Debt Rattle, June 19 2008: I know why Citi never sleeps

Dorothea Lange Mud Bowl June 1938
Caddo, Oklahoma. Migrants leave the small towns as well as the farms of the southwest.
This region is a source of many emigrants to the Pacific Coast

Ilargi: Yeah, that title was my immediate reaction when I saw Citi’s new slogan, ”Citi never sleeps”, earlier in the year. Not every slogan is as strong as it may at first appear.

Today seems a good time to get back to it. The heavy hitters are coming out this week, the designated power sluggers are called in. I like the baseball analogy, especially since someone quoted below paints a great picture: "If we're in the seventh or eighth inning, this is a 100-inning game."

I said yesterday that the “we are escaping recession” articles make me tired, and I refuse to cover them any longer. There’s plenty more of them today, UK retail surges, and some 'index of leading US economic indicators' rises "unexpectedly" (on that $165 billion tax handout).

It’s all pink and white noise, guys, and nothing else. For the same reasons, I don’t look much at the Dow either: it’s not some barometer for the state of the economy, it’s at best one for the level of gullibility still out there, and for the suckers being sucked dry.

In the real state of affairs that we try to present here, RBS’ Bob Janjuah’s prediction of an all-out crash within 3 months is by no means the only ball that’s going-going-gone. Today, Meredith Whitney comes closer than ever to predicting the end of Citi, let’s call it The Big Sleep: "It's an impossible feat. It's not a case of changing the chef. The whole restaurant has to be shut down."

John Paulson, Wall Street’s MVP for 2007, forecasts $1.3 trillion in bank writedowns, meaning only 25% has been done thus far. Paulson also calls Ambac "the most leveraged, troubled company out there", and while we’re looking at monoline insurers, MBIA needs a priest as well.

My guess is that the half year numbers, due June 30, may well reveal a "trillion tons of truthiness".


Mayo Gets to Citigroup First While Whitney Is Everyone's Oracle

The call sent Citigroup shares reeling -- down 11 percent in seven trading days. The analyst had downgraded the stock after citing investor dissatisfaction with Citigroup's senior management and saying Chairman and Chief Executive Officer Charles Prince should resign.

The analyst in question was Michael Mayo, a stock picker at Deutsche Bank -- not Meredith Whitney, the Oppenheimer analyst who has become the toast of Wall Street since her own report on Citigroup. She downgraded the stock to "underperform" from "neutral" on Oct. 31 after calculating in a research report that the bank's dividends for the third quarter of 2007 exceeded its profits. She also said the bank needed to raise $30 billion in capital.

Mayo, 45, gave his negative assessment of Citigroup more than two weeks before Whitney's. He downgraded the stock to a "sell" from a "buy," the best call on Citigroup for the 12 months ended on March 31, according to data compiled by Bloomberg. On the night of Oct. 11, Mayo got a call on his mobile phone while he was attending a New York Knicks basketball game. A colleague tipped him off that Citigroup had made some changes.

In a press release, Prince had announced the departure of Citigroup trading chief Thomas Maheras, following almost $6 billion in losses and debt writedowns, and the promotion of Vikram Pandit, then chief of alternative investments, to head a new unit, the institutional client group. That same night, online news stories quoted Citigroup Executive Board Chairman Robert Rubin as praising Prince and saying the CEO would be in charge of Citigroup for many years to come.

Mayo, who has a Master of Business Administration from Washington-based George Washington University, was a longtime critic of Prince. The next day, he fired off a report downgrading Citigroup's stock. "Our prior thesis was that either the company would perform well or top management would be replaced," Mayo wrote in his note. "We feel that changes are needed in the office of the chairman."

Of the two reports, Whitney's Oct. 31 call got much more publicity because it had a greater impact. Citigroup shares fell 8.1 percent the next day, their steepest decline since September 2002 -- compared with 3.4 percent the day after Mayo's downgrade -- and Prince resigned four days later.

After Whitney's call, the stock fell 51 percent through June 18. In January, Citigroup slashed its dividend, just as she said it should, to 32 cents a share from 54 cents. Pandit, who succeeded Prince in December, has raised $44 billion in new capital.

Neither Whitney nor Mayo would comment on the other's work. Both have continued to criticize Citigroup's management. Whitney, 38, who arrived on Wall Street 16 years ago after earning a history degree from Brown University in Providence, Rhode Island, holds out little hope that Pandit can solve the bank's myriad ills. "It's an impossible feat," she says. "It's not a case of changing the chef. The whole restaurant has to be shut down."

Since Whitney's Citigroup downgrade, she's made dozens of appearances on cable TV business shows and has been quoted hundreds of times in the press. "I love all the attention," she says. "I think all the pressure is so much fun." Whitney's calls also get more attention from portfolio managers.

"She stepped out of the pack and, for that, she's a hero," says Michael Holland, who oversees more than $4 billion at Holland & Co. in New York. "If she had been wrong, she'd have a black mark against her. It's good to have someone who takes the risk."

Citigroup was not Mayo's first bold, contrarian call. In 1999, he was a banking analyst at Credit Suisse First Boston. At the height of dot-com mania in the spring of 1999, he issued a "sell" rating on all banking stocks when he saw that the merger boom was slowing and problem loans were growing. The stocks did fall dramatically in the next six months. Mayo was fired in September 2000.

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Paulson & Co. Says Writedowns May Reach $1.3 Trillion

John Paulson, founder of the hedge fund company Paulson & Co., said global writedowns and losses from the credit crisis may reach $1.3 trillion, exceeding the International Monetary Fund's $945 billion estimate. "We're only about a third of the way through the writedowns,"

Paulson, 52, told the GAIM International hedge fund conference in Monaco today. "There are a lot of problems out there and it will continue to be felt through the year. We don't see any signs of stabilizing." Paulson, whose New York-based company manages about $33 billion, made bets last year that subprime-mortgage debt would fall after he noticed "bubble like" prices.

His Paulson Partners fund rose 18 percent a year since it started in 1994, and his main subprime-debt fund rose 591 percent last year. Banks and securities firm worldwide posted more than $395 billion in losses and writedowns since the subprime crisis started last year.

The U.S. is heading into a recession as falling home prices weigh on consumer spending, Paulson said. The second half of this year will be worse than the first as the economic slowdown spills into 2009. Signs of stress are "accelerating" in the housing market, and he's betting on falling securities prices, he said. "I don't consider myself a bull or a bear," he told the audience at Monaco's Grimaldi Forum. "I'm a realist."

