks in times of crisis.

The subprime mortgages crisis has forced the rescue of several national focused banks such as Northern Rock and IKB but fortunately for Europe, there have been no cross-border bank failures yet.

The MOU lays out guidelines on how national supervisors would work together if a cross-border bank gets into trouble. "It puts the elements in place on how they would work together in the event of a crisis," a senior EU official said. Signing the MOU would give McCreevy the green light to push ahead with introducing "colleges" of national supervisors to oversee the big cross border banks in times of crisis.

The proposal would be part of a revision later this year of EU laws known as the capital requirements directive or Basel II that oversee how much capital the EU's 8,000 banks must set aside to cover risk on their books.

---

Spent, spent, spent

John Kemp at Sempra Metals notes that until the 1980s personal saving was remarkably steady at around 8% of post-tax income, and it even rose slightly during the 1970s amid rising inflation and greater economic insecurity.

Since the mid-80s, however, the trend is all too apparent, with deregulation and rapid financial innovation culminating in the final 100 per cent, self-certification, teaser-rate mad mortgage flurry of 2007 - when US households, in aggregate, saved nothing.
Kemp puts it in dollar terms:

• US households saved around $160 billion on income of $2,160 billion in 1979.
  
• By the end of 2007, US households saved zero (actually overspent by $300 million) on income of $11,855 billion…
  
• The debt-driven consumer boom has reached the end of the road.

---

Counterparty of last resort? Yes, but...

It's official. The LLC that the Fed and J.P. Morgan recently formed to manage $30B Bear Stearns assets has taken over a portfolio of derivative positions along with those assets. Those positions involve both rights to receive and obligations to pay whose value may depend upon both circumstance and counterparty quality.

Of course, if liabilities associated with those positions ever exceed the value of the LLCs assets, the limited liablity company could declare bankruptcy, so in theory, the Fed's maximum exposure is $29B. But, if, out of reputational concern or to promote systemic stability, the Fed would inject capital rather than let the LLC default, then the Fed has indeed become a counterparty of last resort. However, the derivative positions are all claimed to be hedges related to the LLC's "cash assets". So, I guess the word of the day is basis risk.

Timothy Geithner's speech yesterday amounts to the clearest narrative and strongest defense we've seen from an insider regarding the Fed's management of the Bear Stearns crisis. (Hat tip Felix Salmon, Calculated Risk.) We learn that the assets effectively acquired by the Fed from Bear Stearns are

investment grade securities (i.e. securities rated BBB- or higher by at least one of the three principal credit rating agencies and no lower than that by the others) and residential or commercial mortgage loans classified as 'performing'. All of the assets are current as to principal and interest (as of March 14, 2008).

However, these "cash assets" are bundled with "related hedges". What are these hedges? It's not stated explicitly, but the "Summary of Terms and Conditions" regarding the formation of the LLC, published with the speech, includes the following language:

[Bear Stearns] will sell to [the new LLC]... the assets identified by JPMC, the NY Fed and the Asset Manager as described on Schedule A hereto (the "Scheduled Collateral Pool"), together with the hedges identified by JPMC, the NY Fed and the Asset Manager [BlackRock] as described on Schedule B hereto (the "Related Hedges") and including the Pre-Closing Date Proceeds Amount. For the avoidance of doubt, the Related Hedges include the amount that the Borrower [the new LLC] would have to pay to, or the amount that the Borrower would receive from, the applicable counterparty if the Borrower had entered into an identical transaction on March 14, 2008 based on the Bear Stearns marks as of such date (the "Transfer Value"), as well as all accumulated mark to market gains or losses thereafter and any cash proceeds as a result of Related Hedges' being unwound.
...
[The new LLC] will assume as an economic matter the obligations under the Related Hedges and receive the benefits thereof by entering into a total return swap with the [Bear Stearns], such total return swap having an initial fair value as of the Closing Date equal to the fair value of the Related Hedges as of the Closing Date. The Controlling Party (as defined below) [the NY Fed] shall have the right to make all determinations related to the underlying hedges (e.g., whether and when to terminate) that are subject to the total return swap. At the request of the NY Fed, the Seller will use its commercially reasonable efforts to replace the total return swap with direct hedges with underlying counterparties through novation.

