Friday, June 13, 2008

Debt Rattle, June 13 2008: Left Unprepared for the Bad

Dorothea Lange: Mississippi Cotton Patch July 1936.
"Old-time Negro living on a cotton patch near Vicksburg, Mississippi."

Ilargi: Stoneleigh is very busy this morning, and wouldn't be able to get anything up till mid-afternoon. So here's a first batch from me, from the land of little time. More later.

NOTE: It looks very much like Ireland is about to reject the new European Treaty in today's referendum. That could have earth shattering consequences politically and economically; the Treaty has to be ratified by all 27 member states, or it's gone.

Stoneleigh: My additions can be found at the bottom of the post.

Foreclosures Rise 48% in May as U.S. Bank Repossessions Double
Bank repossessions more than doubled in May and foreclosure filings rose 48 percent from a year earlier as previously foreclosed properties dragged down housing prices, RealtyTrac Inc. said in a report today.

One in every 483 U.S. homeowners lost their houses to foreclosure or received either a default warning or notice that their home would go up for sale at auction, RealtyTrac said. That was the highest rate since the Irvine, California-based company began reporting in January 2005 and the 29th consecutive month of year-over-year increases. Nevada, California and Arizona posted the highest rates in the U.S. and New Jersey entered the Top 10, according to RealtyTrac.

"It's definitely a different kind of market than what we got used to a couple years ago," said Devin Reiss, owner of Realty 500 Reiss Corp. in Las Vegas. "We used to sell homes in a day. Now 50 percent of our sales are foreclosures." Foreclosures add to inventory and crowd out regular sales, Michelle Meyer and Ethan Harris, economists at Lehman Brothers Holdings Inc. in New York, wrote in a report yesterday.

Foreclosures will account for 30 percent of national home sales this year as 1.2 million foreclosed single-family homes will eventually enter the market, they said. They estimate that foreclosed properties, which typically sell for about 20 percent less than other homes, will depress home prices by 6 percent.

"The risk is that an adverse feedback loop will develop, in which problems in the housing market undercut the economy, causing even more stress in the housing and mortgage markets," Meyer and Harris wrote. A homeowner usually receives a notice of default after falling more than 90 days behind on mortgage payments. If the borrower still doesn't pay what's owed, the property is sold to the highest bidder at an auction, typically held at a county courthouse. If bids don't reach a set amount, the lender takes ownership. Such houses are referred to as REO, or "real estate- owned."

Lenders took possession of 73,794 houses in May, more than doubling the 28,548 REOs in May 2007, RealtyTrac said. That pushed total REOs to more than 700,000, RealtyTrac said. "Right now, lenders are afraid to lend and buyers are afraid they'll be under water in a year, so unless something dramatic happens we're going to continue to see the trend go in the wrong direction," said Rick Sharga, RealtyTrac's vice president of marketing.

Legislation that would allow the federal government to guarantee up to $300 billion in refinanced mortgages passed the House of Representatives and awaits debate in the Senate, which is scheduled to recess before the July 4 holiday. Government help would make it easier for homebuyers to get loans and would ease the number of foreclosures, said John Gall, president of the Arizona Association of Realtors and owner of Arizona Land Quest LLC in Kingman, Arizona.

"Resolving credit issues is going to require cooperation between Wall Street and Washington to provide a secure platform for lenders to loosen up their criteria," Gall said. "It would absolutely help here in Arizona." Arizona's foreclosure rate -- one in every 201 households received a filing in May -- was a 119 percent increase compared with May 2007 and ranked third in the U.S., RealtyTrac said. Only Nevada, with one in every 118 households, and California, with one in every 183, had higher filing rates in May, the company said.

Exxon to exit U.S. retail gas business
Exxon Mobil Corp said on Thursday it is getting out of the retail gas business in the United States as sky-high crude oil prices squeeze margins. Those branded service stations may be the most public aspect of Exxon's business, but they account for a small part of the company's profits.

Out of the roughly 12,000 Exxon Mobil branded stations in the United States, Exxon, the world's largest publicly-traded oil company, owns about 2,220. Exxon plans to sell those service stations over several years. They include about 820 stations that it also operates. The company will maintain the Exxon and Mobil brands, Exxon spokeswoman Prem Nair said.

Consumers will still be buying gasoline at stations that carry the Exxon and Mobil names, but they will not be owned by the company. Service stations have struggled, even with $4-a-gallon plus gasoline prices because they have not been able to pass along to customers their additional costs from soaring crude oil.

According to federal data, gasoline prices are up about 31 percent over the last year, and oil prices have nearly doubled over the same period.

Support for euro in doubt as Germans reject Latin bloc notes
Ordinary Germans have begun to reject euro bank notes with serial numbers from Italy, Spain, Greece and Portugal, raising concerns that public support for monetary union may be waning in the eurozone's anchor country.

Germany's Handelsblatt newspaper says bankers have detected a curious pattern where customers are withdrawing cash directly from branches, screening the notes to determine the origin of issue. They ask for paper from the southern states to be exchanged for German notes. Each country prints its own notes according to its economic weight, under strict guidelines from the European Central Bank in Frankfurt.

The German notes have an "X"' at the start of the serial numbers, showing that they come from the Bundesdruckerei in Berlin. Italian notes have an "S" from the Instituto Poligrafico in Rome, and Spanish notes have a "V" from the Fabrica Nacional de Moneda in Madrid. The notes are entirely interchangeable and circulate freely through the eurozone and, indeed, beyond.

People clearly suspect that southern notes may lose value in a crisis, or if the eurozone breaks apart. This is what happened in the US in the Jackson era of the 1840s when dollar notes from different regions traded at different values. "The scurrilous idea behind this is that if the eurozone should succumb to growing divergences, then it is best to cling to most stable countries," said the Handelsblatt. "There are no grounds for panic. The Italian state is not Bear Stearns," it said.

Germans appear to be responding to a mix of concerns. Many own property in Spain or Portugal and have become aware of the Iberian housing slump. A spate of news articles in the German press has begun to highlight the economic rift between the North and South of eurozone. There is criticism of comments from Italian, Spanish, and French politicians that threaten the independence of the ECB, viewed as sacrosanct in Germany.

