Debt Rattle, May 24 2008: Starting Over

Dorothea Lange: Starting Over, December 1935
"Resettled farm child. From Taos Junction to Bosque Farms project, New Mexico."

Ilargi: America, the land where people can no longer afford to pay for the gas they need to drive to the jobs they work to pay for the homes they can no longer afford.

When I started reading this morning, I expected a quiet day’s work. Long weekend, nice weather out there, things like that. But I was wrong.

Today’s Debt Rattle, in my view, turned into one of the scariest I have posted to date. I don’t really know why, it just happened. And for me it lent a deeply cynical connotation to the title Dorothea Lange gave her photograph above.

The picture gets both bleaker and darker so fast now that a purely rational approach is no longer sufficient. There are times when we must feel reality in order to understand it, a notion epitomized for instance in this quote from CNN earlier this week:

”There are 12 parking lots across Santa Barbara that have been set up to accommodate the growing middle-class homelessness."

That I can feel. That is the new reality. And that is the new meaning of "Starting over".


The Housing Wipeout: The Next Leg

We learned [Thursday] that U.S. home prices posted their sharpest first-quarter decline since the government began tracking the data 17 years ago. The Washington-based Office of Federal Housing Enterprise Oversight said Thursday that home prices fell 3.1 percent in the first quarter compared with last year. The index also fell 1.7 percent from the fourth quarter of 2007 to the first quarter of 2008, the largest quarterly price drop on record.

One of the more brilliant innovations in the mortgage industry in the last four years -- the option ARM -- allowed homeowners to pick their payment each month for a few years. As the borrower, you decide how much to pay each month… bare minimum, interest only or -- gasp -- interest plus part of the principal. Great while you get to choose. But when the option expires, the bank resets your [budget] with a hefty fixed rate. 


That second wave of adjustable-mortgage resets won’t even begin until next year. And as you can see from the chart, the quantity dwarfs the amount that caused Wall Street, the Fed and Congress to vomit in unison already this year. The Prime Mortgages can include the ARMs, and there were many, many ARMS originated between 2002 and 2006 that are hanging on the edge of the "reset precipice".

Then in the next 3 years the many option ARMS and "Alt-A" ARMs (Alt-A loans are the no document "liar loans" that were originated by the millions during the housing and mortgage bubble). These resets and expired, low interest rate Alt-A ARMs will peak in 2012...oh my God, 2012! 

This indicates that we have at least 3 more years of the mortgage meltdown and the housing wipeout to deal with and that is not a promising indicator of the health of the US, British, and Canadian economies in the the foreseeable future. "“The credit crisis will extend well into 2009,” opines Oppenheimer analyst Meredith Whitney, “and perhaps beyond.”

Whitney became somewhat of a contrarian demigod last year when she brazenly forecast Citigroup’s massive write-downs before the crisis dominated headlines. Her report yesterday had “investors” racing for the exits. "Multitrillion dollars of loans were underwritten,” writes Whitney characterizing the root of the problem, “with the false assumption that home prices would go up in perpetuity on a national basis.”

Unfortunately for many… the assumption was false. The road to hell is paved with good intentions and false assumptions. “We see no near- or medium-term comeback,” she says of the firm’s outlook. “We believe losses will only accelerate further and be far worse than even the most draconian estimates. Due to continued deterioration in consumer liquidity, we are raising our loss expectations significantly for the group and lowering our earnings estimates significantly."

As the crisis unfolds, it’s not just Wall Street fat cats getting the shaft. “There are 12 parking lots across Santa Barbara that have been set up to accommodate the growing middle-class homelessness,” CNN reports. Counseling centers there have urged the city to lend parking lots during the night, as this atypical breed of homeless car owners needs a legal place to sleep.
 
"The way the economy is going,” said Nancy Kapp of the New Beginnings Counseling Center, “it's just amazing the people that are becoming homeless. It's hit the middle class." Knapp said these parking lot hostels are overwhelmingly populated by senior citizens and single mothers.

In a related domain, "From time to time we find ourselves wondering: How could all of this happen? This morning we have our answer: It was all a big mistake.

A “computer glitch” prompted Moody’s to incorrectly assign billions of dollars of worthless debt their coveted AAA rating. An investigation by the Financial Times reveals many of the AAA ratings Moody’s assigned in 2007 should have been “up to four notches lower,” but were left AAA... well... because the computer said so. [No wonder there has been a massacre in ABCP, CMO, and MBS type debt "securities", which perhaps should have been more accurately labeled "insecurities"].

Moody’s officials were well aware of the error, but did nothing. According to the salmon-colored rag, Moody’s fixed the glitch by quietly reducing errant ratings during their massive wave of downgrades late last year. “It’s so absurd,” writes our managing editor, Chris Mayer, by e-mail this morning, “it might just work. I’m telling you… if a fiction writer wrote this story, we’d laugh our ass off. ‘That’s ridiculous,’ we’d huff, ‘no one would believe that.’
 
“You can’t make this stuff up.”  And that is why we see home prices plunging more over the next 3 years, even in coveted areas such as Santa Barbara, CA or Jupiter Beach/West Palm Beach, Florida, not to mention Portland, OR and Seattle, WA. These areas have been perceived as "immune" or "different" and up to recently that has been the case. But that is about to change over the next 18 to 36 months in a dramatic fashion.

