Debt Rattle, May 21 2008: Choose to believe

Dorothea Lange: Home Is Where the Tent Is
Willow Creek area, Malheur County, Oregon. October 1939
"The Fairbanks family has moved to three different places on the project in one year."

Ilargi: What can I say guys? Go through the list of liars and crooks below, from Bernanke to Ron Sandler and Gordon Brown, to Moody’s to Freddie Mac and so on. Then realize that none of these people are in jail, they are still out there playing with billions of dollars in funds that you will be forced to cough up down the line.

You have very little time left to get up stand up and do something about it. If they came to your home and started dragging out your tables and chairs and other belongings, wouldn’t you try to stop them, or call the police and expect them to help?

Well, what’s going on here will cost you much more than a few pieces of furniture. But you’re not doing anything. Can you explain to me why that is? Make no mistake, you’re well on your way to living in a place at least as desolate as the one you see in the photograph above.

If you choose to believe that I am wrong when I tell you these things, please explain that too. I don’t think I understand.


Freddie Mac Suffers Bout of Temporary Insanity

How long does the word "temporary" mean? The accountant who wants to stay employed knows the right answer: "How long do you want it to mean?" That new twist on an old joke goes a long way toward explaining Freddie Mac's net loss last quarter of $151 million, which was smaller than analysts' estimates. In reality, Freddie is gushing much more red ink than that. Yet hardly any of it is showing up on the company's income statement.

That's mainly because the government-chartered mortgage financier has deemed $32.4 billion of paper losses from mortgage- related securities as "temporary." Freddie's big sister, Fannie Mae, is in a similar, though less extreme, position with $9.3 billion of such losses. To ordinary folks, temporary means something of limited duration. Under the accounting rules, the word means almost nothing.

The designation means the losses don't have to be counted in Freddie's calculations of net income or capital, which is supposed to be the company's financial cushion against losses. Most of these losses are on securities backed by subprime mortgages. About $13.2 billion of them are on securities that have been valued below Freddie's cost for a year or longer. Some of the losses stretch back more than two years.

All this has occurred under the tolerant eyes of Freddie's feeble regulator, the Office of Federal Housing Enterprise Oversight. To put this in perspective, $32.4 billion is more than double Freddie's $16 billion of shareholder equity under generally accepted accounting principles. It's almost twice as much as the company's $17 billion stock-market value. And it's infinitely greater than the fair value of Freddie's net assets, which at March 31 was negative $5.2 billion.

Freddie can get away with this because it has hung the label "available for sale" on these investments. The rules say it still must reflect the losses on its balance sheet. Yet the for- sale label is an arbitrary one. Had Freddie classified the same holdings as "trading" securities, it would have been required to recognize the losses in its earnings and capital already. Instead, Freddie gets to wait until it decides the losses no longer are temporary.

At that point it would have to record a charge against net income. Freddie, based in McLean, Virginia, has never recorded such a charge to earnings on any of its subprime or "Alt-A" mortgage-related securities. (Alt-A loans also fall short of prime.) It strains credulity to posit that every one of these investments' values will rebound shortly, whatever that means, much less in their entirety.

Freddie's subprime and Alt-A portfolios were responsible for $28.1 billion, or 86 percent, of the company's total unrealized losses on available-for-sale securities at March 31. With a combined fair value of $114.8 billion, these holdings finished the first quarter 20 percent below their cost. Presumably, some of Freddie's securities had declined much more than that.

The Financial Accounting Standards Board's rules don't define the word temporary, and that is a big part of the problem. The Securities and Exchange Commission's staff has said that when a security's value has been below cost for more than six months, that is "a strong indication" the decline isn't temporary.

There is no hard-and-fast rule, though. Companies must consider the length of time and the severity of the drop in a security's value when deciding whether to record a charge. They also must have the intent and ability to hold the security for as long as they believe it will take for the investment to recover its value.

---

Ilargi: Even if this were a case of an honest mistake, and excuse me for seriously doubting that, any and all thin veneer of honesty vanished when Moody's "found out" some 15 months ago. They never said a thing. It takes a newspaper to point it out. That is enough to throw quite a few people in jail for quite a while. Think that will happen?

Moody’s error gave top ratings to debt products

Moody’s awarded incorrect triple-A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models, a Financial Times investigation has discovered.

Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.

News of the coding error comes as ratings agencies are under pressure from regulators and governments, who see failings in the rating of complex structured debt as an integral part of the financial crisis. While coding errors do occur there is no record of one being so significant.

Moody’s said it was “conducting a thorough review” of the rating of the constant proportion debt obligations – derivative instruments conceived at the height of the credit bubble that appeared to promise investors very high returns with little risk. Moody’s is also reviewing what disclosure of the error was made.

The products were designed for institutional investors. In the recent credit market turmoil, those who still hold the products will have suffered some paper losses while others who have bailed out have lost up to 60 per cent of their investment. On discovering the error early in 2007, Moody’s corrected the coding glitch and instituted methodology changes. One document seen by the FT says “the impact of our code issue after those improvements in the model is then reduced”.

The products remained triple A until January this year when, amid general market declines, they were downgraded several notches. In a statement to the FT, Moody’s said: “Moody’s regularly changes its analytical models and enhances its methodologies for a variety of reasons, including to reflect changing credit conditions and outlooks. In addition, Moody’s has adjusted its analytical models on the infrequent occasions that errors have been detected.