In English, Bear Stearns is selling various securities to an LLC controlled and largely financed by the Fed, but it is also transferring ("as an economic matter") a portfolio of derivatives that are characterized as hedges of those assets. (In practice, these derivatives may be bilateral contracts not easily transferable to the Fed's LLC, so the LLC and Bear are establishing a new contract, a total return swap, under which the LLC reimburses Bear for whatever is owed, and Bear forwards to the LLC whatever is earned, on positions that can't be replaced with direct contracts.)

Specific information about the securities and the portfolio of derivatives has not been revealed. The schedules on which they are listed are not public. They could be credit default swaps on which the Bear Stearns had acted solely as protection buyer, which would be pretty benign. (These are like insurance contracts — the very worst that could happen is the LLC pays a regular premium, but when some of its bonds catch fire and disappear the insurer fails to pay up.) But lots of instruments could arguably qualify as a "related hedge", some of which would be much riskier.

I would like to know general types and notional values of the LLC's contracts, as well as the current exposures, gross and net. I know. I'd like a pony, too. Still I can't see why the Fed should withhold this information other than potentially "bad optics". Is this really a set of well tailored hedges to the cash assets described? How much counterparty risk has the Fed taken on?

---

Ilargi: Socialism? Well, yes, perhaps it is. But it also makes me think of Benito Mussolini’s definition of fascism, where corporations blend with government.

"That is socialism"

Hours from a market meltdown, as U.S. regulators pressed him for help in rescuing Bear Stearns Cos., Jamie Dimon said no. The JPMorgan Chase & Co. chief executive officer was concerned that liabilities on the firm's books would bring along too much risk, Dimon and others involved in the bailout told Congress yesterday. Dimon's refusal prompted the Federal Reserve to step in with a loan, announced minutes before Asian markets opened that Sunday, March 16.

The testimony provided the most extensive account yet by participants in the largest U.S. rescue of a securities firm. Dimon, New York Federal Reserve President Timothy Geithner and Fed Chairman Ben Bernanke defended the bailout while some lawmakers said it only rewarded risky market bets. The officials compared the turmoil they feared that weekend to the Panic of 1907 and the Great Depression-era run on banks.

"Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education and the expenses of everyday life, lower value of retirement savings and rising unemployment," Geithner told a U.S. Senate banking committee.

Lawmakers are scrutinizing the deal, concerned the government put taxpayer money at risk and acted more quickly to save a Wall Street firm than it has for homeowners facing foreclosures. New York-based Bear Stearns was the second-largest underwriter of mortgage bonds last year, behind Lehman Brothers Holdings Inc.

"I want to hear from our witnesses why they thought it was necessary to stop the invisible hand of the market from delivering discipline," said Senator Jim Bunning, a Kentucky Republican. "That is socialism."

---

Big banks face break-up calls in subprime wake

Battle lines are forming in banking that pit bigger-is-better against break-up advocates, and some of the largest conglomerates – like subprime victims UBS and Citigroup – could fall prey. Such sprawling financial groups are facing pressure from regulators and shareholders to look back to the future and simplify, sell assets and focus on what they do well.

Big banks have long held that they profit from broad strategies in two ways: one business unit often feeds another, and diversified activities lessen earnings volatility. But new risks have come to the fore with the subprime crisis which saw, for example, a handful of traders and managers at UBS's investment bank rack up over $37-billion (U.S.) in losses and damage the reputation of its prestigious wealth-management division, the world's largest.

“The supposed synergies of having investment banking and private banking in one company have been grossly overstated by the previous UBS management,” said analyst Peter Thorne at brokerage Helvea. “They have persistently ignored the large conglomerate discount that held back the UBS share price because of the presence of the risky investment bank,” Mr. Thorne said.

UBS on Friday suddenly saw the emergence of a major shareholder who is leading a campaign to break up the bank into its parts and possibly sell them off, reducing the Swiss bank to its core wealth-management activities. Luqman Arnold – who in no small irony served briefly as UBS CEO in 2001 – controls a 0.7 per cent stake in the bank and launched the campaign by sending a letter to UBS management.

“We are not convinced that the “one bank' integrated business model ... will survive the damage inflicted by the proprietary trading losses and write-downs,” Mr. Arnold wrote. In a parallel case, Citigroup faced criticism from a former senior executive that the $166-billion mega-merger he helped mastermind in 1998 and that made it the world's largest financial company was a mistake. Neither stockholders nor customers nor employees of the firm have benefited from the deal, said John Reed, according to a report in the Financial Times.