But the key concern appears to be price stability. Germany's wholesale inflation rate reached 8.1pc in May, the highest level in 26 years. The cost of bread, milk and other staples has rocketed, adding to the sense that prices are spiralling out of control. Ordinary people are blaming the new currency - the "Teuro" - a pun on expensive - for their travails in the supermarket, even though the recent spike in farm goods and energy prices has nothing to do with monetary union.

Inflation touches a very sensitive nerve in Germany. Holger Schmeiding, from Bank of America, said the country had suffered two traumatic sets of inflation in living memory, first in Weimar in 1923 and then in 1948. "People suffered a 90pc haircut on financial assets in the currency reform of 1948. The inflationary effects of two world wars were catastrophic," he said.

A group of leading German professors warned at the outset of EMU that the euro would tend to be weaker than old Deutsche Mark, and that it would fuel inflation over time. German citizens were never given a vote on the abolition of the D-Mark, which had become a symbol of Germany's rebirth after the war. Many have kept a stash of D-Marks hidden in mattresses to this day. A recent IPOS poll showed that 59pc of Germany now had serious doubts about the euro.

When you hear ‘new paradigm’ head for the hills
In financial markets, as soon as you hear the words “new paradigm” you know the next cata?strophe is not far away. The reasons are not complex nor are the observations opaque. It does not matter whether it is dotcoms or subprime mortgages. Sooner or later in market cycles the main participants, and especially the banks, become carried away with a Wildean belief in their own, oft-declared genius.

The gains get magnified by leverage and the egos inflate in direct correlation to the paper profits. At this point, the Darwinian principle that he who makes the profit must be both protected from the rules applied to the rest and rewarded irrespective of risk start to apply. In the recent case of subprime mortgages, bankers lent money to anyone, irrespective of their credit history, because the risk was securitised and the financial equivalent of explosive pass-the-parcel ensued.

When the game ended, bankers walked away with much of the gains while the parcel exploded in all our faces. The paper gains disappeared and the losses were added to our tax bill. This is real moral hazard. It just happens more quickly in bear markets. In the midst of this the regulators tinker with the safety rules of the Titanic (it always sinks, regardless). What they cannot change is greed and stupidity.

Moral hazard is when risk and reward have an asymmetrical relationship – usually a lot of reward for one person and most of the risk for the other. This is the root cause of the subprime and credit crisis. And it is at the heart of most financial meltdowns. They just manifest themselves differently and therefore catch us unawares. It is like generals planning for the next war based on the experience of the last one; and just as failed generals get medals, bankers get bailed out.

As Mervyn King, governor of the Bank of England, put it this week: “If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time the parties will become wilder and wilder.”

When an Enron, or even a Barings, fails in isolation and there is no general market failure, the regulators get sanctimonious about the dangers of systemic moral hazard, because collateral market damage is not perceived as a great risk. But when a Northern Rock or Bear Stearns is about to fail in the midst of a market crisis, they have to be bailed out irrespective of moral hazard. Until we can think of another source of mass access to paper and electronic debt that we call money, then every time the banks mess it up they will always be bailed out. This is a problem not just for banking; it is a moral question for society.

The new stagflation: an Asian export
Fears of 1970s-style stagflation are back in the air. Global bond markets are growing ever more nervous over this possibility, and US and European central bankers are talking increasingly tough about the perils of mounting inflation. Yet today’s stagflation risks are very different from those that wreaked such havoc 35 years ago.

Unlike in that earlier period, wages in the developed economies have been delinked from prices. That all but eliminates the automatic indexation features of the once dreaded wage-price spiral – perhaps the most insidious feature of the “great inflation” of the 1970s. Moreover, as the stunning surge of the US unemployment rate in May suggests, slowing economic growth in the industrial economies is likely to open up further slack in labour markets, thereby putting downward cyclical pressure on wages over the next couple of years.

But there is a new threat to global inflation that was not present in the 1970s. It is arising from the developing world, especially in Asia, where price pressures are lurching out of control. For developing Asia as a whole, consumer price index inflation hit 7.5 per cent in April 2008, close to a 9?-year high and more than double the 3.6 per cent pace of a year ago.

Sure, a good portion of the recent acceleration in pricing is a result of food and energy – critically important components of household budgets in poorer countries and yet items that many analysts mistakenly remove to get a cleaner read on underlying inflation. But even the residual, or “core”, inflation rate in developing Asia surged to 3.8 per cent in April, more than double the 1.8 per cent pace of a year ago.

Given Asia’s new-found role as the world’s producer, such an outbreak of surging inflation in this region is not without serious risks to the global economy. The globalisation of trade flows is a new transmission mechanism of worldwide inflation that was not evident in the 1970s. According to estimates from the International Monetary Fund, overall exports should hit a record 32.5 per cent of world gross domestic product in 2008, more than 50 per cent above the export share of 21 per cent prevailing in 1980, when the “great inflation” was nearing its peak.

At the margin, that means cost pressures and price determination today are shaped much more in the global arena than they were during the domestically driven stagflation of the past. Asia’s outbreak of surging inflation is especially problematic in that regard. Nowhere is that more evident than in China – the new engine of Asian output and exports. Chinese inflation has surged at an 8.3 per cent average annual rate over the four months ending May 2008, the sharpest sustained increase on a year-on-year basis since the mid 1990s.

China’s inflation problem is much deeper than the food and energy price shocks that thus far have played a disproportionate role in driving its consumer price index higher. Also at work are serious wage pressures reflecting, in part, increases in minimum wages associated with new labour reform laws. Meanwhile the People’s Bank of China has held its policy lending rate below headline inflation, resulting in negative real short-term interest rates.

The result has been an ominous increase in Chinese inflationary expectations, strikingly reminiscent of similar occurrences that plagued the developed world in the 1970s and early 1980s. History does not treat kindly a serious deterioration in inflationary expectations. The longer such a trend persists, the more wrenching the monetary tightening required to arrest it – and the greater the risk of a subsequent hard landing. That is the last thing China wants or needs.

Stephen Roach is chairman of Morgan Stanley Asia

Fed, ECB Credit-Crunch Markets Into Rate Panic
The global economy is in a funk, the banking industry is in meltdown, house prices are collapsing, and companies are starting to default on their debts -- so central banks are threatening to crank interest rates higher. Go figure. Anti-inflation zeal is coercing the self-appointed guardians of financial stability into policy mistakes of epic proportions.