“However, it would be inconsistent with Moody’s analytical standards and company policies to change methodologies in an effort to mask errors. The integrity of our ratings and rating methodologies is extremely important to us, and we take seriously the questions raised about European CPDOs. We are therefore conducting a thorough review of this matter.”

Credit ratings are hugely important within the financial system because many investors – such as pension funds, insurance companies and banks – use them as a yardstick either to restrict the kinds of products they buy, or to decide how much capital they need to hold against them. The world’s other major credit agency, Standard and Poor’s, was the first to award triple A status to CPDOs but many investors require ratings from two agencies before they invest so the Moody’s involvement supplied that crucial second rating.

S&P stood by its ratings, saying: “Our model for rating CPDOs was developed independently and, like our other ratings models, was made widely available to the market. We continue to closely monitor the performance of these securities in light of the extreme volatility in CDS prices and may make further adjustments to our assumptions and rating opinions if we think that is appropriate.”

---

A rolling loan gathers no loss

On Monday two powerful senators agreed on a homeowner rescue package that will allow the Federal Housing Administration to back $300 billion in new loans for borrowers facing foreclosure. There is a similar bill working its way through the House of Representatives.

The idea is to offer relief to borrowers who face losing their homes but who normally don't have the good credit to qualify for government-backed loans. Lawmakers have been wringing their hands as they try to ensure that whatever rescue package they come up with doesn't reward nefarious speculators or bail out the lenders who failed to ask the appropriate questions. Most agree that with heavy lobbying from various corners of the financial markets, the bills will die.

"People are generally concerned that Congress will just make matters worse," said Bert Ely, a bank regulatory consultant in Alexandria, Va. "The country might be better off" to let the markets work through the problems. Ely and others say the bill--and other legislation--doesn't tackle the fundamental problem the credit crisis unveiled: misaligned incentives on Wall Street that work against socially desired outcomes.

One thing's for sure: The tension between what lawmakers want to do to prevent another credit crisis and what Wall Street wants is mounting. It was inevitable. Washington is trying to walk the fine line between helping struggling consumers in an election year and bailing out wealthy Wall Street bankers, who are potential campaign donors.

At the same time, bankers publicly embrace the idea of reform but chafe at the idea of more regulation that will stifle innovation (which on Wall Street is the more artful term for "making money"). In a speech in April, Greenlight Capital's David Einhorn, one of the more aggressive activist investors, said these misaligned incentives helped Wall Street outmaneuver the regulators.

"With no one watching, the managements of the investment banks did exactly what they were incentivized to do: maximize employee compensation," he said. Wall Street's originate-to-distribute model, designed to mitigate risk by spreading it around a vast array of parties, actually exacerbated those risks. First, it encouraged banks to loosen lending standards because more loan volume meant higher profits. Then it led to over-leveraging, and finally it led to complacency.

Wall Street created an endless stream of paper to trade based on the false assumption that housing prices would always rise.
The first wave of the crisis affected trading books, but the second wave will hit lending. This is because consumers got accustomed to the same "a rolling loan gathers no loss" mentality, said Oppenheimer & Co. analyst Meredith Whitney. As long as housing values continued to rise, borrowers could refinance in perpetuity to avoid default.

Losses mounted when that refinancing spigot got shut off. "A result of poor risk management at some financial institutions was that the spreading of risk, one of the purported benefits of the originate-to-distribute model, proved to be much less extensive than many believed," said Federal Reserve Chairman Ben Bernanke, in a speech earlier this month. Worse, banks began to rely too much on the securitization markets to boost lending to consumers, particularly in the form of mortgages.

Eventually, some lending will return, but the dizzying revenues from the last four years will be hard to reclaim, Whitney said in a research note released late Monday. The banking sector's pullback in lending, in part because the securitization market just isn't what it used to be, will cause further painful losses. Already, Whitney estimates, banks will have to reserve an additional $170 billion through the end of next year, just to keep up with estimated loan losses.

Banks will rein in lending in return, to the tune of $2 trillion worth of available credit lines. "New and unforeseen strains on consumer liquidity will push more consumers into precarious credit positions and cause consumer credit losses to be far worse than what is currently estimated, even by the most draconian of investors," Whitney said.

Nothing Washington has proposed can stop that, nor can it prevent a damaging crisis from happening again. "The animal spirits will still rule the markets," Ely said.

---

Ilargi: Well England, there you have it. Ron Sandler, put in charge of Northern Rock by Gordon Brown personally, is a two-bit crook who lies to your face. Gordon Brown is not a hair better. He’s known all of this for a long time.

Sandler claims: "We are operating in extremely hard to predict economic circumstances," and goes on to say that a mere 5% drop in home prices will mean that you will not get YOUR money back that was handed out to save the Rock.

Do you believe that when the Rock nationalization scheme was set up last year, nobody at the table took into account the possibility of even a 5% drop in home prices? Do you believe that? No precaution whatsoever in a $100+ billion deal? If you don’t, beware; that is precisely what Sandler is saying.

No-one could have foreseen a 5% drop? That is a blatant lie, Brits, and you are paying for it. They all knew, and still closed the deal, at your expense. Tell me, what are you planning to do about it?