Citigroup is reeling from the subprime crisis and is also facing calls to simplify after being forced to raise some $30-billion of capital and slash its dividend. The bank has shed more than 6,000 jobs this year, and more cuts are widely expected, including in the investment bank. “If you look at UBS and Citigroup here, there are similar problems here in terms of size and complexity,” Mr. Arnold said in an interview on CNBC television. So, why is yesterday's fashion today's curse?

In a word, complexity. Once the saviour, complexity became the tormentor as highly engineered products collapsed.
Banks grew enamoured of their ability to manage multiple risks, which grew increasingly complicated and overlapped in unforeseen ways to the point that they flew out of control, but not before a critical number of banks had gotten deeply involved. Simplicity and transparency – for structured products, for balance sheets and for business models – is now what investors and regulators seek.

Investors want to know exactly what they are buying and regulators want to know exactly what they are regulating.
In addition, regulators have made it no secret that the trading activities of investment banks – who often get cheap funding from a conglomerate's more staid divisions – will face new fees that will make them less attractive. Investment banks at groups such as UBS were able to get cheap capital from the wealth-management division, for example, and use it to leverage themselves 80 times or more by some estimates in risky markets for complicated mortgage products.

Regulators have signalled they will assign new, higher risk fees in terms of capital requirements to risky trading activities that will make those activities less profitable. What happens next?

The precedent set by former Dutch banking group ABN AMRO last year is more relevant than ever: The eight month-long battle that saw ABN AMRO taken over and broken up started with a single activist, who sent a letter in February 2007 to top management arguing there was more value in the sum of the parts than in the conglomerate as a whole.

---

The National Association of Homebuilders, who cut off funding to their poodles in Congress a few months ago, get their little bitches back in line

Ah, ya gotta love our Senate. The best that the REIC could buy. Harry Reid? Corrupt. Chris Dodd? Corrupt. Mitch McConnell? Corrupt. Chuck Schumer? Corrupt. And the National Association of Homebuilders? Happy as a clam now that their poodles have rewarded them for stupid behavior with a massive tax break.

Vote 'em out folks. All of 'em. Our leaders have been corrupted by the REIC. The House and Senate have been sold to the highest bidder. If they don't want to reform, if they don't want to cut off the REIC money, then the voters need to do it for them. It's time to throw the bums out. And maybe arrest a few of 'em too. This should ENRAGE YOU.

Builders Get Breaks From Congress - Builders, Mortgage Companies Get Additions, Subtractions They Asked for in Senate Housing Deal. Homebuilders and the mortgage industry are emerging as big victors in a bipartisan agreement reached by Senate leaders on legislation designed to limit the housing crisis.

The $15 billion measure, announced Wednesday by Majority Leader Harry Reid, D-Nev., and GOP leader Mitch McConnell of Kentucky, contains a $6 billion emergency tax break that would let companies use losses from 2008 and 2009 to offset profits earned over the previous four years, instead of the usual two-year timeframe.

That's good news for big homebuilders such as KB Home and Pulte Homes Inc., which have been saddled with massive losses over the past year. Homeowners facing bankruptcy, however, won't find relief in the proposal. The mortgage industry fought fiercely to spike a provision to let bankruptcy judges rewrite the terms of distressed mortgages. It won that battle; the provision was left out.

Earlier this year, the builders' trade group was so dissatisfied by lawmakers' actions -- notably not including the tax provision in the economic stimulus bill-- that it snapped shut its political purse. NAHB said it would stop making contributions to congressional candidates "until further notice."

Since 1990, the trade group has given nearly $20 million to federal candidates, with 35 percent going to Democrats and 65 percent to Republicans, according to the Center for Responsive Politics. It's not clear if the new plan will kick back open the coffers.

Other big beneficiaries would be Wall Street banks such as Citigroup Inc., Merrill Lynch & Co. and Morgan Stanley. In fact, any company now struggling after years of healthy profits that pumped up their tax bills could benefit.

---

U.S. payrolls contract by 80,000 in March

U.S. employers cut back their hiring in March for the third straight month, confirming widespread pessimism about the near-term economic outlook, government data released on Friday showed. Nonfarm payrolls fell by an estimated 80,000 in March, the Labor Department said. This is the largest decline since March 2003 and underscored how employers remain reluctant to commit to making new hires.