Here's an imaginary conversation that could have taken place in recent weeks between Federal Reserve Chairman Ben Bernanke and European Central Bank President Jean-Claude Trichet. "Ben, I just wanted to thank you for talking the dollar off the ledge yesterday. At $1.60, I really would have been tempted to intervene in the currency markets to tell the euro bulls that enough is enough."

"My pleasure, Jean-Claude. You know how keen I am to expand the Fed's arena of responsibility, and currency policy seemed ripe for a takeover. Besides, I can barely afford to fuel my Ford Hippopotamus for the drive to work, so it's helpful to give those pesky oil speculators something to chew on. If oil gets to $200 a barrel, I can kiss my second term goodbye." "There's just one problem, Ben. I'm going to raise rates before the summer ends, and the Bundesbankers are bullying me to warn the markets in advance. As soon as I do, the euro will be off to the races again."

"You're in luck, J-C. The guys and I are thinking along the same lines. How about you use your regular press conference tomorrow to fire a warning shot, and next week I'll follow with some mumbleswerve about commodity prices?"

Changing Lanes On June 3, Bernanke said "we are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations." Two days later, Trichet said " we could decide to move our rates by a small amount at our next meeting." This week, Bernanke said officials will "strongly resist" any increase in expectations for faster inflation.

So Helicopter Ben has parked his whirlybird in the hangar. Trichet has finally decided that inflation, which has overshot the ECB's 2 percent target every year since 1999 and is currently running at a 16-year high of 3.6 percent, merits the first policy move in a year. This is madness. Consumer confidence, undermined by unemployment worries and headlines about the real-estate crash, is too fragile to withstand an increase in borrowing costs. The banking industry needs a steep, positive yield curve, with low short-term rates and higher long-term rates, to repair balance sheets

Western banks fall into the addiction trap, Japanese-style
A decade ago I lived in Tokyo, where I wrote about Japan's banking woes. For several nail-biting years, I watched as the Bank of Japan unveiled a stream of ever-more creative measures that were designed to combat the risk of a financial meltdown.

By the start of this decade, this crisis was - finally - ebbing away. So when I left Tokyo in 2001, I naively assumed that the BoJ's "emergency" policies were destined to vanish too. Not entirely so. As Tadashi Nakamae, a Japanese economist, pointed out to me, one "emergency" practice from that era that has not gone back on the shelf is the idea that the BoJ should buy lots of Japanese government bonds.

Ever since the BoJ deployed this "temporary", crisis-busting step - supposedly to help the banks - the Ministry of Finance has become fond of keeping long-term bond yields down. Thus, whenever the BoJ threatens to withdraw its JGB support, the Ministry blocks the idea on the grounds the move could unleash more financial turmoil. It is a salutary tale that western policymakers would do well to note.

In the past 10 months, as a financial crisis has swept through western markets, US and European central banks have also produced all manner of crisis-busting, money-market manoeuvres. And, perhaps unsurprisingly, some of these seem to have been copied from 1990s Japan. Thus far, these steps have won widespread plaudits from market participants.

And I would not criticise the western central banks for acting to avert a full-scale financial collapse in this way. But the more I look at these measures, the more I wonder how the US and European banks will avoid the Japanese trap. After all, if western central banks halt these emergency steps too fast, they could unleash turmoil again; but if they wait too long, they could breed a new form of financial addiction among private banks and politicians alike.

And as any addict knows, addiction rarely disappears by itself. On the contrary, procrastination tends to make the problem worse, as habits become deeply ingrained - be that in Japan, or anywhere else. The US Federal Reserve, for its part, appears to be keenly aware of this problem. And Timothy Geithner, New York Fed president (and himself an expert on Japan), has signalled his desire to avoid any Tokyo-style policy fudge by calling for a broader rethink of the regulatory structure.

The Fed has also indicated that it will withdraw the generous liquidity support that it is providing to broker-dealers, after the Bear Stearns drama, by September. But whether the Fed will actually meet this deadline remains an open bet. After all, brokers such as Lehman Brothers are hardly flourishing - and the prospect of the September deadline is already spooking the markets. Meanwhile, on the other side of the Atlantic, the European Central Bank has its own problems.

The Frankfurt-based group has not set any deadline for scaling back its programme of emergency money market support. However, some officials are becoming concerned about the addiction patterns this is breeding. More specifically, there is concern that private sector banks have little incentive to restart the mortgage securitisation market - precisely because it is so easy (and cheap) to get funding from ECB sources instead. But the ECB knows that if it tries to withdraw its aid before the securitisation market has reopened, it will face strong political criticism. Worse still, it could even hurt some banks.

Perhaps this dilemma will quietly resolve itself over time. After all, if banks recapitalise themselves over the summer and investors regain confidence, it should become easier to withdraw central bank support this year or next - or so the optimists hope.

But in the meantime I am told that many western banks are becoming increasingly creative about how they repackage their assets to get central bank support. Addiction, in other words, is not disappearing of its own accord. No wonder some bankers now joke that the "originate to distribute" model has quietly morphed into "originate to repo" pattern instead. It is indeed a difficult policy trap. Do not bet on an easy or smooth exit soon.

Good Times Left Lehman Unprepared for the Bad
Sometimes, when you really mess up, it is good to admit you erred. Unfortunately, no one seems to have gotten that message through to Lehman Brothers, the embattled brokerage house that is now fighting to persuade the financial markets that it will not be the next Bear Stearns.

This week it raised $6 billion in new capital, at the same time it disclosed a $2.8 billion loss in the quarter that ended last month. Such a loss seemed to come as a shock to analysts, and on Thursday the chief financial officer and the president were demoted. But if Richard S. Fuld Jr., the chief executive, knows of any mistakes he has made, he has yet to share them with the rest of us.

The days that followed Monday’s announcement were horrible for the firm. Lehman’s stock fell as analysts withdrew buy recommendations and worried about the possibility of more losses. The cost of insuring against a Lehman default on its debts went up. That is not what you would expect after a firm raises billions in additional capital.