Yesterday I said US home prices will fall 80%. Even if they plunge less in the UK, and I doubt that, it won’t be by more than 10%. So prepare for your housing prices to come down by at least 70%. Sell while you still can. You can choose to ignore my warning, of course. But can you afford to let the crooks and liars define and execute financial policy, which involves your money and your children's? I say you can’t, it will cost you all dearly. It already does.

House price falls threaten Northern Rock loan repayments

Falls in house prices of as little as 5 per cent a year could put a strain on Northern Rock's plan to pay back the Bank of England's loans and shed its Government guarantees, the nat-ionalised lender's management said yesterday.

Ron Sandler, the bank's executive chairman, told the Commons Treasury Select Com-mittee: "If things were to remain as they are, I'm confident the plan can be delivered." House price falls of 5, 10 or 15 per cent "would put a great deal of stress on our ability to deliver the plan", he added.

Ann Godbehere, the finance director, told MPs a recession similar to that of the early 1990s, with a 10 per cent fall in house prices this year and next, would force a six-month delay for repayment of the Bank of England's £24bn loan and would require the Government's guarantees of deposits to remain for longer.

Mr Sandler said the plan to repay the Bank of England money, which supports the bank's loan book, depends partly on the ability of Rock customers to find mortgages elsewhere when their initial rates end. The best customers will find it easier to get deals elsewhere, raising the prospect of the lender being left with riskier customers in a process of "adverse selection", Mr Sandler said.

"We are operating in extremely hard to predict economic circumstances," he added. The bank will review its plan in the third quarter of this year to check "whether or not it remains robust in the world as we see it". Despite the risks involved, Mr Sandler and Ms Godbehere said their plan was "robust" and that they expected to repay 25 per cent of the central bank's loans this year, 75 per cent by the end of 2009 and the rest in 2010.

A key element of the plan is to raise retail deposits to replace the wholesale funding that Northern Rock relied on too heavily before it nearly crashed in September. Mr Sandler said the bank would consider increasing its 76-branch network if European state aid rules did not place such big constraints on expansion.

Mr Sandler said Northern Rock's brand had been damaged but that he had decided to keep it. It is in Northern Rock's commercial interest to keep its sponsorship of Newcastle United and the Newcastle Falcons, he added

---

Are Pension Funds Fueling High Oil?

A Senate hearing weighs charges that speculation by big investors and sovereign wealth funds is behind the rise in commodities and energy prices.

If you're wondering why driving to work has gotten so expensive, you might want to peruse your pension fund's investments. That's because speculation by institutional investors pouring money into the commodities market may be largely to blame for spiking oil prices, according to testimony on May 20 before the Senate Committee on Homeland Security & Governmental Affairs.

Crude oil, a so-called hard asset, is viewed as a buffer against inflation -- a foe of longer-term investment returns. At the hearing, "Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation?," senators heard from those defending the role of speculators in oil and commodities markets as well as those who argue that excessive speculation is the root of global price surges.

"[Commodities] are experiencing demand shock from a new category of speculators: institutional investors like corporate and government pension funds, university endowments, and sovereign wealth funds," said Michael Masters, managing member of Masters Capital Management, a Virgin Islands-based hedge fund. "Index speculators are the primary cause of the recent price spikes in commodities."

On May 20, crude oil prices settled at a record $129.07 on the New York Mercantile Exchange after touching a new high of $129.60. The national average for a gallon of gasoline hit a record of $3.80 per gallon the same day. The explosion in the number of financial players in the energy markets has occurred particularly in the past two years -- also a period of soaring energy prices. That's why speculators are now under fire from Congress and the public as potential culprits.

But in the hearing, Masters distinguished between traditional speculators and what he calls index speculators, or passive investors who enter the commodities markets as a long-term hedge against inflation. Commodities exchanges limit the number of positions an investor can take in the market, but Masters says the Commodity Futures Trading Commission has allowed unlimited speculation in these markets through a loophole.

This so-called swaps loophole exempts investment banks like Goldman Sachs and Merrill Lynch from reporting requirements and limits on trading positions that are required of other investors. The loophole allows pension funds to enter into a swap agreement with an investment bank, which can then trade unlimited numbers of the contracts in futures markets.

Some experts fault the CFTC, charged with regulating commodities markets, for allowing such loopholes. "Congress has provided the CFTC the power to control this unlimited [speculation]; the law is very specific about establishing position limits," says Steve Briese, author of The Commitments of Traders Bible and CommitmentsOfTraders.org, a site that focuses on US futures markets.

"The problem is they have abdicated this role." The dramatic surge in energy prices has helped to spark inflation across the economy and, as others at the hearing testified, has cut into profits of most in the supply chain. Briese points to Treasury reports that the top five users of swap agreements are investment banks, four of which dominate swap dealing in commodities and commodities futures: Bank of America, Citigroup, JPMorgan Chase, HSBC North America Holdings, and Wachovia.

Speculative activity in commodity markets has grown dramatically over the last several years. In the past decade, the share of long interests -- positions that benefit when prices rise -- held by financial speculators has grown from one-quarter to two-thirds of the commodity market. In only five years, from 2003 to 2008, investment in index funds tied to commodities has grown twentyfold, from $13 billion to $260 billion.