Private-sector payrolls have declined for four consecutive months, the data showed. The nation's unemployment rate surged to 5.1%, the highest since September 2005. The decline in payrolls was steeper than the 60,000 decrease that had been expected by Wall Street economists surveyed by MarketWatch. Adding to the sense of weakness in employment, payrolls in January and February were revised lower by a cumulative 67,000.

Job losses thus have totaled 232,000 since the New Year, an average of 77,000 lost jobs per month. The government's separate household survey showed a decline in employment of 24,000 in March, and a 434,000 rise in unemployment. As a result, the unemployment rate rose. The job report should add to the growing sense that the Federal Reserve will cut the federal funds target interest rate again at its next meeting on April 29-30.

The report suggests that businesses are growing increasingly cautious about hiring in the wake of the credit crunch and financial markets' recent turmoil. Earlier this week, Fed chief Ben Bernanke said a recession was possible in the first six months of the year. But, in testimony before Congress, Bernanke stressed that the economy is still expected to turn around some time this summer

---

Surge in US bank borrowing from Fed

Bank borrowing from the Federal Reserve’s discount window surged in recent days, as primary dealers continued to draw still larger amounts of cash from their new emergency finance facility, figures released by the US central bank showed on Thursday.

The Fed said bank borrowing from the discount window averaged $7bn in the week to April 2 – a $6.5bn jump from the previous week. The total amount outstanding on April 2 was $10.3bn.

---

Dinallo warns on FGIC woes

The US regulator overseeing efforts to prop up FGIC said the troubled bond insurer should come up with fresh capital in “the next 30 days” to avoid worst-case scenarios such as closing down. Eric Dinallo, New York State insurance superintendent, said his department was working “avidly” on resolving FGIC’s crisis, which has resulted in sharp cuts in its credit ratings.

In a video interview with the FT, Dinallo said FGIC, which insures billions of dollars of municipal and structured bonds, could go into “a run-off” and lose all its business if it does not find fresh funds.

---

HSBC chairman says banks should stare down hedge fund investors

HSBC Holding PLC Chairman Stephen Green said in an interview published Friday that banks should "stare down" hedge fund investors who've been seeking a more active role in company strategy.

"It's not enough to have 1% equity and feel you have the right to condition the choices of a big financial institution," Green told business daily Il Sole-24 Ore.

Knight Vinke Asset Management called in September for a fundamental review of strategy at Europe's largest bank, arguing that it needed to focus more on its traditional strengths in Asia.

---

John Reed calls Citigroup deal a mistake

Ten years on from the $166 billion deal that created Citigroup, one of its architects is expressing regret. John Reed told the Financial Times in an interview that the deal to create Citigroup was a mistake and a "sad story."
"The stockholders have not benefited, the employees certainly have not benefited and I don't think the customers have benefited," Reed said.

Reed, who left the bank in 2000 after a clash with Sandy Weill, said the consumer business became product pushers. He added the business wasn't oriented enough around its client base.

The newspaper also quoted Weill, who defended the merger saying the "model worked very well for customers, employees and shareholders. What didn't work was that we had very poor management and management decisions over the past couple of years."

Citigroup has underperformed most of its rivals over the last decade and has needed cash infusions in the wake of billions of dollars in write-downs.

---

Merrill Lynch: No need for additional funding

Merrill Lynch & Co. has no need to raise fresh capital, Chief Executive John Thain said in a published report, brushing aside rumors that the U.S. financial-services firm would further tap the equity market. "We have plenty of capital going forward and we don't need to come back into the equity market," Thain told the Nikkei in an interview published on the Japanese business daily's Web site and dated for Friday.

Noting Merrill's liquidity position of $80 billion in cash at the end of 2007, Thain indicated that a similar amount has been held through the quarter ended in March. "The goal is to maintain our current ratings," Thain was quoted by the Nikkei, referring to Merrill's A-plus status. He also said that the firm is in the process of reducing illiquid assets and reassessing such noncore segments as the mortgage business.

Late last year, Merrill received a capital injection totaling about $6.6 billion from Middle Eastern and Asian investors, including Japan's Mizuho Corporate Bank, a unit of Mizuho Financial Group Inc. Thain declined to comment on speculation that Merrill Lynch will report a third straight quarterly loss for the period ended in March when it releases results April 17.