From the outside, it is impossible to know if Lehman is marking its assets at appropriate levels, or whether it should have taken write-downs earlier than it did. Like other Wall Street firms, it does not disclose its specific assets, or how much it thinks they are worth. But what is clear is that Lehman’s strategy, as the subprime mortgage crisis unfolded and expanded, was to seek to differentiate itself as being so well managed that it would not have the problems other firms might have.

In its annual report for the year that ended last November, the letter to shareholders from Mr. Fuld and Joseph M. Gregory, the president, now demoted, proudly proclaimed that the firm had record profits for the fourth consecutive year.

“Despite this record performance, our greatest disappointment in 2007 was that our share price declined for the first time in five years,” they added. “We are more focused than ever on demonstrating to the markets that we have a proven ability to continue to grow our diversified set of businesses, manage risk and capital effectively, and deliver strong results in all market environments.”

In January, two weeks after Citigroup slashed its dividend, Lehman raised its dividend and extended its share repurchase program. On March 18, when the company reported a profit for the first quarter, even as other firms were reporting losses — and just after Bear Stearns collapsed — Lehman had to confront rumors that had sent its share price tumbling.

It did so with pride and confidence. Erin M. Callan, the relatively new chief financial officer, now deposed, spoke of “disciplined liquidity and capital management, which we consider to be a core competency.” With hindsight, it is clear that it is specifically in the area of capital management that Lehman has done the worst job, notwithstanding the boasts.

Its policy on share buybacks was to avoid the dilution caused by grants of restricted shares and options issued to employees, and that meant it bought back about as many shares as it issued. It succeeded. The number of shares outstanding at the end of the first quarter was virtually the same as it was at the end of the 2004 fiscal year, after adjusting for a stock split.

But with the stock rising for much of that time, those purchases cost a lot of money. In the 13 quarters from the end of that year through this year’s first quarter — that is, before the new $2.8 billion loss — Lehman reported net income of $11.9 billion, and spent $11.8 billion on share repurchases. The net effect was that Lehman built up no cushion during the good times, and was ill-prepared for the bad times.

The hubris reflected in the claim that it could “deliver strong results in all market environments” left it with an insufficient capital cushion when the market environment turned hostile. In that March call, Ms. Callan said the company had already sold all the preferred stock it planned to sell in 2008, when it issued $1.9 billion of such stock in February. Two weeks later, with the stock under pressure, it sold $4 billion in convertible preferred shares.

That sale came off in a relatively normal way. This week, the terms were far harsher. The common stock sold at $28 a share. The convertible preferred, with a coupon of 8.75 percent, had a conversion feature with no assured premium. When it must be converted in three years, the conversion price will be $28 to $33.04, depending on where the common is then.

Even if we assume that the company will get the higher conversion price, Lehman will have reaped $6 billion by issuing 203.4 million shares. That does not compare favorably with its share buybacks over the past 13 quarters, when it spent nearly twice as much to buy 189.5 million shares. It paid an average price of $62.19 for shares that dropped under $23 after the shake-up was announced.

On the call Monday, Ms. Callan emphasized that Lehman had taken its gross leverage down to 25 times its equity — meaning that it had $25 in assets for each dollar of shareholder equity, down from more than $30 — and that the firm felt that was far enough. The new capital, she said, would be used “to take advantage of future market opportunities, which are abundant.”

There was no sign of institutional humility, no admission of the obvious fact that Lehman had not anticipated the market conditions that now bedeviled it, or that it was possible that it might once again have underestimated the problems it faced. “From a risk management perspective,” Ms. Callan said, “we continued to operate in our disciplined manner we’re known for.”

On Wednesday night, hours before she found out she had lost the job she was given in December, I asked Ms. Callan about the call. “Trying to strike the right tone, to tell what really happened, what are the facts, and trying to give some confidence to your stakeholders, is a difficult process,” she said. “You don’t always get it right.” Lehman will have another chance Monday, when it formally releases the earnings numbers that it previewed this week. It must decide how much more to disclose.

Treasury's Paulson says investment banks making progress on liquidity
US Treasury Secretary Henry Paulson indicated today that he is pleased with the progress made so far by some investment banks as they try to disentangle themselves from the ongoing housing and credit crises. 'Since March, I believe the investment banks have continued to make progress,' Paulson told reporters just before the start of the G-8 finance ministers meeting in Japan.

'Some have learned lessons, they have continued to de-leverage, they've improved their funding and liquidity, and they've strengthened their capital position,' he said. Paulson spoke in a week that saw Lehman Brothers announce a 3 bln usd loss in the second quarter and the departure of some of its senior officers, although he did not specifically mention Lehman or any other companies.

Paulson was set to hold two bilateral meetings on Friday, the first with the UK's Chancellor of the Exchequer Alistair Darling, the second with Japanese Finance Minister Fukushiro Nukaga. Treasury officials said this week that Saturday's G-8 meeting would focus on how to combat rising food and energy prices. Treasury Undersecretary David McCormick said discussions on how to increase the supply of both would be on the agenda.

For energy, that means continuing work toward the development of biofuels, but also cutting back energy use. Regarding food, McCormick said the talks would focus on ensuring countries around the world have access to technologies that help increase crop yield.

McCormick also said the talks would likely address foreign exchange regimes. The last finance ministers meeting in April in Washington noted 'sharp fluctuations in major currencies,' and said ministers would monitor markets closely, which many economists took as a sign that some form of intervention may be coming. In recent weeks, Paulson has refused to rule out currency intervention in various interviews.

Paulson, Nukaga, Darling and World Bank President Robert Zoellick today announced their effort to set up a fund that would be used to help developing countries pay for technologies that are safer for the environment. Paulson said he wants to see 10 bln usd for this effort, and said he is 'optimistic' the idea will receive support from the G-8 this weekend. 'I expect to get support broadly from the G-8,' he said. 'It's been very encouraging.'

Emerging markets face inflation meltdown
Central banks across much of Asia, Latin America, and Eastern Europe will soon have to jam on the breaks or risk a serious crisis as inflation spirals into the danger zone. As the stark reality becomes ever clearer, this year's correction in emerging market bourses and bond markets has now accelerted into a full-fledged rout.