---

Windup Wednesday

Tuesday we discover that Moody's made a, uh, "mistake" in their computer software that erroneously rated certain synthetic debt obligations (CPDOs), causing "AAA" ratings to be applied when they should have been four notches lower. This apparently was discovered internally at Moody's in early 2007, but do you remember any public announcement of this error, any mass-rerating of these securities, or any, uh, compensation to those who were screwed?

I don't seem to recall that disclosure, do you? Gee, you don't think that perhaps investors, the public, and oh my gosh, the buyers who overpaid for these CPDOs had a right to know that there had been an error made, do you? I mean its one thing to make a mistake, but its quite another to cover it up! Cough-Watergate-cough.

Never mind that the curtain appears to be slowly drawing back on The Great Wizard of Oz, otherwise known as the government's scam in how it computes and publishes numbers of all sorts related to our economy. We're now seeing mainstream media articles on silly little inconvenient facts like:

• Intentional understatement of price inflation....
  
• Which leads to overstating GDP....
  
• And screwing Granny in her COLA adjustment on Social Security....
  
• And convincing people that unemployment is low (which it is not)....
  
• And enticing people to buy government bonds (T-bills) at a negative rate of return....
  
• While intentionally throwing hundred of billions of excess liquidity into the banking system so that your "best buddies" don't have to fess up to their losses which....
  
• Empowers Wall Street to blow bubble after bubble, while offloading their trash and costs into pension funds and ordinary people's pockets so we will all eat it while at the same time they pocket billions in fees and bonuses.

Never mind the cover up of all of this, where the lies just keep getting bigger and bigger as the compounding of fraud and theft snowballs just like 30% interest on a subprime credit card. And before you go lambaste Republicans for this, stop right where you are. Democrats are just as guilty.

Did you hear either political party go after Bernanke on The Hill after Bear Stearns was "bailed out"? On price inflation over the last few years? On his and Greenspan's insane "monetary policy" which amounted to intentional and willful blindness to fraud throughout the financial system, offloading the costs onto all of us? Oh hell no. As long as they can pretend there's a Maestro behind the curtain, the show will go on. Or will it?

In other astounding news we had hearings in the Senate Tuesday in which it was claimed that "speculators are driving a commodity bubble."

"Benn Steil, director of international economics with the Council on Foreign Relations, testified that the value of commodity index investments has grown by about one-third since the beginning of the year to more than $250 billion.
"The sharp recent rises in global commodities prices, particularly in the energy and agricultural sectors, is undoubtedly causing hardship for many Americans, and is indeed threatening the health of many millions in developing countries."

That's a very curious number, $250 billion. It all seems to have shown up out of nowhere, like Dorothy in The Wizard Of Oz, starting right about last August. How'd that happen, one must wonder?

Oh, don't look behind that curtain over there! Why if you do that you'll find one Doctor Ben Bernanke pulling levers to fiddle with the slosh in the banking system, intentionally tamping down interest rates and taking trash collateral in exchange for his pristine Treasuries and cold, hard cash so his buddies don't have to recognize their losses.....

Oddly enough, the amount of money that he's been tossing around, the excess liquidity that he has allocated to this nefarious purpose is....... about $250 billion dollars. Oh my. I think we figured out where the problem came from.

---

Euro Strengthens as Ifo Says German Business Confidence Rose

The euro rose one cent against the dollar and climbed to the highest in three weeks versus the U.K. pound after German business confidence unexpectedly increased. The euro also gained versus the Japanese yen after the Munich-based Ifo institute said its business-climate index rose in May.

The yen advanced to the highest in more than a week against the dollar as a decline in European and Asian stocks prompted investors to pare holdings of higher-yielding assets funded in the Japanese currency. The Australian dollar rose to a 24-year high against the U.S. currency.

"Ifo obviously shows the German economy is very resilient and is in a much better position than the rest of the world," said Derek Halpenny, head of global currency research at Bank of Tokyo-Mitsubishi UFJ Ltd. in London. "The euro will appreciate again and start hitting new all-time highs on the back of the resilience of the German economy."

The ECB shelved a planned interest-rate increase last year to assess the economic impact of the credit squeeze. It has left the benchmark rate at a 6 1/2-year high of 4 percent since June. ECB President Jean-Claude Trichet said last month there is "strong short-term upward pressure on inflation' and the economy has "sound" fundamentals.

---

Ilargi: My take: Citi needs at least $1 billion to stave off expensive litigation they can’t win.

Citi offers $250m to hedge fund investors

Citigroup is coming under pressure to bail out investors in one of its troubled hedge funds, in another embarrassment for a company already among the biggest losers from the credit crisis. The company has begun quietly asking private clients to accept a $250m compensation package, in return for dropping legal claims against the company.

Banks which have sunk an estimated $1.6bn into the fund are also examining their legal options. The problems stem from Citigroup's Falcon Strategies hedge fund, an investment vehicle that traded mortgage bonds, government debt and a range of credit derivatives, which began experiencing big losses when the credit markets ran into difficulties last summer.

Thousands of Citigroup clients – advised to invest in the fund by brokers at its Smith Barney wealth management division – face being wiped out. And three big regional banks, including Wachovia, one of the largest in the US, have also been forced to write off large parts of their investments, after putting some internal life insurance money into Falcon.

Wachovia posted a $315m loss on life insurance assets, largely as a result of its $1bn exposure to Falcon. Fifth Third of Cincinnati is suing the investment advisers which suggested it sink $612m into Falcon and which, it alleges, failed to pull the money back out again when the first signs of trouble emerged.