A Royal Bank of Scotland Group Plc strategist agrees that stock and credit markets still face the worst in a slump that started almost eight months ago. "Mid-July through to October is likely to be the most bearish period we will experience in the bear market that began in the fourth quarter of last year," Bob Janjuah, a credit strategist at the bank in London, wrote in a report dated June 11.

The MSCI World Index has lost 13 percent since reaching a record in October. The index is down 4.1 percent this month after the Federal Reserve and the European Central Bank policy makers indicated interest rates may need to increase as the threat of inflation intensifies. The economic slowdown and inflation have put central bankers "into a dangerous corner" where the chance of a "major policy error has just super-spiked," Janjuah wrote.

Ambac Financial Group Inc., the second-biggest bond insurer, is "the most leveraged, troubled company out there," Paulson said. It's at risk of being downgraded to non-investment grade, he said. Ambac spokeswoman Vandana Sharma declined to comment. Ambac shares have lost 92 percent of their value this year after losses on subprime mortgage securities caused the company to lose its AAA credit rating at Fitch Ratings.

The housing and credit-market slump pushed Ambac to three straight quarterly losses after more than a decade of profit. It has written down $5.2 billion since the collapse of the U.S. subprime mortgage market last year. Paulson's outlook is consistent with the view of hedge funds meeting in Monaco this week. More than 80 percent of the 1,300 fund managers, investors and service providers gathered in Monaco for the annual conference said they expect the credit crisis will continue, according to a GAIM survey. About 23 percent said the situation "will deteriorate significantly."

Bill Browder, founder and head of Hermitage Capital Management, said securities firms have a "vested interest" in claiming an early end to the crunch. "If we're in the seventh or eighth inning, this is a 100-inning game," he said. Paulson's speech was the biggest draw at the event, which comes as the hedge fund industry endures some of its worst performance in nearly two decades, rising just 0.13 percent through May, according to Chicago-based Hedge Fund Research Inc.

"John Paulson has of course been very successful by making the right trade last year," said Manuel Echeverria, chief investment officer of Optimal Investment Services SA, a Geneva based investor with about $10 billion under management. "We'll have to see what he's going to do now that the trade has run out of juice." Paulson said he's preparing to buy distressed securities such as bank loans, call them a "potentially $10 trillion opportunity."

While it is still "premature" to invest in many of them, he sees "opportunities this year" to buy mortgage backed debt, he said. He hired employees this year to research securities firms such as Citigroup Inc. for long-term investment positions. "We're trying to see the right entrance point," he said. "If you invest too early, you lose money."

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Bill Ackman Was Right: MBIA, Ambac on 'Ratings Cliff'

Bill Ackman was right: the world's largest bond insurers aren't worthy of a AAA credit rating and may be headed for the bottom of the scale.

Ackman, the 42-year-old hedge fund manager who says he stands to make hundreds of millions of dollars betting against MBIA Inc. and Ambac Financial Group Inc. if they go bankrupt, will tell investors at a conference in New York today that losses posted by bond insurers may threaten to breach the capital limits allowed by regulators, making them insolvent.

That once-unthinkable scenario would trigger clauses in $400 billion of derivative contracts written to insure collateralized debt obligations and other securities, allowing policyholders to demand immediate payment for market losses, which have reached $20 billion, according to company filings. Downgrades of the insurers would cause a drop in rankings for the $2 trillion of debt that the companies guarantee, wiping out the value of the CDO insurance held by Wall Street firms, analysts at Oppenheimer & Co. said.

"Given the volume of credit-default swap contracts the industry has written, there is a real element of a ratings cliff across the bond insurance sector," said Fitch managing director Thomas Abruzzo, the first analyst to strip MBIA and Ambac of their top ratings. Ambac said today it asked Fitch to remove ratings on all of the company's subsidiaries. MBIA asked Fitch to stop assigning a financial strength rating in March.

CIFG North America may fall first. The company's credit rating has been cut by 17 levels to CCC from AAA by Fitch since March because of concern it won't be able to make payments on $57 billion of the contracts. Ackman said CIFG "provides a road map for what happens to a bond insurer when its capital is depleted." Ackman, whose $6 billion Pershing Square Capital Management hedge fund in New York returned 22 percent last year, began betting against bond insurers in 2002.

In his report "Is MBIA Triple-A?," Ackman was the first to say the insurer's use of derivatives to guarantee debt threatened to drain capital. MBIA, of Armonk, New York, Ambac, Security Capital's XL Capital Assurance and FGIC Corp. also have guarantees with similar clauses to CIFG that may allow policyholders to demand billions of dollars if the companies became insolvent, according to company filings.

CIFG, XL Capital Assurance, and FGIC's insurance unit may all fall short of regulatory capital requirements by June 30, according to Robert Haines, an analyst with CreditSights Inc. in New York. Downgrades may cause Citigroup Inc., Merrill Lynch & Co. and UBS AG to write down the value of insured-debt holdings by at least $10 billion, according to Meredith Whitney, an analyst at Oppenheimer in New York.

Banks and insurance companies would also be required by regulators to hold more capital to protect against losses on lower-rated debt, according to analysts at Charlotte, North Carolina-based Wachovia Corp. CIFG is working on a plan to bolster capital, spokesman Michael Ballinger said. Because MBIA has a surplus of $3.9 billion, insolvency is "both highly theoretical and extremely unlikely," Kevin Brown, a spokesman for MBIA said in an e-mailed statement.

Vandana Sharma, a spokeswoman for Ambac, with a $3.6 billion surplus, declined to comment, as did Security Capital spokesman Michael Gormley and New York-based FGIC's chief risk officer, John Dubel. Insurers, including MBIA and Ambac, expanded beyond municipal debt into insuring CDOs, which package pools of securities and slice them into pieces of varying risk. The move was criticized by Ackman, who said it may ultimately bankrupt the companies.

In January, Ackman, who started a hedge fund after working at his family's commercial mortgage brokerage, estimated MBIA and New York-based Ambac faced losses on home-loan securities of almost $12 billion each, a claim the companies disputed as recently as February. Ackman said he took an interest in MBIA after asking a credit-market trader which companies didn't deserve AAA ratings.

That led to his report and his decision to take a short position in MBIA and Ambac stock, selling borrowed stock, expecting to repurchase it later at a lower price. Ackman also bought credit- default swaps on MBIA and Ambac debt. The swaps would rise in value if doubts about the companies grew.