No one knows for sure how bad the rest of the housing tragedy will be and how far home prices will fall from here. All we have are the clear and documented "early warning signals" and the evidence (see the graph at the top of this article) as well as many anecdotal pieces that foreshadow things to come.

Here's our official prediction, and it is worth about as much as you are paying to read this. House prices will fall another 30% as a nationwide average. In some over-inflated areas we might see another 50% from here, believe it or not. Our biggest regrets and sorrow are for those who will suffer as a result, and that is why we hope we are wrong

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Bank failures to surge in coming years

Only three banks have failed so far in 2008. But that number is set to surge as the credit crunch slows economic growth and hammers some lenders that grew too fast during the recent real-estate boom, experts say. The roots of today's banking crisis grew out of the boom and bust in the real estate market.

Lenders originated more and more mortgages, while other banks, particularly smaller and medium-sized institutions, ploughed money into construction and development loans. While loan growth soared in 2004 and 2005, most regulators failed to scrutinize many banks or restrain this heady expansion of credit. Now that the loans have been made and delinquencies are climbing, some banks may already be doomed.

"At this point in the crisis, you can't stop bank failures," said Joseph Mason, associate professor of finance at Drexel University's LeBow College of Business, who has studied past financial crises. "At this point you manage through failures and arrange marriages where another stronger bank takes on the assets and deposits," he said. "You move through the problem. You don't avoid the problem. It's too late to wait and hope that things get better."

Things may get worse before they get better. At least 150 banks will fail in the U.S. during the next two to three years, according to a projection by Gerard Cassidy and his colleagues at RBC Capital Markets. If the current economic slowdown deteriorates into a recession on the scale of those from the 1980s and early 1990's, the number of failures will be much higher this time around -- probably as high as 300 of them, by RBC's reckoning.

That's a massive surge compared to the recent boom years of the credit and real estate markets. From the second half of 2004 through end of 2006 there were 10 consecutive quarters without a bank failure in the U.S. -- a record length of time, Cassidy notes. "This downturn will trigger a significant amount of bank failures relative to the past five years," he said. "There has been excessive loan growth and some banks won't be able to access capital markets to replace the money that will disappear as credit losses rise."

Cassidy and his colleagues have developed an early-warning system for spotting future trouble at banks called the Texas Ratio. The ratio is calculated by dividing a bank's non-performing loans, including those 90 days delinquent, by the company's tangible equity capital plus money set aside for future loan losses.

The number basically measures credit problems as a percentage of the capital a lender has available to deal with them. Cassidy came up with the idea after covering Texas banks in the 1980s. Until the recession hit that decade, many banks in the state were considered some of the best in the country. But as problem assets climbed, that view was cruelly challenged, Cassidy recalls.

The analyst noticed that when problem assets grew to more than 100% of capital, most of the Texas banks in that precarious position ended up going under. A similar pattern occurred in the New England banking sector during the recession of the early 1990s, Cassidy said.

IndyMac Bancorp, a large savings and loan institution and a leading mortgage lender, is one of Cassidy's biggest concerns, with a whopping Texas Ratio around 140%. IndyMac is finding it much tougher to package up and sell the mortgages it originates in securitizations. That used to be a major source of new money for the company to turn around and use in further lending. When lenders need to raise new capital, they can try to boost deposits by offering attractive interest rates on certificates of deposits, or CDs.

IndyMac is currently offering the highest rates on one-year CDs, according to Bankrate.com. Others in the top 10 include Corus Bankshares, Imperial Capital Bancorp and GMAC bank. When Countrywide Financial was struggling last year, its federal savings bank unit began offering some of the highest CD rates in the U.S. to build deposits. Bank of America has since agreed to acquire Countrywide and it didn't make it onto Bankrate.com's list of top 10 CD rates this week.

"These banks that are challenged for liquidity are having to go out and pay up in the market for CDs," Joe Morford, a colleague of Cassidy's at RBC, said. Imperial Capital stopped paying dividends earlier this year. GMAC, owned by leveraged buyout giant Cerberus Capital Management and General Motors, is struggling to keep its Residential Capital mortgage business afloat.

Corus, offering the fifth-highest rates on one-year CDs, had a Texas Ratio of nearly 70% at the end of the first quarter, up from 9.1% in 2006, according to Morford. Corus is also highly exposed to types of loans that some experts worry will be the next major source of losses for banks after the mortgage meltdown. Construction and development, or C&D, loans made up 83% of the Chicago-based bank's total loans at the end of 2007, according to RiskMetrics Group.

This type of loans helps to pay for things like the building of real-estate development projects and the construction of office buildings. Small and medium-sized banks found it difficult to compete with large lenders in the national markets for mortgages and other consumer loans. So many focused on C&D loans because this type of financing relies more on local, personal connections, said Zach Gast, financial sector analyst at RiskMetrics.

As the real estate market boomed, C&D loans did too. A decade ago, bank holding companies had $60 billion of these loans. That number is now $480 billion, according to Gast, who also notes that C&D loans are almost never securitized, so they're held on banks' balance sheets. Such rapid loan growth usually creates trouble later. Indeed, delinquencies represented 7.1% of total C&D loans at the end of the first quarter, up from 0.9% at the end of 2005, Gast said.