Citigroup is not involved in Fifth Third's lawsuit but it does face a class action from private clients. The action is being led by Robert Zeff, a Smith Barney client in Florida, who put $500,000 into the Falcon fund. He says the fund was marketed to clients as "an extremely low-risk investment".

---

UBS $100 Billion Wager Prompted $24 Billion Loss in Nine Months

The annual shareholders meeting of UBS AG used to be a time for Chairman Marcel Ospel to gloat over his accomplishments. Shareholders would praise Ospel for turning a slow-growing, insular Swiss bank into a global financial powerhouse, with a stock price that rose 115 percent from January 1999 to January 2007.

Just last year, Ospel bragged to shareholders about how the bank's record profit was the result of its "smart expansion strategy." At UBS's most recent annual meeting in April, shareholders cheered Ospel again. This time, though, it was when he announced his resignation. Ospel, 58, wearing a navy blue suit and bright yellow tie, didn't flinch. Glasses resting on the end of his nose, he made a lengthy speech comparing himself to the captain of a ship emerging from a storm.

Shareholders responded that it was the chairman himself who had steered the bank into choppy waters. "Ospel is responsible for this malaise," Gerhard Meier, a shareholder for 30 years, told investors at the meeting. In the nine months ended on March 31, UBS lost 25.4 billion Swiss francs ($24.3 billion), more than any other bank caught in the worldwide credit crunch.

Shareholders say Ospel and his fellow managers took a profitable Swiss bank and wrecked it on the shoals of structured finance and subprime mortgages. "He built up enormous risks, which were damaging the whole organization," says Herbert Braendli, president of Profond, a Swiss pension fund that has been selling down its holding of about 2.3 million UBS shares because it's unhappy with the bank's management. "He intentionally pushed it with his expansion goals."

As Ospel exited, he took with him his ambition, which he articulated in 2004, to make UBS the No. 1 investment bank in the world -- a ranking it already held in wealth management. Under Ospel's watch, the bank sank more than $100 billion into U.S. asset-backed securities.

As of the end of March, those investments had resulted in $38 billion in writedowns of UBS assets. The bank agreed to sell $15 billion of its distressed securities to a newly created fund managed by BlackRock Inc., the U.S. money manager founded by Laurence Fink. "We were shocked when all this stuff came to light," says Henry Herrmann, CEO of Overland Park, Kansas-based Waddell & Reed Financial Inc., which manages $66 billion.

"UBS was the one we perceived in a better light than the others. Like others, it didn't fully appreciate the magnitude of the debt buildup." The bad news didn't end there. Also in May, UBS said it would slash 5,500 jobs by the middle of next year, including 2,600 immediately at the investment bank. UBS will sell or close its New York-based municipal bond department, which employs about 300 people

---

60,000 UK second homes to be sold off in next 2 years

Demand for second homes in Britain will "plummet" over the next two years as up to 25% of those with more than one property sell up in response to falling property prices, according to a report out today. A study by Capital Economics, a forecasting and consultancy group, said almost 60,000 homes could be placed on the market in England alone, adding to the downward pressure on prices.

The south west would be hardest hit with the Midlands the least affected part of the country. Seema Shah, the author of the report, said rising house prices over the past decade had acted as an incentive to buy a second home but with house prices now falling this trend was about to go into reverse.

"Now that the housing market correction is underway, expectations of house price growth have deteriorated significantly and the incentives to own a second home will fade. We could plausibly see a 25% decline in second home ownership over the next two years." Shah added that the downward pressure on prices would be greatest in those regions where properties were less likely to be bought as a main residence because ownership was more sensitive to the future course of prices.

Capital believes that across the UK as a whole house prices will fall by 20% by the end of 2009. "The south west, with the highest concentration of second homes and with many of them located in coastal towns where demand for a primary residence is weaker, is likely to feel the greatest impact. London and the south east, where a signficant share of second homes are for work purposes and therefore less sensitive to house price falls, may fare better than other regions."

The report said that second ownership was strongly linked to movements in house prices, with an 18% jump in ownership during the boom of the late 1980s followed by a 25% slump during the crash of the early 1990s. Second home ownership has risen by 20% in the past 14 years, during which time house prices have almost tripled. Over the past year, however, the market has cooled rapidly with both the Halifax and the Nationwide house prices surveys showing annual falls in their most recent snapshots of the trend.

Shah said that there were 240,000 second homes in England, of which 40% were bought as investments and a further 40% as a holiday or retirement home. She estimated that 57,600 could be put on the market in the next two years, adding between 4-6% to the supply of homes. "It is extremely difficult to gauge how much of an effect this would have on prices", she said. "But given that conditions in the market look like being pretty dire, the effect of an extra supply could be substantial."

---

Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults

It's Friday, March 14, and hedge fund adviser Tim Backshall is trying to stave off panic. Backshall sits in the Walnut Creek, California, office of his firm, Credit Derivatives Research LLC, at a U-shaped desk dominated by five computer monitors.

Bear Stearns Cos. shares have plunged 50 percent since trading began today, and his fund manager clients, some of whom have their cash and other accounts at Bear, worry that the bank is on the verge of bankruptcy. They're unsure whether they should protect their assets by purchasing credit-default swaps, a type of insurance that's supposed to pay them face value if Bear's debt goes under.