Pershing Square profited as MBIA tumbled 91 percent in the past 12 months and Ambac plunged 98 percent in New York Stock Exchange composite trading. Security Capital is down 99 percent.

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Ambac asks Fitch to withdraw ratings

Ambac Financial said on Wednesday that it has asked Fitch Ratings to withdraw its ratings as the bond insurer tries to survive a disastrous foray into guaranteeing risky mortgage-related securities.

"Our decision to refocus and realign our business around our core expertise in the public finance and infrastructure sectors has led us to re-evaluate our ratings needs," Ambac said in a statement. "As part of this review, we have asked Fitch to remove its ratings on Ambac and all its subsidiaries effective immediately." Fitch said it is considering Ambac's request.

Fitch was the first of the largest three ratings agencies to cut Ambac's AAA rating. The agency downgraded the bond insurer to AA in January, more than four months before Moody's Investors Service and Standard & Poor's took similar action. Bond insurers rely on AAA ratings to write new business, so the loss of Ambac's top ratings from all three leading agencies by early June crushed the company. Ambac shares are trading at $2.10, down 98% in the past year.

For Fitch, having the foresight to take such ratings action earlier than rivals has been a mixed blessing. Ratings agencies are paid by the companies they rate, so if customers end contracts after being downgraded, that can cut into revenue and profits. That's a flaw in the ratings agency business model that's being hotly debated.

After Fitch cut the AAA ratings of rival bond insurer MBIA Inc. earlier this year, the company asked the agency to stop rating it. Fitch refused and continued analyzing MBIA and publishing ratings without being paid for it. MBIA then went further, asking the agency to return or destroy information the company had given to Fitch. That made it harder for the agency to come up with accurate and informed ratings on the company.

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MBIA Debt Is Setting Up a Quandary

The risks associated with the vast, unregulated market for credit default swaps played a crucial role in the bailout of Bear Stearns. Now these financial instruments are taking center stage in another Wall Street drama: whether regulators will let MBIA, the big bond insurance company, renege on a promise to shore up a crucial unit with $900 million in capital.

MBIA has written $137 billion in swaps, which are privately traded insurance contracts that let people bet on companies’ financial health. Most of these contracts stipulate that if MBIA’s bond insurance unit becomes insolvent or is taken over by state regulators, buyers can demand payment immediately.

But if that were to happen, MBIA would have far less money to pay policyholders and owners of municipal bonds backed by the company. So the swaps give MBIA significant leverage over Eric R. Dinallo, the commissioner of the New York State insurance department, who wanted the company to bolster its insurance unit with the $900 million in cash.

In the case of Bear Stearns, the Federal Reserve feared that credit default swaps might unleash a chain reaction of losses if the bank were allowed to collapse. Given the threat that similar swaps may pose to MBIA, Mr. Dinallo is unlikely to push for a regulatory takeover of the subsidiary even if Joseph W. Brown, MBIA’s chief executive, refuses to recapitalize the unit.

Mr. Dinallo confirmed last week that the swaps written by MBIA and other financial guarantors were a big factor in his dealings with the weakened bond insurers. “It is a concern that possibly if one of the companies filed for rehabilitation or if we move to rehabilitate, the holders of the credit default swaps could move to get preferential treatment,” he said.

Mr. Dinallo said he could refuse to honor acceleration demands if he took over a bond insurance firm, but such a move would almost certainly prompt investors who hold the credit default swaps to press their cases in court. The acceleration clause is a standard feature in credit default swaps written by many bond guarantors, including Ambac and the Financial Guaranty Insurance Company.

MBIA, which insures $670 billion in municipal bonds and mortgage-related securities, has been hit hard by the credit crisis. It recorded a $2.4 billion loss in its most recent quarter and lost its prized AAA rating from Fitch Ratings and Standard & Poor’s; its shareholders have watched their holdings plummet 67 percent since the beginning of the year.

Wall Street is worried that rising losses on the $230 billion in mortgage and related securities that MBIA has guaranteed will burn through the company’s capital in the coming years. The company has said it expects total losses of $2 billion, while other analysts believe the number could be as high as $14 billion.

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Ex-Bear Stearns Fund Managers Arrested by FBI Agents

Two former managers at Bear Stearns Cos. hedge funds were arrested at their homes this morning by agents of the Federal Bureau of Investigation over their roles in the collapse of hedge funds that ignited the subprime mortgage crisis last year.

Ralph Cioffi, 52, was arrested at his Tenafly, New Jersey, home and Matthew Tannin, 46, was arrested at his Manhattan apartment, said James Margolin, a spokesman for the FBI's New York office. He said they were to be taken to federal court in Brooklyn for a court appearance later today in connection with an indictment.

The arrests are the first in a U.S. probe of possible fraud by banks and mortgage companies whose investment in subprime loans and securities plunged in value. The U.S. Securities and Exchange Commission may sue the two men as early as today, claiming they committed fraud, people with knowledge of the case said.

"The arrests are appropriate given the magnitude and the egregiousness of their alleged misconduct," said attorney Steven B. Caruso, who is representing investors in arbitration claims against the hedge funds. Cioffi and Tannin engaged in a "gross violation of the public trust that was given to them by investors," he said.

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Hundreds swept up in mortgage fraud arrests

The FBI says it has arrested about 300 real estate industry players since March — including dozens over the last two days — in its crackdown on incidents of mortgage fraud that have contributed to the country's housing crisis. One law enforcement official put the losses to homeowners and other borrowers who were victims in the schemes at over $1 billion.

The Justice Department and FBI plan to announce the recent arrests — including apprehensions in Chicago, Atlanta, Miami, and suburban Maryland — at a news conference set for Thursday afternoon in Washington. Two former Bear Stearns managers in New York were also included in the sweep, becoming the first executives to face criminal charges related to the collapse of the subprime mortgage market.

More than 400 people are being charged in the sting that began March 1 and ended this week, authorities said. They include industry borrowers, loan originators and real estate agents. An estimated 50 people were arrested in the last two days alone.
Across the country, reports of mortgage fraud have soared over the past year as the subprime mortgage market collapsed and defaults and foreclosures soared.

Banks reported nearly 53,000 cases of suspected mortgage fraud last year, up from more than 37,000 a year earlier and about 10 times the level of reports in 2001 and 2002, according to the Treasury Department's Financial Crimes Enforcement Network.