Some analysts expect Merrill to record $4.5 billion to $6 billion in write-downs from exposure to mortgage-related securities and troubled bond insurers during the first quarter. "If you look at the prices of credit-related assets, mortgages, leverage loans, commercial real estate, all of those have deteriorated over the last three months," Thain told Nikkei. "We own all of those."

Despite the eroding value of some of its assets, he said: "I don't have any plan to sell the company or merge" with a bank, according to the Nikkei report.

---

UBS 'Must Reboot'

UBS believes it knows how to dig itself out of a very deep, subprime hole, but a well-regarded former president has other ideas. Luqman Arnold, now a shareholder in UBS, called Friday for a break-up of the troubled Swiss bank, and gave investors hope that such radical action could actually take place.

Arnold, whose investment fund, Olivant Advisors, holds a 0.7% stake in UBS, told the bank it should consider selling off its global asset management division to boost its capital position. In an open letter to board member Sergio Marchionne, Arnold warned that there were "realistic scenarios" under which a proposed rights issue "may not be sufficient to achieve finality."

With the possibility of further write-downs looming large, UBS has planned to create a " bad bank" to hold its toxic assets, as well as get a $15 billion capital injection. Luqman also recommended that the bank consider selling Pactual, its Brazilian wealth management business, and its Australasian business. Shares in UBS rose 2.0%, to 33.04 Swiss francs ($32.78), on Friday morning in Zurich.

"It is good news that activist investors are taking a serious interest in UBS, and Olivant and Arnold have a lot of credibility," said Dirk Becking, an analyst at Sanford Bernstein. Arnold has hands-on experience with UBS, having spent eight months as its president, a position that is roughly equivalent to chief executive. He stepped down in December 2001 due to "differences of opinion" with the board.

It is unlikely that UBS will like the idea of selling its asset management division, which is in the middle of being restructured. "This would not be an optimal time to sell the asset management division, and it would currently sell at below what the company may be able to achieve if it hangs on to the division," said Becker. Also, selling the unit would be an acknowledgement that the bank needed a further capital injection and would therefore make further investment losses.

---

SEC hunts illegal trades in Bear case

US securities regulators are trying to determine whether illegal trading and rumour mongering took place in the days leading up to the emergency sale of Bear Stearns to JP-Morgan Chase, the chairman of the Securities and Exchange Commission said yesterday.

Chris Cox, SEC chairman, told the Senate banking committee that enforcement officials were taking a "very active" look at the trading of securities tied to Bear in the days before the sale. He said rumours circulating about the bank were "too big to miss".

Answering a question about the SEC’s response to allegations of abusive trading, Mr Cox said: "Your hopes will be, I think, met and exceeded, with respect to the agencies’ response to these concerns."

---

Bear's Market

Yesterday Wall Street and the government's top financial regulators were in a place they'd rather not be: Wrapped in a bear hug from Congress. Whatever the merits of the case for the Federal Reserve's decision to let J.P. Morgan buy Bear Stearns, the deal raised sufficient and legitimate questions of public interest to justify Senator Chris Dodd and his Senate Banking Committee brethren getting up close and personal with Ben Bernanke and the rest of the boys who did the deal. No one should expect Congress to regard this as a once-only date.

Details that emerged from the hearing offered a better understanding of the high drama during the days of the sale. These particulars make us inclined to give the Fed the benefit of the doubt on doing the basic deal to forestall systemic risk. We remain unconvinced about the new precedent of the government holding $29 billion in mortgage-related securities as collateral.

As described, the Fed learned from the Securities and Exchange Commission on Thursday evening March 13 that Bear would have to declare bankruptcy the next morning. That Thursday, according to SEC Chairman Chris Cox, Bear's liquidity dropped to $2 billion from $12 billion. That would focus anyone's mind. Bear's customers and counterparties were accelerating their refusal to deal with the bank. As Mr. Cox summarized: "Run" isn't normally associated with investment banks, but "the analogy is nearly complete."

At the most basic level of justification – that Bear's collapse posed a systemic risk to both the financial market and the broader economy – the regulators made a plausible case for their actions that weekend. But once past this first-order goal, we find much in the testimony to merit concern.