"It's a huge increase. Most of the deterioration seems to be coming from residential construction projects, but certainly there's deterioration in commercial projects too," the analyst said. "The rate of deterioration is still accelerating."

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Ilargi: Reggie Middleton is doing a very impressive series of articles. Highly recommended as a crash course, and a tutorial, in what he calls deep doo-doo banking. That’s a very scary list of banks he’s got there. And before you write him off as a doped-up doomer, note that at the very least he knows his data.

As I see it, 32 commercial banks and thrifts may see the feces hit the fan blades

I have identified 32 banks that are $@%%. It's really as simple as that. I have been publishing the research that  I used to build my investment thesis. I am almost prepared to start listing more of my commercial banking shorts, but before I do I want to delve even further into the educational realm so there is no doubt as to why I am as bearish as I am. For those who can't wait to see my ultimate shorts, I will give you the complete list of what I call the "Deep Doo-Doo Banks". These are the banks that are steeped pretty deep in it. Are you ready? Can you handle the pressure? Okay, here we go!

1. Wells Fargo
2. Popular Inc
3. SunTrust
4. KeyCorp
5. Synovus Financial Corp
6. Marshall & Ilsley
7. Associated Banc
8. First Charter
9. M&T Bank Corp
10. Huntington Bancshares
11. BB&T Corp
12. JPM Chase
13. U.S. Bancorp
14. Bank of America
15. Capital One
16. Nara Bancorp
17. Sandy Spring Bancorp
18. PNC
19. Harleysville National
20. CVB Financial
21. Glacier Bancorp
22. First Horizon
23. National City Corp
24. WAMU
25. Countrywide
26. Regions Financial Corp
27. Citigroup
28. Wachovia Corp
29. Zions Bancorp
30. TriCo Bancshares
31. Fifth Third Bancorp
32. Sovereign Bancorp

Now, I already release some of my work on one of the banks, chosen due to paper thin capitalization - along with a different view on leverage.  Keep in mind, for the purposes of this blog, I'm just a resourceful individual investor - albeit one that is very lucky to date (this post was before Bear Stearns dropped 98%). Therefore, no one, and I really mean no one, should be taking my opinions on this blog as investment advice. It is not intended as such and should not be percieved as such. 

Rising Delinquencies - Click to enlarge

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'Maybe at $6 or $7 a gallon, it becomes less attractive to go to work'

Judging from the futures markets, shock at the gas pump is bound to get worse. Maybe much worse. Since the beginning of the year, benchmark oil and gasoline futures on the New York Mercantile Exchange both have increased by more than a third, but the average retail price of gasoline in the U.S. has risen by 22%. That bodes ill for consumers.

So far, oil refiners and petroleum-product distributors have absorbed much of the increase, but their ability to continue to swallow losses and operate at thin margins is limited. Many analysts consider $4-a-gallon retail gasoline across the U.S. a foregone conclusion this summer driving season, a period of typically peak demand, but those estimates take only current record-high oil prices into account.

Thursday, light, sweet crude futures breached $135 a barrel, more than double the price a year ago. If oil hits $200 a barrel, which is the upper end of Goldman Sach's prediction for prices over the next six months to two years, the gasoline picture changes quite dramatically.

At $200 a barrel, crude alone would cost $4.76 a gallon. Add on the costs of refining and distributing as well as taxes, and pump prices could rise to a range of $6 to $7 a gallon.

U.S. drivers haven't radically changed their behavior, and it is unclear at what price it becomes unprofitable for Americans to go about their usual day-to-day activities, said Eric DeGesero, executive vice president of the Fuel Merchants Association of New Jersey. "Maybe at $6 or $7 a gallon, it becomes less attractive to go to work," Mr. DeGesero said. "We haven't hit that point yet, but we might soon."

Retail gasoline prices have topped $4 a gallon in Alaska, California, Connecticut, Illinois and New York ahead of the Memorial Day holiday weekend, according to the AAA Daily Fuel Gauge Report. Nationwide, gasoline averages $3.831 a gallon.

Consumers have already taken note, with U.S. gasoline demand down 0.6% this year compared with the same period in 2007, according to the Department of Energy.

The erosion in demand is likely to accelerate if gasoline prices shoot above $6, but a radical cutback in consumption will occur only if high prices weaken the U.S. economy further and contribute to increased unemployment.

In regions of the U.S. that have been particularly hard hit by weakness in the housing market and economic instability, the fall in gasoline demand has already outpaced the national average, said Ann Kohler, an energy analyst with New York investment bank Caris & Co.

"There would still be additional hurt if there was further escalation in gasoline pricing, because other parts of the country would become involved," Ms. Kohler said.

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An Inquiry Into Interbank Loan Rate

Each morning in London, a handful of banks quietly decide how much it costs to borrow money all over the world. But now a troubling question is swirling around this elite banking club: Have some of its members been lying about one of the world’s most important interest rates?

That concern is prompting the 89-year-old British Bankers’ Association to examine the way it sets the rate at which banks borrow money from each other. The rate, known as the London interbank offered rate, or Libor, in turn affects the rates banks charge on things like home mortgages, student loans and corporate I.O.U.’s.