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Fallout From Bad Loans Rocks Regional Banks

In Ohio, the Panic of 1907 drove the Fifth National Bank into the arms of the Third National Bank, creating the singularly named Fifth Third Bank of Cincinnati. But today Fifth Third and other regional banks across the nation are being shaken to the core by a 21st century financial crisis. For many of them, things are going from bad to worse.

Home mortgages and other loans that the banks made in good times are souring so fast that many of the lenders are scrambling to prop themselves up. If the pain worsens — and many analysts say it will — some of these banks, like Fifth Third’s predecessors, may eventually seek out suitors, most likely large national rivals. For now, however, no one seems to want the regional banks.

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Stock market investors are deserting them en masse. On Wednesday, Fifth Third’s share price plunged 27 percent to $9.26, its lowest level in more than a decade, after the bank said it would cut its dividend and seek to raise $2 billion. Other financial stocks, particularly regional banks’ shares, also tumbled. The Standard & Poor’s 500 Regional Banks Index sank 6.8 percent.

“Everybody is trying to figure out where the bottom is,” said Jennifer Thompson, a regional bank analyst for Portales Partners in New York. “Every time a bank reports another capital raise or reports that things are worse than they anticipated, there is another round of selling.” But Wednesday was just one more bad day in what has been a horrible year for small and midsize banks.

Their descent in the stock market has been remorseless, reflecting the economic pain in their own backyards. Weakening housing and construction markets in regions like the Midwest, Southeast and Southwest have hit lenders in those areas hard. For the banks’ shareholders, the numbers tell a sad story: Wednesday’s decline brought the loss for the S.& P. bank index to 39.3 percent so far this year.

Fifth Third’s odd name almost seems like a bad joke. Fifth Third has lost two-thirds of its value this year. Shares of two other banks based in Ohio, the National City Corporation, of Cleveland, and Huntington Bancshares, of Columbus, have suffered similar declines. Banks based in the Southeast are hurting, too. The Regions Financial Corporation, the biggest bank in Alabama, has lost half its value.

Standard & Poor’s predicted this week that Regions would cut its dividend to conserve its capital in the face of rising losses on real estate loans. The share price of SunTrust Banks, which operates across the Southeast, has fallen almost 41 percent. Small and midsize lenders are in far less danger than they were during the 1980s and early 1990s, when about 1,600 federally insured institutions failed during a savings and loan crisis.

But the breadth and depth of the current troubles have caught bank executives by surprise. Federal regulators are particularly concerned about the exposure of smaller banks to the commercial real estate market, which has softened in some parts of the country. But another worry is that raising money will become increasingly costly for banks that need capital.

In a report issued this week, analysts at Goldman Sachs said banks might need as much as $65 billion on top of the $120 billion they have already raised. But so far the vast majority of investors who bought into financial companies in the hope that the industry was out of the woods have lost, and lost big. As a result, many investors are reluctant to sink more money into regional banks, fearing their investments will be diluted if the banks sell even more stock.

While many regional banks are trading far below their book values — at $4.83 on Wednesday, National City fetched just a fifth of its book value per share — many people are simply afraid to buy. “You are in this death spiral of dilution,” said David Ellison, the chief investment officer of FBR Funds, a mutual fund company based in Arlington, Va. “It’s this toxic math.”

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Investment in U.S. commercial real estate falls 70%

Investment in U.S. commercial real estate fell 70% in the first quarter from a year earlier as banks curtailed credit, the National Assn. of Realtors said Wednesday. Investors spent $48.2 billion on commercial properties in the period, down from $157.8 billion in the year-earlier period, the trade group said.

"Slow economic growth is lowering demand for commercial space, mostly in the office and industrial sectors," said Lawrence Yun, the Chicago-based association's chief economist. "Despite the slowdown, the commercial real estate market is in much better shape compared to conditions during the 2001 recession."

Office vacancies are projected to increase to 13.7% in the fourth quarter from 12.5% a year earlier, reducing annual rent growth to 3% from 8% last year. Office building transaction volume has declined. In the first four months of 2008, $18.5 billion in office buildings traded, down from $95 billion in the same period in 2007, the Realtors said.

The biggest decline occurred in the suburban markets, the group said. The value of retail space changing hands fell 72% from last year, to $7.5 billion during the first four months of 2008 from $27.7 billion a year earlier.

Even as international buyers have invested in strip malls in Southern California, Chicago, the Northeast and the Southeast, transaction volume for such properties has declined 77% from a year earlier, the group said.

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Housing Market Bottom Keeps Moving Lower

The bottom of the U.S. housing market keeps getting lower. With 30-year fixed mortgage rates at an eight-month high, Fannie Mae cut its forecast for new and existing home sales and Lehman Brothers Holdings Inc. said a recovery isn't imminent.

Fannie Mae, the largest mortgage buyer, now expects combined new and existing home sales to fall to 5.29 million in 2008, lower than the 5.32 million it estimated a month ago, the Washington-based company said in a forecast posted on its Web site yesterday. Higher rates may "strain affordability, suggesting home prices may have to fall further to provide an offset," Lehman economist Michelle Meyer said in a note today.

New-home sales probably will reach a bottom of 527,000, the lowest in 17 years, and sales of previously owned homes are likely to tally 4.76 million, before both see "modest gains" in 2009, Fannie Mae said. The average U.S. rate for a 30-year fixed mortgage was 6.32 percent last week, the highest since the end of October, according to Freddie Mac, the second-largest mortgage buyer.

"You're going to get the sticker shock of higher rates and that's never positive," said James McCanless, a homebuilding analyst at FTN Midwest Securities Corp. in Nashville, Tennessee. "If you think about the majority of your homebuyers, the most important determinate for them once you get past schools and location, is the payment."

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U.S. MBA's Mortgage Applications Index Fell 8.8%

Mortgage applications in the U.S. declined last week, led by a slump in refinancing as borrowing costs surged.The Mortgage Bankers Association's index of applications to purchase a home or refinance a loan fell 8.8 percent to 507.9 from 557.1 the prior week. The index reached a six-year low of 502.3 last month. The group's purchase index decreased 4.4 percent and its refinancing gauge lost 15 percent.

Prospective buyers are holding off as rising foreclosures add to the glut of properties on the market and force home values down even more. Sales will probably remain depressed as lenders restrict credit, and concern over inflation boosts mortgage rates. "The increase in mortgage rates is decidedly negative for the housing outlook," said Michelle Meyer, an economist at Lehman Brothers Holdings Inc. in New York. "Higher rates strain affordability, suggesting home prices may have to fall further to provide an offset."