Shanghai's composite index touched a fourteen-month low of 2,900 yesterday. It follows moves this week by the central bank raised reserve requirement yet again, draining a further $60bn from the banking system. Chinese stocks have now slumped by almost 50pc since peaking in October.

In India, Mumbai's BSE index has lost 27pc of its value as the exodus of foreign funds accelerates. The central bank has raised rates to 8pc to curb inflation and halt a run on the rupee, but critics still say the country waited too long to tackle overheating. The current account deficit has shot up to near 3.5pc of GDP. A plethora of subsidies has pushed the budget deficit to 9pc of GDP.

Russia, Brazil, India, Vietnam, South Africa, Indonesia, Nigeria, and Chile - among others - have all had to raise interest rates or tighten monetary policy in recent days. Most are still behind the curve. "The inflation genie is out of the bottle: easy money is the culprit," said Joachim Fels, chief economist at Morgan Stanley.

"Weighted global interest rates are 4.3pc, while global inflation is above 5pc. The real policy rate in the world is negative," he said. The currencies of Korea, Thailand, the Phillipines, and Malaysia have come under pressure this week as investors scramble for dollars in moves that echo the East Asia crisis in 1997-1998. Several countries have had to intervene to slow the currency slide.

The sudden shift in sentiment appears to follow comments by Ben Bernanke and Tim Geithner, the heads of the US Federal Reserve and the New York Fed, leaving no doubt that Washington has lost patience with the crumbling dollar. It is almost unprecedented for Fed officials to take a public stand on the Greenback. The orchestrated move is clearly aimed at halting the vicious circle in the oil markets, where crude prices are feeding off dollar weakness - with multiples of leverage.

The "strong dollar" campaign has switched into high gear. US Treasury Secretary Hank Paulson has conducted an aggressive lobbying drive behind the scenes in the Middle East and Asia. America's friends and foes have been left in no doubt that the enormous strategic might of the United States is now firmly behind the currency. From now on, they cross Washington at their peril.

The markets are now pricing in two rate rises by the Fed this year. Investors no longer doubt that the US - and Europe - will do what is needed to restore credibility. This display of resolve has suddenly switched the focus to the very different universe of emerging markets, where a host of countries have repeated the errors of the 1970s.

Wild Ride In Lehman, Financials
There is no breathing room for the box Bernanke is in. Several Fed governors are in open revolt calling for higher rates, and others are openly questioning the Term Auction Facility (TAF), and Primary Dealer Credit Facility (PDCF). US consumers are getting smoked by rising prices, banks are getting smoked by falling margins, rising defaults, and the need to raise capital. Housing will be further smoked if Bernanke is forced to raise rates and the dollar may be further smoked if he does not.

Economic Checkmate!

S&P Lowers Ratings on 65 classes of Alt-A Securities
In a completely expected move (at least in this corner) is yet another S&P downgrade in Alt-A mortgage backed securities.

"June 11, 2008-Standard & Poor's Ratings Services today lowered its ratings on 65 classes from 19 residential mortgage-backed securities (RMBS) transactions backed by U.S. Alternative-A (Alt-A) mortgage loan collateral issued in 2006."

Many of the downgrades were from AAA to BB or BBB-.

U.S. Financial Firms Cut Dividends Most in Five Years
Citigroup Inc., Wachovia Corp. and KeyCorp are among 16 U.S. financial firms that slashed dividends this year, a tally that exceeds the previous five years combined. Goldman Sachs Group Inc. and Bank of America Corp. may follow as mortgage-related losses escalate, analysts say.

Banks are trying to hang onto capital as the U.S. home market implodes and loan losses soar. KeyCorp, Ohio's third- largest bank, chopped its payout in half today -- the first decrease in 43 years -- and said it must raise $1.5 billion after losing a tax case. The world's biggest financial companies have raised $293.8 billion to bolster their balance sheets.

``They need the cash on hand,'' said Bartley Barnett, head of equity trading at Morgan Keegan Inc. in Memphis, in an interview yesterday. ``If that's the case or not, that's the perception.''

Foolish Friday
So Lehman closed its transaction yesterday; they actually managed to get the money. Of course this is not a huge surprise, given that once you hit the "buy" button (whether in the free market or not) there isn't much you can do about it.

Just ask the fools who bought Bear Stearns as it was sliding, and then ultimately wound up with $10 or less a share.

The number of chainsaw-jugglers in this market continues to amaze me. Why would anyone in their right mind have bought into that deal? What, you think you didn't have warning? Let's look at it for a second:

* AHM goes down, and their business gets picked up by Wilbur Ross. How much do you think he has lost - thus far?
* Countrywide did a big convertible offering last year. Poof.
* NCC did an equity deal recently. Bang.

And on and on and on. The financials keep managing to find suckers who literally are playing fire starter with $100 bills! You have to be farm-animal stupid to be doing any of these deals at this point. Buy Lehman's stock in a deal like this? Why? You can buy it for $5 less in the open market! That's a huge and immediate loss and it doesn't matter if it "works out" later on or not - its still a real loss compared to what you could have bought the stock for in the open market yesterday or, for that matter, in any of the last few days.

Bottom line: You can't buy or own any financial firm's stock in this market.

It appears as if MBIA and Ambac plan on stiffing the banks
MBIA is now reconsidering sending the funds received from their last round of fund raising to the insurance subsidiary. The funds are currently held at the holding company level. According to the WSJ, they are scheming on capitalizing a fresh entity to write AAA public finance wraps. Okay, so what about the structured product business, which is what was demanding the vast bulk of the capital in the first place. Oh yeah, those customers get stuck holding the $119 billion dollar bag!, just as I told you those many months ago. Expect whatever entity holding that structured product noxious trash to get downgraded to junk since even the parent company is showing it no love. The I banks have not cut those marks nearly as deep as they are going to have to.

It's amazing that this stuff was all over the news a quarter or two ago, hailed by the media as Armageddon, and now that it is finally arrived, you can barely find details on it. Well, here's a not tip. The situation has gotten no better from last year, and actually it has gotten much worse.

For those of you who are planning to buy those financials on the dip.... Peace be with you, my friends.

The ECB calls Bernanke's bluff
On June 3rd, the super-dovish Fed chief Benjamin Bernanke, couldn't remain silent any longer, and shocked the global money markets, when he spoke out for the first time, about the need for the Fed to defend the US dollar in the foreign exchange market, before an international television audience.