The association is trying to determine whether some of the 16 banks that it polls each day to set Libor provided false or misleading rates. If that is the case, the repercussions could be enormous. Libor is currently used to price more than $360 trillion of financial products globally. “It’s a real cornerstone of the financial markets,” Jason Simpson, a strategist at ABN Amro in London, said of Libor.

The association’s system for setting Libor has worked for the last 22 years. But when the credit market seized up last August, many banks, concerned about their own financial positions, were no longer willing to lend money to one another. As a result, Libor shot up, even as central banks like the Federal Reserve tried to drive borrowing costs lower.

Some now worry that system may have enabled banks to manipulate Libor to their advantage. Analysts and industry professionals said some banks quoted lower rates to allay concern about their finances or reduce their borrowing costs during a time of financial stress. Quotes from all banks are published on the association’s Web site.

“There are definitely incentives for banks to push the rate lower,” said Sean Maloney, a bond analyst at Nomura in London. “They would get the rate down while still charging their customers more.” If the banks did manipulate Libor, that would mean that rates subsequently charged on thousands of financial contracts were artificially low.

The British Bankers’ Association, which is set to report the findings of its Libor review on May 30, denied there was a problem with Libor. “The money markets are stressed at the moment, and Libor reflects this,” said John Ewan, the association’s director responsible for Libor. Even so, the association brought forward its annual review of the rate-setting process by a month to deal with the unusual uncertainty about Libor.

The group is talking to regulators, central banks, brokerage firms, hedge funds, stock exchanges, derivative exchanges and fund managers about possible changes. “Naturally we wish to ensure that the rates are as accurate a reflection of prevailing market conditions as possible,” Mr. Ewan said.

Libor is going through its worst credibility crisis since its creation in 1986, when British banks asked the association to come up with a benchmark rate to price syndicated loans and derivatives. Rates are quoted by 16 banks from seven countries, including the United States, Switzerland and Germany, for 15 different borrowing periods ranging from a day to a year in 10 different currencies.

The banks are asked at which rate each could borrow a “reasonable amount.” The association then eliminates the four highest and lowest rates and averages the remaining ones to determine various Libor rates. A change under consideration is widening the circle of banks that the association polls, from 16 to 20. Adding more American banks might provide a better reading for the cost of borrowing in dollars, Terry Belton, an analyst at JPMorgan Chase, said.

Right now, the group that determines dollar rates is skewed toward European banks. And some bankers have urged the industry to create a New York equivalent of Libor, called Nybor. Drastic changes might do more harm than good, said Mark Durling of the London-based asset manager Brewin Dolphin. “There is a lot of criticism about Libor, but to change the mechanism that has been working for years is unwise,” he said.

At a time many banks are struggling, it is not entirely surprising that interbank lending rates are behaving unusually. “There are no easy fixes,” said Michael Cloherty, head of U.S. interest-rate strategy at Bank of America in New York. “The underlying issue is a bank balance sheet issue, and that cannot be solved by changing the way the rate is calculated.”

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Comptroller Dugan Tells Lenders that Unprecedented Home Equity LoanLosses Show Need for Higher Reserves and Return to Stronger Underwriting Practices

Comptroller of the Currency John C. Dugan said today that accelerating losses in the home equity business show the need to build reserves and to return to the stronger underwriting standards of past years.Home equity loans and lines of credit grew dramatically in recent years, more than doubling, to $1.1 trillion, since 2002.

In part, that’s because of the rapid appreciation in house prices, the tax deductibility feature of home equity loans, and low interest rates. “But another contributing factor was perhaps not so obvious: liberalized underwriting standards,” Mr. Dugan said, in a speech to the Financial Services Roundtable’s Housing Policy Council. “These relaxed standards helped more people to qualify for loans, and more people to qualify for significantly larger loans.”

These relaxed standards included limited verification of a borrower’s assets, employment, or income; higher debt to equity ratios; and the use of home equity loans as “piggyback” loans that helped borrowers qualify for first mortgages with low down payments and without mortgage insurance, resulting in ever-higher cumulative loan-to-value ratios.

Consequently, once house prices began to decline in 2007, home equity lenders began to experience unprecedented losses. While losses have traditionally run at about 20 basis points, or two tenths of a percent of loans, they shot up to nearly 1 percent in the fourth quarter of 2007 and to 1.73 percent in the first three months of 2008.

Looked at in dollar terms, losses on all home equity loans, including HELOCs and junior home equity liens, rose from $273 million in the first quarter of 2007 to almost $2.4 billion in the first three months of 2008 – a nine-fold increase. And the largest home equity lenders are now saying that they expect losses to continue to escalate in 2008 and beyond, Mr. Dugan said.

The Comptroller said these loss numbers need to be viewed in perspective. Though accelerating quickly, they are still much lower than the loss rates for other types of retail credit, such as credit card loans. “It’s true that home equity credit was priced with lower margins than these other types of credit, and it’s true that the product has become a significant on-balance sheet asset for a number of our largest banks,” he said.

“Nevertheless, the higher level of losses and projected losses – even under stress scenarios – are what we at the OCC would describe generally as an earnings issue, not a capital issue. That is, while these elevated losses, depending on their magnitude, could have a significant effect on earnings over time, with few exceptions they are not in and of themselves likely to be large enough to impair capital.”