The refinancing gauge decreased to 1378.6, the lowest level since July 2006, from 1622.1. The share of applications for refinancing fell to 37.4 percent from 39.8 percent the prior week. The highest mortgage rates in a year may have precipitated the slump in demand. The average rate on a 30-year fixed-rate loan rose to 6.57, the highest level since June 2007, from 6.24 percent. At the current rate, monthly borrowing costs for each $100,000 of a loan would be $637, up $69 from the year's low reached in January.

The average rate on a 15-year fixed mortgage increased to 6.14 percent from 5.78 percent, while the rate on a one-year adjustable mortgage jumped to 7.22 percent, the highest level since December 2000, from 6.87 percent. The Mortgage Bankers Association this month reported that the number of Americans in danger of losing their homes to foreclosure rose to the highest in at least three decades during the first quarter as borrowers who fell behind on payments were unable to sell their homes.

As home prices fall, more and more homeowners are unable to refinance out of adjustable-rate loans and are forced into foreclosure. The share of applicants seeking variable-rate loans fell to 9.7 percent last week from 10.3 percent a week earlier. The figure reached a 17-year low of 3.8 percent in March.

Builders in the U.S. broke ground in May on the fewest houses in 17 years, the Commerce Department said yesterday in Washington. Building permits, an indicator of future construction, also fell. Homebuilders are feeling the crunch. Irvine, California- based Standard Pacific Corp. this week said new-home orders for April and May fell 12 percent from a year earlier.

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Free Trade in Food Is 'On the Ropes' Amid Shortages, Price Rise

Free-trade policies long advanced by World Bank President Robert Zoellick and U.S. President George W. Bush are losing favor as countries in Africa, Asia and Latin America find they can't buy enough food to feed their people. Global food prices have spiked 60 percent since the beginning of 2007, sparking riots in more than 30 countries that depend on imported food, including Cameroon and Egypt.

The surge in prices threatens to push the number of malnourished people in the world from 860 million to almost 1 billion, according to the World Food Programme in Rome. Leaders of developing nations including the Philippines, Gambia and El Salvador now say the only way to nourish their people is to grow more food themselves rather than rely on cheap imports. The backlash may sink global trade talks, reduce the almost $1 trillion in annual food trade and lead to the return of high agricultural tariffs and subsidies around the world.

"Trade as the route to food security, that idea is on the ropes," said Arvind Subramanian, a senior fellow at the Peterson Institute for International Economics in Washington. "If the guy who is selling it doesn't want to sell it overseas, then the guy at the other end is terribly exposed."

In dozens of interviews and speeches at the United Nations Food and Agriculture Organization's Rome conference on the food crisis this month, officials from developing countries, farmers and leaders of non-governmental organizations said food self- sufficiency is the new goal for many poor nations. Grain exporters such as Argentina and Vietnam have restricted shipments, driving global prices higher and leaving nations that depend on imports searching for adequate supplies.

"The idea of trade liberalization was that you could count on global markets, but they're not proving reliable," said David Orden, a fellow at the International Food Policy Research Institute in Washington. The Philippines has embarked on a worldwide search for additional food supplies to build stockpiles and ensure it can feed its people amid record prices.

The surging costs of rice, other grains and fuels have stoked inflation and triggered concern of civil unrest, according to the International Monetary Fund. Philippines President Gloria Macapagal-Arroyo said her country will try to become self-sufficient in food by 2010. "For a long time, it made sense to buy food from the international market," said Arthur Yap, the Philippines Agriculture Minister, in an interview June 4 in Rome. "The situation has changed."

The rift between developing countries and wealthy nations on food trade was apparent at the Rome conference. The U.S., the European Union and the World Bank all pushed for a new global trade agreement to cut subsidies and import duties in countries such as India and South Africa. The latest round of World Trade Organization negotiations was launched in 2001 in Doha, Qatar.

The goal was to cut subsidies in rich nations and tariffs in poor nations, allowing the most efficient producers -- be they in Iowa or Cordoba, Argentina -- to sell to the world. Supporters say the economic rationale still holds. "The reason why getting a Doha Round done is important is it'll end up reducing the cost of food, importing food," Bush said at the White House on May 1.

The U.S. and Europe continue to subsidize production of grains and other commodities, enabling their farmers to undercut the prices of competitors in developing countries. Zoellick, Bush's former top trade adviser, said this month in Rome that one key to long-term food security is "closing the Doha WTO deal, phasing out huge distortions from subsidies and tariffs."

Most alarming to policy makers in food-importing nations are the export constraints imposed in Indonesia, Argentina, India and others. Thailand, the world's largest rice exporter, said in February that it would restrict shipments abroad to ensure stable prices at home. The country later reversed the decision.

"There is no security if your food basket is coming from another country," said Bakary Trawally, permanent secretary of Gambia's Department of State for Agriculture, in an interview in Rome. "If they close it off, like Thailand did, you would be in trouble." Trawally and officials from other developing countries say they will use more subsidies to boost domestic production.

"A few years ago it was thought it was better to buy food in other countries, but that whole policy failed," said Raul Robles, Agriculture Minister of Guatemala, in an interview. Now Guatemala has reversed course and is supporting farmers "with land, seeds and technical help," he said. The trend has disheartened free-traders such as Orden and U.S. Agriculture Secretary Ed Schafer.

"We need to open up markets so you can have the free flow of food where you need it," Schafer said in an interview last week. The current crisis has shown the limits of free trade to provide food, some analysts say. "Agriculture markets are notoriously volatile, and all countries really do have to make sure that they have at a minimum systems that don't let their people go hungry," said Sandra Polaski, a former Clinton administration trade official and fellow at the Carnegie Endowment in Washington.

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Fed, Regulators Lay Plans for Investment-Bank Aid When Credit Window Shuts

U.S. regulators are planning how to let investment banks retain access to Federal Reserve loans if the central bank shuts an emergency program in September, two government officials said.

Federal Reserve Chairman Ben S. Bernanke, Treasury Secretary Henry Paulson and Securities and Exchange Commission Chairman Christopher Cox and their staffs are in almost daily discussions about the future of the so-called Primary Dealer Credit Facility, said one of the officials on condition of anonymity.

The Treasury and SEC want the program, designed to be in place until at least September, to be temporary. The discussions with the Fed center in part on what precautions might need to be in place in case a large securities company with hundreds of trading counterparties faces failure, as was the case with Bear Stearns Cos. At the same time, any new rules would need to deter firms from becoming too dependent on Fed loans, addressing concerns that such aid might lead to more reckless lending and future financial crises.