"The Fed is working with the Treasury to carefully monitor developments in foreign exchange markets," Bernanke warned. "We are attentive to the changes in the value of the dollar and inflation expectations. The Fed's commitment to price stability is a key factor, insuring that the dollar remains a strong and stable currency. The possibility that commodity prices will continue to rise, and lift inflation expectations are significant risks, that might ultimately become self-confirming," he said.

A week later, currency traders were left wondering if Bernanke had undergone a brain transplant, and re-programmed as a Bundesbank hawk, when he downplayed the biggest monthly surge in the US jobless rate in 22-years. "The risk that the US economy has entered into a substantial downturn appears to have diminished. The FOMC will strongly resist an erosion of longer-term inflation expectations. There are significant upside risks for inflation through commodities," Bernanke declared.

Instinctively, foreign currency traders rushed to cover over-extended short positions in the dollar, as yields on the US Treasury's 2-year note, jumped by a startling half-percent in just two-days, to 2.90%, discounting the likelihood of 75-basis points in Fed rate hikes by year's end. Something must have changed, to cause "Helicopter" Ben to suddenly talk about switching gears, from inflating the US money supply at a 17% annualized rate, its fastest in history, to a more prudent course of defending the purchasing power of the dollar.

But if "Helicopter" Ben is just bluffing about his determination to defend the US dollar, then it would have been better, had he remained silent last week. Foreign currency traders know the first line of defense for a currency in the $3.2 trillion per day FX market is "jawboning" - or trying to alter trader behavior and psychology with words alone. Initially, "open-mouth operations" are cost-free, and might even achieve the central bank's objective without more expensive remedies.

Capitulation Among the Oil Shorts?
Make no mistake, however, we are now also witnessing signs of capitulation among those players who have been on the short side of the crude oil futures market. Subscribers please consider the following:

1. The balance sheet problems at many commercial and investment banks have made them reluctant to act in their natural roles by taking the other side of crude oil and general commodity speculators, including players such as fully-collateralized commodity funds from PIMCO and the USO ETF. Up until a few years ago, financial players have traditionally been long (i.e. they took the other side of the natural hedgers such as energy producers) - now, they are short. Given the breakdown of the roles among financial players, there is no question that the crude futures market (and the corn futures market) has broken down. Ironically, the general credit crunch - which in turn has led to a slowdown in credit creation and economic growth - has been partially responsible for the latest run-up in crude oil prices.

2. The balance sheet problems, as well as the relentless rise in oil prices coming into last week and the bean counters' will in forcing "mark to market" accounting on energy producers, mean that many energy producers now have no ability to hedge their production, as many investment banks have become reluctant to extend margin loans to the smaller energy producers. The lack of hedging "pressure" to counteract the buying power from the index funds has no doubt added to the relentless rise in oil prices over the last few months.

3. As an extension to points 1) and 2), this has also led the prime brokers to either clam down or cut back on margin loans to hedge funds who want to short oil - thus taking out other significant financial players on the short side as well. Note that raising margin requirements would not affect the long-side players, as commodity index funds and ETFs are in general, fully collateralized. If anything, raising margin requirements will put pressure on the short side, thus exacerbating the current rise in oil prices. Furthermore, the two-day spike in oil prices ending last Friday had all the signs of a capitulation and panic by those on the short side. I would not be surprised if some energy producers actually went into the market late last week to cover some of their long-term hedges - as a way to reduce or eliminate mark-to-market losses in upcoming earnings reports.

In other words, the latest spike in oil prices is mostly due to technical rather than fundamental reasons. With the $5 billion common stock offering just announced by Lehman Brothers, and with Barclays PLC now taping US$5 billion from sovereign wealth funds and potentially acquiring some of the weaker financial institutions (Lehman and UBS were mentioned), my sense is that this extraordinary combination of technical factors in the crude oil futures market is now close to an end. While crude oil prices may well be higher a couple of years from now, crude oil is definitely now due for a short-term and significant correction.

FSA tightens short-selling rules
Hedge funds who try to make a killing by short-selling the shares of a company conducting a rights issue will have to reveal their activities, under new rules announced today.

The Financial Services Authority said that the practice of taking a short position in a company while it is holding a cash call to shareholders was potentially an abuse of the market. From next week, short-sellers will have to disclose their position to the wider market.

The move helped to boost the share price of companies conducting rights issues, and those such as the housebuilders who may need a capital injection.

"In current market conditions, there is increased potential for market abuse through short selling during rights issues," said the FSA.

"This is potentially damaging not only to the issuers in question but also to confidence in the overall fairness and quality of the UK market. It can be particularly prejudicial to the interests of small investors," it added.

The FSA has previously insisted that short-selling is a valuable part of the financial marketplace as it boosts liquidity. Today it reiterated that the wider practice of shorting is not itself abusive, but that it poses a particular problem when cash-strapped firms are seeking new capital.

The announcement comes just two days after shares in HBOS, the UK's biggest lender, plunged below 275p – the price at which it hopes to raise £4bn by selling new shares to existing investors.

Irish voters reject EU treaty
Ireland today decisively rejected the Lisbon treaty on European Union reform, plunging the project into chaos.

Humiliated at the polls, the Irish prime minister, Brian Cowen, admitted the country's no vote had been a potential setback for Europe.

The European commission president, José Manuel Barroso, said he believed the treaty was still "alive", but was immediately contradicted by Luxembourg's prime minister, Jean-Claude Juncker – the longest serving leader in the EU - who said the Irish vote meant it could not enter into force in January 2009 as planned.

Less than 1% of the EU's 490 million citizens appear to have scuppered the deal mapped out in Lisbon that was meant to shape Europe in the 21st century.

Ireland was the only one of the 27 EU member states obliged to hold a referendum on the treaty....

....Politicians in Dublin were stunned by the size of the margin in favour of the disparate no campaign, which comprised a vocal, well-funded free-market ginger group, the ultra-Catholic right, Sinn Fein and the far left.

They were also surprised at the hostility to the EU reform deal in Irish constituencies that have gained so much in European largesse. In the two constituencies of Donegal, for instance, two-thirds of voters said no to Lisbon. The biggest no vote was in Dublin South West, which saw a 65.1% majority.