Exhibit A remains that mammoth guarantee by the Fed to finance billions in illiquid Bear assets. The best face we can put on this decision, based on what was said yesterday, is that the regulators considered the $30 billion to be chump change against the larger, immediate threat to the system. Then as a gesture of mitigation, J.P. Morgan took on the first billion of potential losses from the assets.

Now Fed Chairman Bernanke is describing the bank's new holdings of $29 billion as virtually a deal anyone would want to get in on. Referring to the advice of the Fed's "private" investment advisor on the assets, Mr. Bernanke says they are investment grade and the taxpayer risk here is "not remotely close" to $30 billion. He said the Fed has "the luxury of selling these assets over time into a liquid market." If so, "private" banker J.P. Morgan should be holding more of this paper today.

We remain concerned about the moral hazard here on the public-policy side of the ledger. Asked if he'd do this again, Mr. Bernanke said "we would have to address" any situation that threatens the financial system's integrity. Several Senators pointed out the obvious: that nearly any such situation will again involve highly complex financial instruments.

None of the regulators so much as suggested the $29 billion guarantee should be seen as a one-off event. This piece of the deal sits as a bad precedent. It is the pretext Congress is likely to use for drawing the Fed deeper into the political imperatives of increased regulation of the markets. The Fed's independence is at some risk now.

---

The Great Depression: The sequel

A record number of Americans receiving food stamps. Gas prices at an all-time high, and staples such as milk, eggs and bread costing a prettier penny every week. The average number of Americans filing for unemployment benefits reached its highest level in two years last week, while just this week, construction spending fell for the fifth straight month and manufacturing activity shrank to its lowest level in five years. Real estate values are even plummeting in the Hamptons, and hedge funds started off 2008 with their worst quarter ever.



Most economists are no longer debating whether there will be a recession in 2008. Now, they're arguing over when the recession started -- was it last November, or December? -- and how bad it's likely to get. While they bicker, however, a far more terrifying economic specter from the distant past has sent a chill through the infosphere.

"We have not seen a nationwide decline in housing like this since the Great Depression," said the CEO of Wells Fargo late last year. "It is now clear that the U.S. and global financial markets are experiencing their worst financial crisis since the Great Depression," wrote economist Nouriel Roubini last week.

For the majority of Americans alive today, the Great Depression has an almost mythic luster. We may not remember it -- if you were 18 during the crash of 1929, you're 97 now -- but we cannot escape its foundational legacy. At the very least, we know that back then was when times were really bad, because that's the standard by which historians, economists and journalists always measure every other potentially bad time.

In 1933, 24 percent of the workforce was unemployed. In February 2008, according to the Bureau of Labor Statistics, the U.S. unemployment rate was 4.8 percent (though there are reasons to believe that number significantly underestimates the true picture). Between 1929 and 1933, U.S. GDP growth declined by around 30 percent, the stock market lost almost 90 percent of its value, and a whopping 40 percent of the nation's banks failed.

In the fourth quarter of 2007, GDP growth registered an 0.6 gain. While stocks are down over the last year and a half, there's still no consensus about whether we're living through a "correction" or a full-scale bear market. And even though scores of mortgage lenders have declared bankruptcy in the last year, both the real banking system and the so-called shadow banking system of generally unregulated investment banks and hedge funds are still afloat, thanks in large part to Federal Reserve chairman Ben Bernanke's dogged determination to ensure that if economic disaster does strike, it won't be because the Fed failed to pump enough liquidity into the system (an error that conservative economists are convinced helped cause the first Great Depression).

---

Weak Economy Sours Public’s View of Future

Americans are more dissatisfied with the country’s direction than at any time since the New York Times/CBS News poll began asking about the subject in the early 1990s, according to the latest poll.

In the poll, 81 percent of respondents said they believed that “things have pretty seriously gotten off on the wrong track,” up from 69 percent a year ago and 35 percent in early 2003. Although the public mood has been darkening since the early days of the war in Iraq, it has taken a new turn for the worse in the last few months, as the economy has seemed to slip into recession. There is now nearly a national consensus that the country faces significant problems.

A majority of nearly every demographic and political group — Democrats and Republicans, men and women, residents of cities and rural areas, college graduates and those who finished only high school — say that the United States is headed in the wrong direction. Seventy-eight percent of respondents said the country was worse off than five years ago; just 4 percent said it was better off.