"The question is: What is the appropriate quid-pro-quo for allowing access" to the Fed, said Robert Eisenbeis, former head of research at the Atlanta Fed and now chief monetary economist at Cumberland Advisors Inc., a Vineland, New Jersey, investment firm. "If the Fed is on the hook, they should have the responsibility" to dictate capital and leverage ratios, he said.

Paulson is scheduled to deliver an update on markets and the economy in a 12:45 p.m. speech in Washington. He called for a broader role for the Fed in his "blueprint" for a regulatory overhaul in March, extending its oversight beyond banks. The central bank said in March the PDCF would be in place "for at least six months." By statute, the Fed can only lend to nonbanks in "unusual and exigent circumstances."

The Fed introduced the program March 16, the same day it agreed to lend against $30 billion of Bear Stearns collateral to secure its takeover by JPMorgan Chase & Co. Firms can borrow at the same rate as commercial banks, which are already subject to capital rules and direct oversight by the Fed. The supervisors are discussing measures that can be implemented without action by Congress. One aspect -- setting up a mechanism to shut a failing firm in an orderly manner -- would probably require legislation.

Lawmakers plan hearings to consider measures strengthening oversight of investment banks. Senator Richard Shelby of Alabama, the senior Republican on the Senate Banking Committee, is skeptical of giving the Fed more powers.

Shelby "believes the Congress should carefully consider whether an expansion of the Fed's authority is desirable," said Jonathan Graffeo, his spokesman. Regulators haven't decided whether the Fed or SEC should be the main agency with power over capital and leverage, one official said. While the SEC has authority now, the arrangement failed to prevent the near-collapse of Bear Stearns in March.

Cox says the SEC succeeded in protecting Bear Stearns's clients. The Fed sent its own representatives to investment banks to monitor them after opening the PDCF. Goldman Sachs Group Inc., Lehman Brothers Holdings Inc.,Merrill Lynch & Co. and Morgan Stanley now voluntarily submit their capital and liquidity positions to the SEC. The agency can restrict the firms' broker-dealer operations if they refuse to raise money or reduce leverage at its urging.

Some current and former Fed officials criticized the Fed's lending to Wall Street for creating moral hazard, or encouraging firms to take on more risk in anticipation of a rescue if their bets go wrong. Richmond Fed President Jeffrey Lacker urged that the central bank "clearly" set boundaries for its assistance. He warned in a June 4 interview that even new limits may not be believed by investors unless a financial firm fails "in a costly way."

"We run the risk of sowing the seeds of the next crisis," Philadelphia Fed President Charles Plosser told reporters after a June 5 speech in New York.

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Why Paul Miller in Virginia Is Wall Street's Best Stock Picker

The moment of clarity for Paul Miller came during a July 2007 conference call by the management of Countrywide Financial Corp., the biggest U.S. mortgage lender. Miller, an equity analyst at investment bank Friedman, Billings, Ramsey Group Inc., had thought until then that the crisis in the housing industry was confined to subprime loans.

On the call, Countrywide Chief Executive Officer Angelo Mozilo disclosed that delinquencies were also rising in the bank's prime home equity lines of credit. "The leader of the mortgage industry is telling me I have a problem in my prime mortgages," Miller, whose firm is located in Arlington, Virginia, recalls thinking. He put a "sell" on Countrywide stock that day.

That call helped Miller finish first among bearish analysts, according to data compiled by Bloomberg in its ranking of the world's best stock pickers. From the time he first downgraded Countrywide to a "hold" in May 2007 the stock fell 76 percent. The ranking is based on the stock recommendations of more than 3,000 analysts worldwide at 432 research firms and investment banks.

The ratings stem from calls made by analysts on the share prices of 300 companies with a market value of $5 billion or more whose shares rose or fell at least 20 percent in the year ended on March 31. (See "How We Crunched the Numbers.") In a separate ranking of the top 10 analysts who made bullish calls, the No. 1 spot was taken by Jack Xu of SinoPac Securities Asia Ltd. in Shanghai for his "buy" on shipper China Cosco Holdings Co. Four months after Xu's call, when he downgraded the company to "hold," China Cosco was up 272 percent.

The No. 1 firm, based on the investment advice its analysts provided on the 300 companies, was New York-based Morgan Stanley. Its analysts made 94 accurate calls on the 300 stocks. Zurich- based Credit Suisse Group was No. 2, with 88 accurate calls, followed by New York-based Citigroup Inc., with 80.

The firm with the highest percentage -- as opposed to the highest number -- of accurate calls was New York-based Oppenheimer & Co., according to Bloomberg data. Almost 60 percent of its recommendations on the stocks it covers were accurate. In a time of market turmoil, finding good stocks for investors has never been more important.

"We understand clients want trading offerings from the research department," says Stephen Penwell, head of U.S. equities research at Morgan Stanley. Since early 2007, the bank has linked its analysts' compensation in part to the number of good calls they make. "We put a significantly higher rating on stock picking than we did in the past," Penwell says.

A few good calls aren't enough to repair the tattered reputation of analysts who work for brokerage firms and investment banks. During the tumultuous 12 months ended on March 31, a minority of stock analysts accurately predicted the movement of the most volatile stocks. Of approximately 6,000 calls made by analysts on the 300 stocks during the year, fewer than 1,500 were accurate, Bloomberg data show.

Analysts did a particularly dismal job of perceiving what was going on in their own industry. The majority of the 17 analysts covering Bear Stearns Cos. had rated the stock "sell" or "hold" through 2006, when its price increased 42 percent. Most of the analysts who had had a "buy" on the shares failed to downgrade them before July 2007, when two Bear hedge funds heavily invested in mortgage-backed securities went bankrupt.

Bloomberg data show that New York-based Douglas Sipkin of Wachovia Securities, the investment banking unit of Wachovia Corp., made the best call on Bear Stearns for the year ended on March 31. He had a "buy" on the stock for 27 months before he downgraded it to a "hold" on May 16, 2007. And he downgraded it at a higher price -- $150 -- than any other analyst.

Sipkin says he lost faith in Bear Stearns shares when he decided the firm was too heavily invested in the housing market and not as diversified internationally as other big investment banks. "We certainly didn't anticipate the mortgage collapse," Sipkin says, sitting among piles of computer printouts and bound reports in his office, which overlooks Manhattan's Park Avenue. "But we felt that the spreading mortgage troubles would have a disproportionate impact on Bear Stearns."