Ireland may have enjoyed a net gain of €40bn from Europe since it joined what was then the EEC in the mid-1970s, but its voters were concerned about the loss of sovereignty, possible tax harmonization and a threat to the country's neutrality.


Melancholy Korean said...

Is there any way to trade no more Euro in, say, ten years? Small probability I know, but as Taleb teaches us, get long the black swans! (Or something like that. Haven't read the book.)

cj said...

I would be interested to know if you feel the same as Stonleigh regarding inflation and deflation? She felt that we are moving toward deflation. For those individuals that have no debt she stated that they should have cash in hand and buy Treasuries. In addition she felt that precious metals would get hit hard. Do you agree?

Ilargi said...


Deflation is the only possibility in a world where trillions of dollars disappear into nothing, as we see happening in the west. Mind you, it will get much worse, we've had only a sneak preview so far. Central banks can't print enough to prevent it, even if they'd want to, which they don't. Current price rises have nothing to do with inflation.

Producers of oil and trinkets, Mid East, Russia, China, can see temporary inflation through huge trade surpluses. But they too will deflate over the next few years.

The point about Treasuries is liquidity: being able to get your money out fast. So only short term Treasuries are an option. Whether they're better than old socks, who shall say?

I think PM are risky short term, but in the end will be the winning option. Question is how long one can wait.

A sidenote: the structure of our societies will change profoundly. I see most people reason along the lines of the old one, thinking that having some money for their nuclear family unit will do the trick. I don't believe in that at all. It's a dead-end structure that has lasted no more than 50 years, and moreover has brought us where we are now.

The plus is we don't have to look far to see where we're going, the minus is that we've forgotten most of what we'll need.

Anonymous said...

Hello Ilargi and Stoneleigh,

I admire the wide knowledge of both of you concerning the financial mess we find ourselves in. When you have time, could you post where you gained so much information? I looked at your profiles, but there is nothing there. I see that Ilargi says today he worked for some time in Japan. So did both of you study the financial industry in college? or gain first-hand experience thru jobs? And which country do you live?

Thank you,
Anonymous Reader

cj said...


Just a word of thanks for you and for Stoneleigh.

Stoneleigh said...


Thanks :)

Stoneleigh said...

Anon Reader,

Ilargi hasn't lived in Japan - the writer of the article he quoted did. We're both European (of different nationalities) and now live in Canada. As for the rest, I'll let Ilargi speak for himself.

I am a former academic - a Research Fellow from Oxford University. My formal qualifications are in science and law. In science I had twin interests in neuroscience/psychology and environmental science (focusing on energy), and in law my field was international development law and economics/finance (focusing on the consequences of globalization).

For many years now, since leaving the UK, I have been an independent researcher in energy, environment and finance - looking for the big picture in a world geared towards hyper-specialization. I am also a small-scale farmer interested in developing small communal social structures in the countryside. As Ilargi said, nuclear families are not an ideal social arrangement for weathering a significant and prolonged storm.

StreetWatcher175 said...

I Could not find yesterdays reference to 1929 at the Bank for International settlements. Can Someone please provide it. Note I actually read most of the postings on their website.

Andy in San Diego said...

"nuclear families are not an ideal social arrangement for weathering a significant and prolonged storm."

Can you elaborate? Why is it not ideal? What would be more ideal?


Greenpa said...

Alas, I agree on the dicey-ness of relying on the nuclear family idea; particularly since my own situation is perhaps sub-nuclear.

Community- of some kind, may be an answer. My own favorite at the moment is Rob Hopkins "Transition Towns" movement;

Stoneleigh said...


A nuclear family is not a large enough structure to be able to provide for itself in the absence of state supports. It would be terribly vulnerable. In most of the world where state supports have never been available, people live in extended families where everyone has a role to play.

It would be difficult to bring together extended families here, as families are spread out and the necessary mindset is missing. My approach is that if one doesn't have an extended family, then making one seems like a good idea. To that end we are hoping to build a small community.

Communities can be far less dependent on money than individuals or nuclear families, as the skill-base is much greater. The communal approach doesn't scale up (it makes a lousy basis for running a national government for instance), but can work well at very small scale if people have the necessary cooperative mindset.

Greenpa said...

aha! Canadians! That explains it.


As I've said in multiple places, Canadians seem to be the only grown-ups in North America. The US government has been entirely run by 4 year olds, recently; and 13 year olds, before that. I could go on.


EBrown said...

I heartily concur with the thesis that isolated nuclear families will be a poor social model as we move into Depression 2.0.

I flip-flop between optimism and pessimism over how quickly we North Americans with our cultural reverence for the independent nuclear family will transition to extended models. I'm 28. My grandmother is 82 and lives in an assisted living type facility for elderly people. My perception is she would probably rather die than "impose" on one or more of her children or grandchildren, even if her quality of life were better than it currently is. My parents are nearly 60 and while they make noise about "wanting to leave their kids free" when they get older they have less of a knee-jerk reaction against the idea of multi-generational living than my grandmother does. My wife and I are very familiar wife older people as I am an RN and she is a potter working in the studio of a 83 year old potter. We are entirely commited to supporting our parents in their dotage as we believe it will be the only option available in a few years. While both of us come from upper middle-class families we have no confidence that social security/retirement funds will be available to our parents. So while we are not currently living in an extended arrangement we have made and continue to make the needed psychological preparations.
I mention ages in the above paragraph because my perception is that these generational perspectives are broadly held across the US. Sure there are plenty of young people here who want nothing to do with their parents, but the stigma of living at the parents' house well into ones 20s or even 30s is dramatically weaker than it used to be.
I know there will be all kinds of difficulties and personality conflicts when we are forced into cohabiting with our siblings' families, but we'll work it out one way or another. Having no other options does wonders for that sort of thing...

FB said...

Hello All,

Stoneleigh, you speak of -40°C. Yikes. Talk about a continental climate. We are two hours from the Med and consider -25 very cold. By the way, did you ever notice that the C and F scales cross at minus 40?

When a ewe refuses a little one, I throw her into the "work" position (me standing, the ewe seated with her back to my legs) and let the little one have at it. My children often have to help it in the beginning, but it catches on fast. Just starting the process can sometimes re-establish the relationship with the ewe.