For the near term, Mr. Dugan said, the OCC expects national banks to continue to build reserves. “I can’t stress enough how crucial reserves will be in helping the industry manage its way through this situation,” he said. “At some banks, the portion of reserves attributable to home equity loans just barely covers 2007 chargeoffs. With losses accelerating, those reserves are simply not going to be adequate, and that’s why our examiners are encouraging more robust portfolio analysis and loss reserve levels.”

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Existing Home Sales Fell in April to Another Low

Stocks took a dive on Friday after a report confirmed fears that the housing slump, which has weighed on nearly every corner of the nation’s economy, was nowhere near its end. Sales of previously owned homes, which make up the bulk of the housing market, dipped 1 percent in April, to an annual rate of 4.89 million, the second consecutive month that sales have declined.

That figure represents another record low, although the report, put out by the private National Association of Realtors, dates only to 1999. While sales were slightly better than economists had expected, Wall Street was unimpressed. The Dow Jones industrials dropped 146 points on Friday, capping the worst week in the stock markets since February.

The Dow closed at 12,479.63, down more than 500 points from Monday’s opening bell. The Standard & Poor’s 500-stock index, a broader measure of the American stock market, also stumbled, slipping again on Friday to finish down 3.5 percent for the week. Bond prices rose as investors turned to the safety of government notes. The benchmark 10-year Treasury note rose 18/32, to 100 8/32. Its yield, which moves in the opposite direction, fell to 3.84 percent, from 3.91 percent.

After a period of relative calm on Wall Street, investors seemed shaken by the resurgence of economic problems on several fronts. Oil, which some thought had reached a plateau at $110 a barrel, suddenly surged on reports that experts had decided dwindling supplies would not be able to keep up with global demand. Oil settled on Friday at $132.19 a barrel, up nearly $6 since Monday.

The price of oil, which affects not only the cost of gasoline but also the price of common consumer products, has risen nearly $20 a barrel in May alone. The high cost of fuel is driving fears that inflation will become unhinged. Consumers are already being squeezed by skyrocketing prices for food and gasoline, and a report this week showed businesses were forced to pay more for wholesale goods in April.

The home sales report on Friday topped off a dreary week. The median value of a previously owned home was $202,300 in April, down 8 percent from a year ago, the realty group said on Friday.

Homeowners have watched their property values plunge for months, although the slump comes after several years of a remarkable run-up in home prices. Still, economists say they believe the declines have discouraged purchases, as would-be buyers hold out for prices to fall further.

“Lower prices bring bargain hunters into the market,” Patrick Newport, an economist at Global Insight, a research firm, wrote. “But they also drive away buyers who view their homes as an investment. In today’s market, the fence sitters outnumber the bargain hunters.”

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Four reasons big buildup in home inventories is ominous

Either American home sellers are an incredibly optimistic lot, or they think they are stock traders who need to dump their assets in a declining market. How else to explain the surge in homes going up for sale in April, in the teeth of the worst downturn in housing since the Great Depression?

Because home buyers are spooked by the current environment, in which home prices have been falling in many markets across the country, there has been a glut of unsold homes on the market for more than a year. Sellers have been cutting their prices to attract the limited buyers out there -- the median price of a home sold in the U.S. in April was off 8% from a year earlier -- but that has done little to cut into the inventory.

Against that backdrop, sellers still concluded April was the time to move. The inventory of unsold homes on the market jumped 10.5% in April to 4.55 million units. At the current sales pace, that represents an 11.2-month supply of houses -- nearly double what the real estate industry considers to be a health level.

Of course, April is the biggest time of the year for putting houses on the market. That's because of the school-year cycle; families with kids in school who need to move in the June-August summer recess have to get their homes on the market then in order to sell, buy and close on both transactions before the fall term begins.

But even by seasonal standards the number of houses put on the market last month was high. And here is why that is particularly ominous:

• Many of those potential sales are likely forced. Strapped homeowners who are struggling to keep up with mortgage payments may feel compelled to sell and get what they can for their house before the financial burden overwhelms them.
  
• Many of those houses are foreclosures. With foreclosure proceedings nearly double what they were a year ago, banks are being handed the keys to record number of properties. Their aim is to get rid of them, regardless of market conditions.
  
• Many of these moves are not discretionary. Let's face it: The job market is not the most stable right now. Folks who face layoffs or are "asked" to transfer may have little choice but to put their home on the market.
  
• Many of these properties are failed investments. The speculators who bought -- mostly condos -- in the boom times in anticipation of quick profit have been caught with their windows down. They may have been tempted to hold for a rebound, but like stock traders they will also cut and run with no bottom in sight.

Some of the folks who put their houses on the market in April may end up pulling them off the market in subsequent months, once they see how choppy the water really is. But for most, it's now sink or swim.

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Citigroup Says Swaps Mania in Muniland Is Finished

"The use of synthetic fixed-rate munis has fallen, and it isn't coming back." So says George Friedlander, municipal strategist at Citigroup Inc. in the firm's May 16 "Municipal Market Comment." Let me explain. What analyst Friedlander is saying is that perhaps the most popular type of interest-rate swap engaged in by states and municipalities is history.