The dissatisfaction is especially striking because public opinion usually hits its low point only in the months and years after an economic downturn, not at the beginning of one. Today, however, Americans report being deeply worried about the country even though many say their own personal finances are still in fairly good shape.

Only 21 percent of respondents said that the overall economy was in good condition, the lowest such number since late 1992, when the recession that began in the summer of 1990 had already been over for more than a year. In the latest poll, nearly two in three people said they believed the economy was in recession today.

This unhappiness presents clear risks for Republicans in this year’s elections, given the continued unpopularity of President Bush. Twenty-eight percent of respondents said they approved of the job he was doing, a number that has barely changed since last summer. But Democrats, who have controlled the House and Senate since last year, also face the risk that unhappy voters will punish Congressional incumbents.

Mr. Bush and leaders of both parties on Capitol Hill have moved in recent weeks to react to the economic slowdown, first by passing a stimulus bill that will send checks of up to $1,200 to many couples this spring. They are now negotiating over proposals to overhaul financial regulations, blunt the effects of a likely wave of home foreclosures and otherwise respond to the real estate slump and related crisis on Wall Street.

The poll found that Americans blame government officials for the crisis more than banks or home buyers and other borrowers. Forty percent of respondents said regulators were mostly to blame, while 28 percent named lenders and 14 percent named borrowers. In assessing possible responses to the mortgage crisis, Americans displayed a populist streak, favoring help for individuals but not financial institutions. A clear majority said they did not want the government to lend a hand to banks, even if the measures would help limit the depth of a recession.

“What I learned from economics is that the market is not always going to be a happy place,” Sandi Heller, who works at the University of Colorado and is also studying for a master’s degree in business there, said in a follow-up interview. “If the government steps in to help out, that will facilitate more of it happening.”

---

FHA Loans Grow Costly as Banks Add Fees

Politicians are prodding the Federal Housing Administration to help revive the nation's housing market by enabling more Americans to obtain or refinance home mortgages. But banks that make loans insured by the federal agency are adding fees and restrictions that make those loans more costly and less widely available.

Congress recently approved legislation that raises the ceiling on loans the FHA can insure to as much as $729,750 in the highest-cost areas, up from a previous $362,790. The higher limits are due to expire at year end, but pending legislation is likely to authorize a permanent increase in the eligibility ceiling.

Demand for FHA loans has jumped as other types of mortgages have become more expensive and harder to obtain.
J.P. Morgan Chase & Co.'s home-mortgage unit this week informed lenders that sell loans to the big bank that it will require "price adjustments" on the new, larger variety of FHA loans. The adjustments will add about half a percentage point to the interest rate on those loans, mortgage executives said. A spokeswoman for J.P. Morgan Chase declined to comment.

Lou Barnes, a mortgage banker at Boulder West Financial Services, Boulder, Colo., said other big lenders appear to be making price adjustments roughly in line with those announced by Chase. Mr. Barnes said he could offer a rate of about 6.375%, with no fees or "points" paid to reduce the interest, on the new "jumbo" FHA loans, compared with about 5.875% on smaller FHA loans.

Kevin W. Lynch, a mortgage broker at A. Anderson Scott Mortgage Group in Rockville, Md., said he has been quoted rates of nearly 7% on jumbo FHA loans. The loans are so expensive they "aren't going to sell," Mr. Lynch said. "It's a waste of everybody's time."

---

Fun and games with Aussie rules

Who says you don’t kick a dog when it’s down?, asks Lex, as it muses on the latest upheavals in the Australian stock market. Hedge funds and other investors in Australia’s beleaguered stock market are doing just that. Local media are awash with tales of “shorting and distorting”; rumours are running riot and directors who lend their own stock on margin are considered fair game.

Australia is not alone in grappling with possible market manipulation — just ask HBOS — but repeated problems highlight weaknesses in the regulatory framework.

The collapse of Opes Prime, a margin lending and client broking firm, has caused havoc in large part because of its unusual model. Rather than simply holding clients’ shares as collateral, Opes used sale and repurchase agreements to in effect acquire the shares. Many of Opes’ clients say they were unaware of this arrangement, which — now the firm is in receivership — has pushed big parcels of shares on to the market.