The 1200 are not ours. That would be an enormous herd. But we do give the shepherd a hand, for the fun of it.

About nuclear families, yes, I agree. We are moving to a mountain village of 400, a big jump upscale for us.

The news about the euro was not good. News in general from Europe is not good. I understand many complaints about the EU, notably the irritating use of one language in contradiction with all stated principles, the persistent slide toward big business, the "democratic deficit", etc., but do we want union or not? To change all that, we need to make more efforts, not less. Where is the generosity, the élan? We are shrinking from the challenge.

Any articles you come across concerning the euro and the union are of major interest to me.

One question that has been nagging. Several articles have spoken about the trade books at banks, the inference being that those books are different than the normal ones. Are the trade books the off balance-sheet assets?

Thanks for everything.


westexas said...

Re: Nuclear Families

I read an interesting statistic that the cost of running a household drops off at the square root of the number people in the household, So, one person is one. Two people, 1.4. Three people, 1.73. Four people, 2.0.

In other words, four people can live together for half of the cost that it would cost them to live separately.

Iowa Boy said...

I wrote a DailyKos diary about the Euro zone currency concerns and got slapped silly by those in the know - people with friends and family there pretty much poked all sorts of holes in that "Torygraph" story.

Most of the information here is top notch, but this? If they're right it's Faux News grade, uhhh, stuff.

Anonymous said...


Thank you for your background info. I have wanted to forward this blog to others to gain insight into the impending global financial crisis. Having your academic and formal qualifications give more weight to the seriousness what is to befall our lives.
Ilargi, could you post some background info too? Thank you,
Anonymous Reader

Stoneleigh said...

Iowa Boy,

I think European monetary union is in serious trouble as the stresses building up between areas with different economic fortunes and political cultures are considerable. Grand unifying projects go hand in hand with long periods of expansion, which are underlain by the same optimism that promotes peace, trust, cooperation and inclusion.

When expansion becomes contraction, and there is no longer enough to go around, as is very likely to be the case in Europe in the not-to-distant future, the forces that led to unity will go into reverse. Europe unfortunately has many old hatreds that I'm afraid are likely to flare up again when people begin looking for scapegoats. Sadly, I think the future for Europe is balkanization, which is one reason I no longer live there.

Stoneleigh said...


Nice to see you :)

There are six of us here now, and eventually there will probably be many more.

Stoneleigh said...


Being an RN is an ideal career choice to have made.

I have several siblings and both parents still, but none of them were interested in co-habiting. Although we all live in the same country, it's a big place and we're still spread out over 5000km (literally coast to coast). It makes more sense for us to make our own local extended family.

As you say, many people will have no choice at some point. Household consolidation is likely to become widespread, but it's more likely to be successful if attempted before anyone is desperate. People are much happier if they feel they have some choice in the matter.

Ilargi said...


"I wrote a DailyKos diary about the Euro zone currency concerns and got slapped silly by those in the know"

i tried the read the first two dozen or so entries. Not a single worthy word was spoken. Not my world, sorry. And I'm sure you're smart enough to see that not all we post here is only what we agree with.

Anon 2677843657843657348657486

No credentials from me. It defeats the purpose of this site, which is to make people think for themselves.

Anonymous said...

It's funny to see the Irish saying No to Lisbon treaty.

USAmeican corporations avoiding taxes have a lot of noise machines.

Let's see if they get free smoking in the old pubs.

EntropyBrain said...

There are more than 6 here. Some are less significant than others. :)


FB said...


Iowa Boy, I took a look at the comments on your site and agree with Ilargi. The people commenting are simply not informed.

One person justifies very vague assertions with "I know because I have a house in Spain". Spare me.

Concerning the euro, I would like to know how many Germans are sorting out euro notes and how many are stashing old marks. I have some old marks and francs as souvenirs, but am not in the least nostalgic. It is simply fun to show them to my children.

Next thing you know, people will be saying we all want to return to the old measurement systems simply because the Japanese sell us computer screens marked in inches. Right.

So much for now,

Anonymous said...


That is a very interesting answer, to think for ourselves. I often wonder what happened to people's critical thinking skills. It seems like too many people for too many years have always relied on others to tell them what to do, what to buy, what to eat, what to invest in, etc., that they have lost the ability to think for themselves. No wonder that these people have let others walk all over them and financially destroyed our country and the world. This is my favorite blog, it gets me to think. Thank you,
Anonymous Reader

cj said...

That is a very interesting point. We have become so specialized that we are forced to rely upon the knowledge of others. For instance I am by no means broadly informed and understand the intricacies of current world of finance. It is so complex. We find ourselves on an enormous tangent, we are so far away from what I would call the central way of common sense, and not just in the world of finance, but in just about everything we now do. We find ourselves rationalizing all kinds of behavior that would have been inconceivable a few short years ago. We find ourselves swimming in a sea of corruption and no longer see it as such. Wall Street, the government, the common man on the street, even myself! What ever happened to good manners, common or should I say uncommon courtesy? How easy is it to rationalize running a red light, or not to pick up a piece of trash. When did we start to not care about how we express ourselves, and then complain that my unhappiness is the fault of someone else? We have come to this juncture because we have not wanted to take total responsibility for our living, for what we express, for what I express. In the final analysis, YOU ONLY KNOW WHAT YOU EXPRESS!!
If I am uninformed and don't want to take personal responsibility, take the initiative to educate myself on a topic, to start to think for myself, then let me not blame others for my lot when things go badly. It has become most customary to chose the path of least resistance by playing the victim!!!
Since I have not wanted to take full responsibility for my financial world ( I was lazy ) I now find myself asking a lot of questions of those like ilargi and Stoneleigh. I hope that I didn't wait too long. Let us all be willing to take total responsibility for the choices that we have made and will make.
The world that awaits us is unlikely to be pleasant, and there will be a multitude of circumstances that we could use to justify complaint and blame, which will accomplish nothing, but will in fact multiply the chaos. If we want a creative world who is going to bring it? That guy over there? No. It has to start with me. I realize that the challenges ahead will force me to face the self centered elements in my heart in a way that will be hard to comprehend. I hope that I am up for it!!!