Backshall, 37, tells them there are two rubs: The price of the swaps is skyrocketing by the minute, and the banks selling the insurance are also at risk of collapsing. If Bear goes down, he tells them, it may take other banks with it. "There's always the danger the bank selling you the protection on Bear will fail," Backshall says. If that were to happen, his clients could spend millions of dollars for worthless insurance.

Investors can't tell whether the people selling the swaps - - known as counterparties -- have the money to honor their promises, Backshall says between phone calls. "It's clearly a combination of absolute fear and investors really not knowing," he says.

On this day, a CDS-market meltdown doesn't happen. In a frenzy of weekend activity, the Federal Reserve and JPMorgan Chase & Co. rescue Bear Stearns from bankruptcy -- removing the need for the sellers of credit-default protection to pay up on their contracts.

Backshall and his clients aren't the only ones spooked by the prospect of a CDS catastrophe. Billionaire investor George Soros says a chain reaction of failures in the swaps market could trigger the next global financial crisis. CDSs, which were devised by J.P. Morgan & Co. bankers in the early 1990s to hedge their loan risks, now constitute a sprawling, rapidly growing market that includes contracts protecting $62 trillion in debt.

The market is unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb. "It is a Damocles sword waiting to fall," says Soros. "To allow a market of that size to develop without regulatory supervision is really unacceptable."

---

Ilargi: I was going to let Kevin Phillips’ Harper’s article rest, because it was first published back in April; but it’s picking up web steam, so here it is. Do read the whole piece.

Hard numbers: The economy is worse than you know

Ever since the 1960s, Washington has gulled its citizens and creditors by debasing official statistics, the vital instruments with which the vigor and muscle of the American economy are measured.

The effect has been to create a false sense of economic achievement and rectitude, allowing us to maintain artificially low interest rates, massive government borrowing, and a dangerous reliance on mortgage and financial debt even as real economic growth has been slower than claimed. The corruption has tainted the very measures that most shape public perception of the economy:

• The monthly Consumer Price Index (CPI), which serves as the chief bellwether of inflation;
  
• The quarterly Gross Domestic Product (GDP), which tracks the U.S. economy's overall growth;
  
• The monthly unemployment figure, which for the general public is perhaps the most vivid indicator of economic health or infirmity.

Not only do governments, businesses and individuals use these yardsticks in their decisionmaking, but minor revisions in the data can mean major changes in household circumstances — inflation measurements help determine interest rates, federal interest payments on the national debt, and cost-of-living increases for wages, pensions and Social Security benefits.


The real numbers, to most economically minded Americans, would be a face full of cold water. Based on the criteria in place a quarter century ago, today's U.S. unemployment rate is somewhere between 9 percent and 12 percent; the inflation rate is as high as 7 or even 10 percent; economic growth since the recession of 2001 has been mediocre, despite a huge surge in the wealth and incomes of the superrich, and we are falling back into recession.

If what we have been sold in recent years has been delusional "Pollyanna Creep," what we really need today is a picture of our economy ex-distortion. For what it would reveal is a nation in deep difficulty not just domestically but globally. Undermeasurement of inflation, in particular, hangs over our heads like a guillotine.

To acknowledge it would send interest rates climbing, and thereby would endanger the viability of the massive buildup of public and private debt (from less than $11-trillion in 1987 to $49-trillion last year) that props up the American economy. Moreover, the rising cost of pensions, benefits, borrowing, and interest payments — all indexed or related to inflation — could join with the cost of financial bailouts to overwhelm the federal budget.

Arguably, the unraveling has already begun. As Robert Hardaway, a University of Denver professor, pointed out last fall, the subprime lending crisis "can be directly traced back to the (1983) BLS decision to exclude the price of housing from the CPI. … With the illusion of low inflation inducing lenders to offer 6 percent loans, not only has speculation run rampant on the expectations of ever-rising home prices, but home buyers by the millions have been tricked into buying homes even though they only qualified for the teaser rates."

Were mainstream interest rates to jump into the 7 to 9 percent range — which could happen if inflation were to spur new concern — both Washington and Wall Street would be walking in quicksand. The make-believe economy of the past two decades, with its asset bubbles, massive borrowing, and rampant data distortion, would be in serious jeopardy.

The credit markets are fearful, and the financial markets are nervous. If gloom continues, our humbugged nation may truly regret losing sight of history, risk and common sense.

---

Europe, US Battle Swiss Bank Secrecy

After fighting Switzerland's banking secrecy laws for decades, European finance ministers are about to receive support from the United States. Investigations into major Swiss bank UBS and a proposed law against tax havens are ratcheting up pressure against the system.

Martin Liechti, a senior executive with the private banking division of major Swiss bank UBS, worked through his business appointments in New York with his usual efficiency. A subsequent trip to the Bahamas for a meeting in late April was also pure routine. In the Caribbean paradise, Liechti was scheduled to attend a supervisory board meeting of UBS (Bahamas) Ltd., and to take a closer look at the options for doing business with America's super-rich, including parking their money in Swiss trust accounts.

But Liechti, a man known for his abrasive manner, never arrived in the Bahamas. US officials abruptly ended his trip when he was about to change planes in Miami. Since then, Liechti has been barred from leaving the country because the American authorities are investigating his employer for allegedly helping clients to evade taxes.