At least for now. Preface everything that occurs in Muniland, a place of infinite variety and no memory, with those four words, especially when it comes to financial engineering. This is great news for good-government types who are concerned that municipal issuers shouldn't get involved with things they can't understand or evaluate.

Here's how these things worked. A bond issuer sells bonds whose interest rates are set at regular weekly or monthly intervals, thus availing themselves of the lowest rates possible. The issuer has 30-year bonds, and is paying as though it is only borrowing the money for a week or a month. Then the issuer enters into an interest-rate swap with a bank. The issuer agrees to pay the bank a fixed rate, and the bank agrees to pay the issuer a floating rate.

And then you -- are you confused yet? Because there's more, lots more. Except I guess there's not, according to Citigroup's Friedlander: "The use of synthetic fixed-rate issues has slowed to a trickle largely because of counterparty unwillingness to attempt to hedge the basis risk between long-term munis and long- term Libor swaps, in part because of the crisis in the auction rate market and in part because of the shortage of liquidity facilities to back the variable-rate demand note alternatives to auction rate paper."

Are you paying attention? Because this is one of the simplest swaps there is, and everyone was doing them. No, really! It was the flavor du jour in the municipal market. Sell variable or auction-rate debt, then swap to fixed. Simple as pie!
In February, the auction-rate market, where so many municipalities started the game, froze up when the securities firms that formerly backstopped the sales bowed out.

That left the issuers, usually, to pay penalty rates that reset at sometimes double-digits: 10 percent, 11 percent, 12 percent. Now these issuers are refinancing to regular old fixed-rate debt, and then also terminating the swaps, and of course they have to pay, pay, pay.

Sometimes taxpayers find out about the whole mess when someone hollers. More often than not it's all concealed in yet another, bigger bond issue designed to fix the first one. That's because it's embarrassing for politicians to admit that they approved a financing they never imagined could go so haywire.

Friedlander says these things are dwindling. Yet every day I see rating-company reports on bond issues describing new or existing interest-rate swaps. And on May 19 at a Bond Buyer newspaper conference on derivatives some panelists even suggested that now just might be the time to put together some more swaps. Some issuers at the conference said they were getting a lot of resistance from colleagues when it comes to playing the swaps game again.

My beef with interest-rate swaps and other derivatives isn't that they are bad by their nature. That's silly. My beef is that they shouldn't be used by amateurs. And that's what you have in the municipal market. It's amateur hour. There's an enormous knowledge gap between the men and women at securities firms who sell this stuff and municipal officials, and it looks like some firms exploited that to a fare-thee-well.

Or at least that's what the Securities and Exchange Commission's and Justice Department's investigations into the field seem to promise: collusion and price-fixing. Because most issuers don't have the expertise to figure out how their financings work, they hired the help. Did the help cheat them? We'll soon find out..

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Credit Rating Agencies Reportedly Switched Analysts At Clients' Request

Two days after its stock took a nosedive following a report that a computer error may have mistakenly rated some securities AAA, Moody's Investors Service is again facing intense scrutiny. The Wall Street Journal reported Friday that the credit rating agency at times allowed banks to determine which analysts covered their deals, switching analysts at the bank's request.

The Journal, citing people familiar with the matter, reported that an investment bank requested a switch in analysts after the one assigned to them raised questions about their deals. That analyst was a member of a group that assigned ratings to collateralized debt obligations, the newspaper said.

In a separate instance, Moody's moved another mortgage analyst to the firm's surveillance unit, which assumes a post-operative job to monitor ratings already issued. The switch occurred following complaints from an investment banker that the analyst was "too fussy," the Journal said, citing a person familiar with the situation.

Credit ratings agencies have faced a heavy amount of scrutiny following a series of rapid downgrades of mortgage-backed securities. The downgrades came on the heels of extreme financial turmoil early in the year.

The barrage of bad news have sent shares of Moody's tumbling 23 percent since Wednesday, closing at $34.51 on Thursday on the New York Stock Exchange.

"Wall Street is not switching our analysts," a Moody's spokesman told the Journal. "Moody's makes decisions based on the best interest of the rating."

Moody's managing director Richard Cantor spoke last week at a Banking Structure conference in Chicago, saying his company needs to do a "better job communicating" the potential conflict of interest of the credit rating system. He added that Moody's had done "not nearly enough" to anticipate the magnitude of subprime shocks.

The Journal added that Standard & Poor's also replaced some analysts at the bequest of bond issuers.

Moody's largest shareholder is Warren Buffett's Berkshire Hathaway Inc., which holds a 19.6 percent stake in the company. At a new conference in Madrid, Buffett offered his support for the company.

"I don't think one day will permanently change the franchise value of Moody's," the world's richest man said a news conference in Madrid. On Thursday he commented that anyone caught doing wrong at Moody's should leave the company.

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AIG is sued by Florida pension fund

In another blow to American International Group, a Florida pension fund has accused the insurance company and a number of its top executives of understating its exposure to the subprime mortgage crisis to artificially inflate its stock price.

The Jacksonville Police and Fire Pension Fund made the charge in a lawsuit filed Wednesday in Federal District Court in New York, the first class action suit against American International Group, or AIG, since it disclosed a staggering first-quarter loss of $7.8 billion. That loss, caused by complex financial instruments, shocked many investors because AIG had assured them that any losses on such credit default swaps would be limited, the suit said.