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EU Tinkers With Treaty as Soaring Prices Spur Protest

A day after truckers, taxi drivers and farmers blockaded Brussels to demand that the European Union fight the soaring cost of living, the EU will get to work on a plan of action. The trouble is that the plan responds to an entirely different crisis, one triggered by Ireland's veto of the bloc's new governing treaty.

Disputes over the Lisbon Treaty's fate threaten to turn a summit starting tonight into a political-theory class, distracting the 27 leaders from the economy and stoking charges that the bloc is out of touch with its citizens. Political leaders "aren't asking the right questions or setting the right priorities," Christian Starck, 46, a Belgian dairy farmer, said at yesterday's demonstration as he brandished a poster of a cartoon cow saying "this is getting on my nerves."

In the EU's high councils, Italian Prime Minister Silvio Berlusconi says Ireland "will have to come up with its own solution," while German Chancellor Angela Merkel rejects the notion that the rest of Europe can move ahead without the Irish. Czech President Vaclav Klaus wants to declare the treaty dead. "It is necessary for Ireland to have time now to analyze last week's vote and explore options," Irish Prime Minister Brian Cowen said today. "It is far too early yet for anyone to put forward proposals."

For the protesters, the survival of the new 277-page set of amendments to the EU's governing articles took a back seat to pocketbook issues like an inflation rate of 3.7 percent in the euro region in May, the highest since June 1992. Food costs rose 6.4 percent in May and energy was up 13.7 percent, threatening to push up wages in their wake and raising the specter of the "stagflation" -- a dormant economy with runaway prices -- of the 1970s.

The 15 EU countries using the euro are in a fix because they have handed control of interest rates, the main weapon against inflation, to the European Central Bank and set themselves tight limits on borrowing. Inflation would be higher -- and the ECB weighing more than one increase in its main 4 percent rate -- were it not for the record-breaking run of the euro, which cuts Europe's bill for dollar-denominated commodities like oil.

Europe is caught in the same vise between spiraling prices and weakening growth that is afflicting the U.S. The International Monetary Fund predicts the fastest inflation in the advanced economies since 1995 and the slowest growth in seven years. The EU's answer, according to a draft statement to be issued when the summit ends tomorrow, includes steps such as the sale of surplus foods, an increase in milk quotas, and the go- ahead to national governments to take "short term and targeted" measures.

Beyond rubber-stamping decisions by lower-level ministers, the leaders will call the commodity-price surge a "complex phenomenon with many root causes and consequences," reissue appeals for energy efficiency and strive for "dialogue" with oil-producing countries. Concerned about the disconnect with public opinion, EU leaders will hear reports on the economic situation tonight before looking at how to salvage the treaty that they unanimously negotiated and signed last year.

While the veto will be "foremost on everybody's minds," the leaders must escape "the trap of institutional navel- gazing," European Commission President Jose Barroso said. Renegotiating the document would be "extremely difficult." The treaty can only take effect once all EU countries endorse it, giving the 862,000 Irish who voted "no" a veto over political life in a bloc of 495 million people. So far, 19 countries have ratified it through parliament and the remaining seven plan to follow suit.

There is so much momentum behind the treaty that scuttling it is "pretty inconceivable," said Peter Ludlow, a historian and chairman of EuroComment, a Brussels publisher. Nor is renegotiating it an option because "everybody's sick and tired of constitutional discussions."

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UK: May public finances worst on record

The government's deficit plunged to the worst May number on record last month, the Office for National Statistics said today, as tax receipts slowed sharply. The ONS reported public sector net borrowing of £11bn last month, £2.4bn worse than in the same month last year. It was the lowest May figure since monthly records began in 1993 and was the second worst monthly figure ever.

For the first two months of the 2008/09 fiscal year, the shortfall was £12.7bn, up from £8.4bn last year. The public finances have moved deeply into the red in recent years as the government has boosted spending faster than tax receipts. Many economists warn the situation is going to get a lot worse as the economy slows down.

The breakdown of the data showed that tax receipts in the first two months of the fiscal year were up only 3.6% year-on-year, a lot worse than the 4.8% pencilled in by Alistair Darling in his March budget. Spending was up 5.4%, broadly in line with the budget forecasts. The ONS also said that the current budget deficit, which excludes investment spending, slumped to £9.1bn last month, the worst monthly figure since April 1998, from £7.6bn in May last year.

Howard Archer at Global Insight said: "There seems little doubt that the bad news on the public finances will continue over the coming months. Markedly weaker economic growth will take an increasing toll on VAT and corporation tax receipts over the coming fiscal year, while substantially lower housing market activity and falling house prices will hit stamp duty receipts. This is likely to outweigh the boost to tax revenues coming from record high oil prices.

"On top of this, the government's recent raising of the basic income tax free allowance to help those left worse off by the scrapping of the 10p tax rate expected to cost £2.7bn. Consequently, the chancellor's aim to keep the PSNBR down to £43bn in 2008/09 and the current budget deficit down to £10bn looks ever more out of reach and wishful thinking."

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HBOS: 2008 UK house prices to fall 9%, sales down 45%

HBOS, owner of the country's biggest mortgage lender, Halifax, said this morning it expected house prices to fall 9% this year and house sales to plunge by 45%, and warned that this could lead to an increase in customers falling behind with their home loan payments.

The prediction for the housing market is the most specific the lender has given so far as its scrambles to raise £4bn from investors through a rights issue. It had previously talked of a "mid single digit" decline in house prices. In its trading update, designed to reassure a market unsettled by the profits warning and unprecedented repricing of the Bradford & Bingley rights issue, it revealed that its credit crunch writedowns had increased by £58m in May and would top £1bn in the first half, compared with £227m for the whole of 2007.

But value adjustments it had taken to other investments which do not impact its profits or regulatory capital had fallen by £49m to £1.8bn, still up from £509m at the end of 2007. The bank also acknowledged that it also had exposure to the wider construction and property market which is also feeling the pain of the economic and housing downturn.

The cash call on investors, intended to help HBOS hunker down for an economic downturn, has been troubled by a dramatic fall in its share price through the 275p rights price to 249p at one stage - its lowest level since the bank was created in 2001 through the merger of Halifax and Bank of Scotland. "We're underwritten and this rights issue is going ahead. It's as simple as that. We are not for turning," chief executive Andy Hornby told Reuters today.