And according to The Australian newspaper on Friday, Opes built up its business by aggressively courting stockbrokers with high commissions to encourage their clients to give them business. Brokers with clients who held shares in small companies, particularly Perth-based mining companies, were also targeted, with the clients being offered loans to buy shares that conventional margin lenders would have refused to finance.

An extra twist is that Opes Prime also directly targeted directors of small companies, offering them the finance to keep buying more of their own shares, added The Australian quoting local broking sources. Lex moves on to the general scaremongering that has been going on in Australia over short-selling, which, it notes, is more nuanced.

In some ways, Australia takes a sterner line than other developed markets. It has retained the tick test, which bans short-selling at a lower price than the preceding sale. Only about a quarter of listed companies are approved for short-selling, so illiquid stocks are out of bounds. Short positions on the bulk of these represent less than 1 per cent of the relevant market capitalisation. Loose definitions of shorting allow substantial under-reporting and there are no alternative ways of tracking these positions.

Some 40-50 per cent of borrowed stock is believed to be used by short-sellers but custodians are not obliged to supply stock-lending data. Yet numbers put together by UK-based Spitalfields Advisors show that several casualties of the market turmoil showed higher than average levels of stock lending. Legislators drawing up new rules have plenty of scope to improve the situation. As ever, the trick will be not to bow to market panic and go a step too far.

Meanwhile, Crikey.com, the Australian news and commentary site, says the failure of the Opes Prime group and the daily disclosures of conflicts of interest, poor administration, indifferent regulation and the overriding air of collusive secrecy, is “enough justification for an inquiry into the Australian financial markets. An inquiry that should scour from top to bottom”.

---

Who could be bad guy in BCE buyout?

Who will play the villain if the BCE buyout fails? As the deadline draws near on the world's biggest leveraged buyout - look for the $35-billion cheque to be written some time in May - it's pretty clear who wants to wear the white hats.

Jim Leech, the newly-named CEO of the Ontario Teachers Pension Plan, is doing exactly what it takes to emerge a hero. He has remained solidly behind this buyout since closing the deal in late June. The Teachers fund is the very definition of patient money, so Mr. Leech can afford to stick by his guns. He isn't going to start his tenure at the top of a globally-relevant fund manager by reneging on a globally-watched deal.

The same can be said for Toronto-Dominion Bank boss Ed Clark, who is showing unflagging loyalty to a corporate client. He is reassuring the bank's shareholders that a $3.8-billion commitment to the BCE takeover is financially prudent.
At the same time, he's making it clear that if the all-essential loan package does fall apart, it wasn't due to TD's objections.
So who could wear the  black hat? Who might break ranks, and in doing so scupper the deal?

The key candidates are the two private equity funds partnered with BCE. The lenders are slightly less important because the deal is not conditional on financing - the buyers are supposed to follow through even if the banks walk. And let's be clear: This is all speculation. Outside of Teachers and TD, none of these players is talking.

Of the two other private equity funds allied with Teachers, make Madison Dearborn Partners the most likely to bolt. It's the smallest of the players, and the Chicago-based fund doesn't look to Canada for much of its deal flow. If potential financial losses are weighed against damage to reputation, here is where the scales favour walking out.

The other fund in the mix is Providence Equity Partners. It focuses on the media and telecom world, where BCE is a deal that everyone is talking about. So credibility is an issue. And there should be loyalty from this partner, as the $21-billion (U.S.) Providence fund has looked to Teachers as a backer since it was founded in 1989.

Besides TD, there are three other banks lending to BCE's prospective buyers. One of them, Royal Bank of Scotland, has minimal exposure to Canadian capital markets. If you were to pick the one bank that has the least to lose from breaking ranks, in terms of damage to reputation and lost opportunities, look to the lads from Scotland.

Citigroup is a substantial Canadian player, and is showing it can work through balance sheet issues. Deutsche Bank is in the same category. (However, one banking rival noted either bank will wipe out 10 years of Canadian profits the moment they mark-to-market losses on their planned BCE loans.) 

If the BCE buyout unravels, the phone company collects a $1-billion (Canadian) reverse break fee from the buying group, and one nasty blame game begins. And if the buyout doesn't close, for any reason, a stock that closed Thursday at $35.35, a stock that is the subject of a $42.75-a-share buyout offer, will drop like a rock to something in the $27 neighbourhood.

---