"These folks that have manipulated the market by making false statements have caused severe economic loss to the underlying trust fund which thousands of our members rely on," John Keane, executive director of the Jacksonville fund, said.
The case comes at a challenging moment for AIG and its chief executive, Martin Sullivan. The company has lost about half its value in the stock market in the last year, and its credibility with many investors has disintegrated after a string of unpleasant and surprising corporate announcements.

Sullivan took the helm in 2005 after Maurice Greenberg was forced out as chief executive because of allegations of accounting improprieties. Under Sullivan, AIG has been burdened by slower growth, and its critics have said he is not the right leader. His supporters say he inherited many of the company's problems.

The lawsuit centers on comments made to investors by several AIG senior executives, who assured the investors that the company would weather the subprime crisis better than many of its peers because of its conservative and sophisticated risk management. Last Nov. 8, for example, Sullivan said on a conference call that "AIG does not expect to pay any losses on this carefully structured and well-managed portfolio," referring to the credit default swaps, according to the lawsuit.

But investors received a shock in February, when AIG disclosed that PricewaterhouseCoopers had discovered problems in the company's financial reporting and oversight, requiring AIG to revalue its portfolio of credit swaps. As a result, AIG's losses on the instruments skyrocketed to more than $11 billion, and the company later declared a $7.8 billion first-quarter loss.

AIG was subsequently forced to raise $20 billion in new debt and equity after telling investors it would have to raise only $12.5 billion. "Senior management deprived AIG investors of fundamental information demonstrating that contrary to AIG's repeated statements that the company was well-positioned to weather the subprime storm, it was really a ticking time bomb waiting to explode because of billions of dollars in subprime-related losses," said Gerald Silk, a partner at Bernstein Litowitz Berger & Grossman, the law firm that filed the suit for the pension fund.

The suit cites a number of instances in which company officials assigned little or no risk to AIG's credit default swaps. In an August 2007 conference call, for example, Joseph Cassano, who was head of AIG's derivatives unit, said it was difficult "to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions."

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Internal report pinpoints faults at Société Générale

Weak management and insufficient internal risk controls at Sociéte Générale made it possible for a 31-year-old trader to cause nearly €5 billion in losses at the French bank, a report from an internal investigation has concluded. The report, released Friday, also said that the trader, Jérôme Kerviel, might have had an accomplice.

A panel of independent directors reported that two of the trader's direct bosses had proved "deficient" by failing to detect, despite numerous red flags, that Kerviel had traded beyond his authority for more than two years and secretly exposed the bank to €50 billion, or $78.9 billion, worth of risk.

"The fraud was facilitated, or its detection delayed, by weaknesses in the supervision of the trader and in the controls over market activities," the panel said, citing evidence from the internal audit. "The direct supervisor lacked trading experience and was not given a sufficient degree of support in his new role," it said.

"He demonstrated an inappropriate degree of tolerance in relation to the taking of intraday directional positions and neither he, nor his own supervisor, carried out an adequate review of the trader's activities on the basis of the available figures and reports or reacted to the alerts that would have allowed them to identify the concealed positions."

Kerviel's supervisors were Martial Rouyère, who heads the Delta One desk and Eric Cordelle, his deputy and Kerviel's immediate manager. Both men are in the process of being fired by Sociéte Générale, according to two people with knowledge of the dismissals.

The 71-page internal audit, called the Green Mission, said that Kerviel might have been helped by an assistant when he entered fake trades or unwound unauthorized positions. "We have discovered indications of internal collusion involving a trading assistant, a middle-office operational agent," the audit said. "Due to the current ongoing criminal investigation, we have been unable to question this employee on this subject. The possibility of such internal collusion must therefore be confirmed by the courts."

Mission Green is the final draft of an earlier version published in February that had already identified 75 alerts that should have exposed Kerviel's trading activities to his superiors but did not. For Friday's version, auditors had access to Kerviel's immediate bosses whose interviews allowed them to paint a more detailed picture of the lapses in oversight that had led to the scandal.

In an attempt to reassure shareholders at the upcoming annual meeting Tuesday, the board of Société Générale issued a statement with the report Friday, saying that recent moves by the bank to improve its risk control systems and supervision of traders meant that "the majority of the negative effects of the fraud on the bank's business situation have been overcome."

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For Bank of America stock, it's lonely on the new-lows list

This has been a dismal week for financial stocks in general, but Bank of America Corp. shares may be sending a particularly worrisome signal. BofA stock closed at a new multi-year low Wednesday, falling 76 cents to $34.63. That was 2% below the previous 2008 closing low of $35.31 set on March 10.

For the market as a whole, and especially in the case of financial issues, many investors have been hoping that the March lows marked the worst of the selling brought on by the housing crash and its fallout. To revisit those share prices is to imply that the spring market rally was just a dead-cat bounce. More ominous, it implies that the Federal Reserve hasn’t done enough, after all, to rescue the financial system from its own excesses.