Liechti's former colleague Bradley Birkenfeld, as well as Mario Staggl, an executive with a trust company in Liechtenstein, are under indictment for allegedly helping American billionaire Igor Olenicoff evade taxes. According to the indictment, a fortune of about $200 million (€129 million) was sheltered from tax authorities "in secret bank accounts in Switzerland and Liechtenstein."

Prosecutors allege that Staggl's attorney in Gibraltar even helped Olenicoff hide the details of his ownership of a "147-foot yacht." The accused are alleged to have forged special forms that Swiss banks use to report their US customers' capital gains to the US tax authority, the Internal Revenue Service (IRS). Both Birkenfeld and Staggl have declined to comment on the charges.

"UBS is walking a thin line. On the one hand, it has to show a willingness to cooperate. On the other, it is trying to protect its customers' banking secrets," says Robert Heim, an attorney in New York and a former investigator with the US Securities and Exchange Commission.

"The Justice Department will urge the two to cooperate," says Heim. "The more information they provide, the less severe their penalties will be." He expects that their testimony will soon lead to further indictments and arrests. "This is a very bad development for UBS," says Heim.

According to Heim, the United States is by no means the only place where Swiss high finance and the country's banking secrecy laws are coming under growing pressure. Foreign authorities around the globe are increasingly taking sharper action against tax evaders. Swiss financial institutions, often in tandem with partners in Liechtenstein, play a central role in helping the ultra-rich avoid paying billions in taxes.

An almost unimaginable fortune of more than €3 trillion ($4.7 trillion) is currently sitting in Swiss bank accounts. The discreet Swiss allow vast amounts of money to disappear into trusts, offshore companies and bank accounts, money that is often protected by Switzerland's banking secrecy laws.

---

As oil soars, Japan's plan makes sense

By rights, the Japanese should be panicking. Their rocky island home is all but carbon-free, so it has to import its fossil fuels. When oil prices spiked before, in the 1970s, the country experienced an “oil shock” that temporarily crippled the economy and sent nervous consumers rushing to the market for essentials.

That isn't happening this time, even with oil prices hitting new highs close to $130 (U.S.) a barrel yesterday. Part of the reason is Japan's remarkable success at reducing its dependence on oil. At a time when other major economies are slurping oil at a record pace, Japan has actually reduced its imports to around 4.12 million barrels a day in 2007 from five million in 1973.

Increased energy efficiency is saving Japan about $140-billion a year, calculates Robert Feldman, the managing director of Morgan Stanley in Japan. Japan's consumption of oil per unit of GDP has fallen to one-third of its 1973 level. Japan certainly looks good against other major economies. The U.S., the world's biggest net importer of oil, brings in about 13 million barrels a day, up from about six million in 1973. China, the third largest importer, just behind Japan, has seen imports grow to 7.8 million barrels a day as of last year, up from 4.2 million in 1997, a rise of 86 per cent.

How has Japan done it? Necessity, as ever, has been the mother of invention. Unlike China, which has plentiful supplies of coal, and the United States, which has lots of coal and enough oil to supply a good part of its own needs, Japan relies almost completely on foreign sources for its oil, coal and natural gas. Some of the answers have come from developing nuclear energy and new technologies, while old-fashioned conservation has also played a role.

A shortage of oil to run its military machine was one motive behind Japan's attack on the Western powers in East Asia in the Second World War. An oil embargo was choking off the supplies needed to maintain and expand its Asian imperial conquests. Japan was reminded anew of its dependence on foreign energy when the Arab oil embargo of 1973 sent prices soaring, making Japan's economy shrink for the first time since the end of the war.

Japan came to realize that its economic life hung on a slender, 12,000-kilometre thread – the distance tankers had to travel from the oil fields of the Middle East to Japanese ports. Thus began a three-decade-long national effort to become less reliant on oil. Despite the public's extreme sensitivity about nuclear energy after the trauma of Hiroshima and Nagasaki, the government invested heavily in nuclear, building a network that today includes 55 reactors and generates 30 per cent of its electricity and 11 per cent of total energy requirements.

That makes Japan the third-largest producer of nuclear energy after the United States and France. Japan also shifted away from oil to natural gas, which is available from less distant and more reliable suppliers such as Brunei and Indonesia. Natural gas provides about 15 per cent of Japan's energy needs, up from 2.7 per cent in 1975. Oil provides about 46 per cent, down from 71 per cent. Coal accounts for about 22 per cent, up from 18 per cent, and other sources provide the remainder.

---

The banks don't want to dance

Charles Prince, the deposed chief executive of Citigroup, will live in infamy as the author of the single stupidest remark any banker could have made about the credit bubble.

Remember this? “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing.” Translation: as long as there are big deals to be done, Citi will finance them, even if the credit party's spinning out of control and the terms make no sense.

Guess what: The music was still playing at full volume when Citi and three other banks decided to back the leveraged buyout of BCE. They danced. They drank too much. They went home too late. Now they regret it. It shouldn't be a surprise that they should try every tactic in the book to try to turn back time and mitigate the consequences of their behaviour. That doesn't mean they'll succeed, however.

We can't know precisely what's in the bankers' heads, or what they think they can extract from the Ontario Teachers' Pension Plan and the rest of the private-equity group that agreed to buy BCE for $35-billion last June. What we do have are a couple of documents: the sale agreement between the Teachers group and BCE, and the credit letter signed by the banks on June 29 last year.