So far, the new-lows list is a lonely place for BofA -- which is a good thing, in the big picture. Shares of Citigroup Inc., arguably the megabank with the scariest problems, ended at $21.06 on Wednesday, still above the closing low of $18.62 on March 17. JPMorgan Chase & Co., at $42.42, was comfortably above its recent low of $36.48 on March 10. Today most financial shares are modestly higher as the market overall has edged up. BofA was up 6 cents to $34.69 at about 11:30 a.m. PDT.

BofA investors can take some solace from the fact that, even as their shares lose more ground, the stock has fallen less than some of its rivals since the bottom fell out of bank issues beginning in October. BofA is down 32% since Oct. 1, while Citigroup has plunged 56% and Wachovia Corp. has tumbled nearly 50%. Still, when someone asks where your stock is trading, you'd always prefer not to say, "Why, it's at a new low, thanks!"

What's dogging BofA? One issue is the extent of the losses the bank may face in its huge consumer loan portfolios, as many Americans' finances grow shakier in the struggling economy. BofA will dive much deeper into consumer lending with its planned purchase of mortgage giant Countrywide Financial Corp. BofA obviously thinks it's getting a deal with the seemingly cheap price it's paying for Countrywide, even as the firm's loan delinquencies continue to surge. But Wall Street worries about the cockroach theory: Given the already visible troubles at Countrywide, how many more are behind the walls?

Oppenheimer & Co. analyst Meredith Whitney this week cut her 2008 and 2009 earnings estimates for BofA and four other big banks, citing a "continued deterioration" in consumers' finances. She now expects BofA to earn $2.50 a share this year, down from a previous estimate of $3. She made an even deeper cut in her 2009 estimate, reducing it to $3 from $3.95.

If Whitney is on target with her 2008 estimate, BofA will earn less than the $2.56-a-share annual dividend it pays on its stock. That's another issue weighing on the shares: investors' concern that the dividend will be cut, even though management has said the payout is safe for now. At Wednesday's closing stock price BofA's dividend yield was 7.4%, far above the 5.3% average yield of big-bank stocks. It's a sign investors don't believe the current payout will be sustained.

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Citigroup spent $1.45 million lobbying on housing reform

Citigroup Inc. spent $1.45 million in the first quarter lobbying on a wide range of mortgage proposals and financial regulations, according to a disclosure form.

The company lobbied the federal government on legislation involving student loans, the modernization of the Federal Housing Administration, an economic stimulus package, credit card rules, data protection, sovereign wealth funds, immigration, retirement plans, patent reform, sanctions against Iran and free trade agreements with Panama, Colombia and South Korea.

Citigroup and other financial services firms supported proposals to give the FHA more flexibility to insure home loans for lower-income buyers and raise the caps on mortgage loans the FHA could insure.

In the January-to-March period, Citigroup lobbied Congress, the White House, the Patent and Trademark Office, the Office of Management and Budget, the National Security Council, the Federal Housing Finance Board, the U.S. Trade Representative, and the departments of Treasury, Education, State, Commerce and Homeland Security, according to the form filed with the House clerk's office April 21.

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Oil's tense trading scene may sway a move to Dubai

The Dubai Gold & Commodities Exchange will launch trading of crude-oil futures on Tuesday, a timely move given the astronomical prices for oil and talk of U.S. regulation of speculators in the commodity markets.

Prices for crude peaked above $135 a barrel Thursday in electronic trading on the Chicago Mercantile Exchange Globex platform. Record prices over the past several months have raised questions over manipulation of the market. A U.S. Senate panel listened to testimony on May 20 that said financial speculation by institutional investors and hedge funds in the commodity markets are contributing to energy and food inflation.

"The regulatory environment is becoming so undesirable to foreign and domestic funds that they have no choice but to go offshore," said Kevin Kerr, president of Kerr Trading International and editor of MarketWatch's Global Resources Trader. Speculative activity in commodity markets has grown "enormously" over the past several years, the Homeland Security and Governmental Affairs Committee said in a news release. It pointed out that in five years, from 2003 to 2008, investment in the index funds tied to commodities has grown by 20-fold -- to $260 billion from $13 billion.

The growth offers "justifiable concerns that speculative demand, divorced from the market realities, is driving food and energy price inflation and causing human suffering," HSGAC said. "If Congress makes some laws that reign in speculation, it's possible that speculators will move out of the U.S. markets and into Dubai," said Phil Flynn, a vice president at Alaron Trading.

The backlog of cases for National Futures Association has been growing, said Kerr. The NFA is a provider of regulatory programs that safeguard the integrity of the derivatives markets. "Understaffed and overworked, the regulatory industry has decided to throw the baby out with the bathwater and meanwhile, legislators who are also fearing job loss have decided to blame the speculators and create some sort of witch hunt," said Kerr.

Speakers testifying at the HSGAC hearing Tuesday called on the Commodity Futures Trading Commission to better monitor the market and to take action. "The people of America are about to take up pitchforks, and we are feeling the heat in Congress," Sen. Mary Landrieu, D-La., said during the hearing, according to Platts, a global energy information provider. "It does not appear that our cop on the beat feels the heat like we do."

Given what some may consider a hostile environment for futures trading, investors may look elsewhere to ease the restraints. And "in today's global trading market, the U.S. is far from the only place to do business," said Kerr. "If this environment keeps up, more and more hedge funds will flee for more friendly shores."

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