In the former, let's focus on one clause: Teachers' deal is not – repeat, not – conditional on financing. On closing day, if the banks don't show, the private equity firms are still required to step up, and don't forget your chequebook, gentlemen. Teachers' pockets are deep, but they're not so deep that they'd want to contemplate taking on such a massive liability. (Nor is the prospect of paying $587-million – their portion of the break fee for walking away – an attractive one.

Why accept a loss of that size if you still believe, as Teachers' boss Jim Leech does, that BCE remains a good medium-term investment?) The only rational reason for Teachers to sign a deal without a financing clause is the same reason you might offer to buy a house that way: because they've got a piece of paper that says the banks will fund it. A contract, in other words. The one between the banks and the Teachers group is called a “commitment letter” – emphasis on the first word.

Here's what it says, on page three: “[N]either the commencement nor completion of the syndication of the credit facilities shall constitute a condition precedent to the closing date.” In plain English, it doesn't matter if the banks can't sell the loans for more than 90 cents on the dollar. It doesn't matter if they can't sell them at all. That's their problem, not Teachers'. “It's a very good commitment letter [for the buyers],” says one investor who specializes in analyzing credit and has seen the document.

So what's the game for the banks? The deal always allowed some flexibility for the banks and the buyers to negotiate on interest rates and covenants. The banks want to tilt these in their favour as much as they can, naturally. But they lack the leverage to demand a wholesale renegotiation.

As for the price: many links have been drawn between this deal and the repriced buyout of Clear Channel Communications, the U.S. media outfit, because three of the same banks were involved. But there are major differences, too. The Clear Channel buyout was always a higher-risk endeavour. The debt was higher – about 9 times EBITDA, according to National Bank Financial, versus 6 times EBITDA in BCE. (EBITDA is earnings before interest, taxes, depreciation and amortization.)

Clear Channel's U.S. advertising business is more vulnerable to recession than a Canadian phone company. The structure's different, too. Clear Channel shareholders can carry on (to a limited extent) as owners in the privatized company; it's in their interest to see that it stays solvent. (Highfields Capital Management, the largest Clear Channel shareholder, plans to keep a stake of up to $400-million and was quick to sign on to the renegotiated deal.)

At BCE, the dynamics are not the same. It's all cash. An industry buyer, Telus, awaits if the price falls too low. BCE shareholders want the deal. Teachers says (over and over) that it wants the deal. The banks definitely don't want the deal, but they don't have much choice. It's their own fault. They danced while the music played on and on.

---

Debt details snag BCE buyout

The fight to close the $35-billion purchase of BCE Inc. is zeroing in on concessions the buyers can make to their banks on interest rates and other loan terms, with a price cut a last resort.

The Ontario Teachers' Pension Plan and its partners in the planned acquisition are likely to retreat on loan terms known as covenants and potentially on interest rates for the $34-billion of loans needed for the deal, before giving any ground to banks that are demanding a price reduction to cut the amount they need to lend.

When Teachers and its buyout consortium negotiated the deal to acquire BCE for $42.75 a share at the height of the buyout boom last summer, the intention was always to leave room to give the lending banks breaks. The buyers wanted a fallback position in case negotiations with the banks became rocky.

"They planned on giving them [banks] some minor relief as it relates to some of the covenants, but nothing more than that," said one person familiar with the takeover talks. Covenants are pledges borrowers make that give lenders some control over how the firm is run. During the buyout heyday that culminated with the BCE deal, banks were competing so hard to lend that they stopped asking for covenants.

But now those loans are a millstone for the banks that promised them, because investors won't buy them and banks are stuck holding the debt. Investors aren't so sure that Teachers will be able to hold that line. BCE shares were hammered yesterday in Toronto, dropping 3.7 per cent to $37.40 on concern that the banks may force a price cut.

Talks between Teachers and the banks backing the deal, a group led by Citigroup Inc., heated up over the weekend as the lenders fought for better terms that reflect the popping of the credit bubble. The banks, which also include Deutsche Bank AG, Royal Bank of Scotland and Toronto-Dominion Bank, are pushing for more favourable interest rates and a lower price, though at no time did they threaten to walk away, sources said.

Cutting the price is tough because BCE may fight back in court, and because reducing the amount of borrowed money cuts the buyers' returns. In addition to tightening loan terms, recent moves in interest rates provide room for Teachers and its buying group, which includes Providence Equity Partners LLC, Madison Dearborn Partners and an arm of Merrill Lynch & Co.

The interest rate on the BCE debt is based on a floating rate that has plunged in recent months, giving room to offer better rates to the banks while still preserving the deal's economics. There is also almost $500-million of cash that's built up at BCE after the company cut back on capital spending and deferred a dividend, money the buyers could pledge for debt paydown.

As a result, there's a 75-per-cent chance that the deal closes at $42.75 but with "significantly improved" covenants, Scotia Capital merger analyst Catharine Sterritt said in a note to clients yesterday. There's a 15-per-cent chance of a price cut to $40.50 and a 10-per-cent chance that the deal falls apart, she said.

"The risk of repricing has gone up (because conversations have begun) but we think the probability still favours that price won't get changed given BCE's strong negotiating position and the commitment it has demonstrated in the past to look out for its large retail shareholder base," Ms. Sterritt wrote.

---