However, the shock intervention by the Financial Services Authority to demand all short positions be disclosed during rights issues, has helped its shares recover, although they slipped almost 6% to 301.25p by midday. The bank said: "Trading continues to be satisfactory and remains in line with group expectations." The trading update covers May and updates the previous statement issued on April 29 when it announced its rights issue.

The Edinburgh-based bank usually sells one-in-five mortgages taken out in the UK but admitted today that it does not expect to be so active in the market in this year. It expects only "modest growth" in business but noted that its experience was different with deposits and that it had a record month in May for "retail inflows".

Further proof that the housing market is in trouble came this morning with the latest borrowing figures from the Council of Mortgage Lenders. They showed a 19% drop in total lending this year.

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Goldman Sachs VP calls for U.S. global policy restructuring

As the world's economies become more globalized and the U.S. dollar competes with a stronger euro, America needs to restructure its global policies to attract more foreign capital, Robert Hormats, vice president of Goldman Sachs International, said Wednesday.

The next U.S. administration will need to make "important policy changes to take advantage of new global opportunities," Hormats said during a speech at an Asian banking and finance conference at the San Francisco Federal Reserve Bank.

Those changes include realizing the U.S. needs to accelerate improvements in its trade balance to reduce dependence on foreign money, boost competitiveness by reasserting the Doha Round global effort and be a leader in global policy creation, he said.

The collapse of U.S. domestic savings, compounded by a widening trade deficit and increased consumer borrowing, have contributed to U.S. dependence on foreign capital, Hormats said. "Exports are rising at a much more rapid rate than imports," Hormats said, citing that 95% of the world's consumers now are outside the U.S. "About one-third of the profits of S&P 500 companies come from activities abroad."

Hormats also said the Doha Development Round, a set of international negotiations to promote free world trade, is stalling, and the U.S. needs to take initiative to open global markets for goods and services. "If this round falters, and I think in the current moment there's a good chance that it will ... then the U.S. and other trading nations would do well to devote their efforts to improving -- and ensuring firm adherence to --- existing rules and dispute settlement procedures," Hormats said

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Brace for other shoe to drop in mortgage mess

With most of the country still reeling from the subprime mortgage meltdown, Mark Hanson is warning of the next looming blow. Hanson, a bank consultant and former mortgage broker from the Bay Area who writes a blog under the name "Mr. Mortgage," is among a handful of industry soothsayers who expect another big wave of foreclosures to hit sometime around 2010, driven by defaults among people holding less risky loans known as "alternative-A."

Subprime is the term applied to loans given to people with shaky credit. Alt-A is the next-higher category, typically covering mortgages to borrowers who had better credit but didn't want to document their incomes or wanted an initial period of low payments, often covering only the interest on the loan. Technically the term "alt-A" applies to securities backed by the loans, but it has come to be used for the mortgages themselves.

While defaults have been creeping up in the alt-A category this year, the foreclosures that have wracked the housing market so far have been largely the result of defaults among subprime borrowers. "I think we are through the subprime blowup, but that's nothing compared to what's coming," said Hanson, who made similar predictions on CNN in April.

His theory is that other borrowers will follow the path of subprime borrowers, who started defaulting when their mortgage interest rates reset to higher levels. Many alt-A borrowers face a bump in their monthly payments starting mid-2010, according to financial services company Credit Suisse.

The firm's figures, reported in the International Monetary Fund's report on global financial stability, show a big bubble of U.S. mortgage rate readjustments hitting during that time period, including borrowers with "option ARM" loans that allow a borrower to initially make payments that are so low the balance increases. Others in the industry say such predictions amount to Chicken Little panic.

"I hear that, too -- that there's another subset of groups that haven't come due yet," said Jeff Tarbell, broker of record for Sacramento's Comstock Mortgage. But Tarbell said he's not concerned about a second foreclosure tsunami because borrowers who owe more than their homes are worth aren't waiting for their mortgage rates to reset. Those inclined to bail are already doing so, he said.

A record $400 billion in alt-A loans was issued in 2006, according to data by specialty publisher Inside Mortgage Finance, cited in published reports. Alt-A accounted for 13.4 percent of all mortgages offered that year. Hanson said lenders first started pushing them in 2005 as a way for buyers to combat skyrocketing prices and continued issuing them into 2007 despite the subprime concerns.

Some of the largest issuers of these loans were IndyMac Bank, Washington Mutual Bank, Countrywide Financial and World Savings Bank (now part of Wachovia Corp.). As of January, California has more alt-A loans than subprime loans on the books -- about 728,000 alt-A loans and 496,000 subprime loans among 12.2 million housing units -- according to data from a division of research firm First American CoreLogic Inc., posted on the Federal Reserve Bank of New York's Web site.

The division, LoanPerformance, reported that 83 percent of those California alt-A loans were granted with little or no documentation. In December, the most recent local data posted, there were 48,500 alt-A loans in the four-county Sacramento region.

California's subprime borrowers are defaulting at 2.4 times the rate of alt-A borrowers, according to LoanPerformance. However, late last month, Standard & Poor's issued a warning that alt-A delinquencies are on the rise. Specifically, the ratings agency said the number of serious delinquencies, such as homes with payments 90 days overdue or in foreclosure, rose as much as 10 percent in the span of a month.

Those projecting a second foreclosure wave believe negative equity -- a situation where a homeowner owes more than a house is worth -- is a prime driver of foreclosures. A study released by the Federal Reserve Bank of Boston found that negative equity is a "necessary but not sufficient condition" for a buyer to default. It's not clear whether borrowers whose mortgage payments could double by 2010 are determined to stay put until then.

Irvine-based RealtyTrac Inc., an online service that tracks foreclosed properties, said that it and its competitors can't tell if borrowers have a subprime, alt-A or prime loan when they default. "More affluent borrowers may be more likely to walk because they understand investing," Hanson contends.

Tarbell, who hosts the weekly "Talking Money with Jeff Tarbell" on KHTK-AM 1140, said upside-down borrowers looking at the prospect of an interest rate reset in a couple of years called his show frequently early this year, and seemed unlikely to sit tight until their loans reset.

"It's like I'm Dr. Phil," he said. "I'm doing grief counseling. They have realized they are in a negative equity situation and they're not going to sit around and wait. How many people are going to be willing to double their monthly payment when they're upside-down on the house?" If Hanson's theory holds up, it's bad news for California homeowners just as the country's foreclosure problems are easing slightly.

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Chinese discover first rule of investing - what goes up must come down

She frowned through her glasses at the flashing numbers on the giant screen, trying to assess what they meant for the pension money she had invested. The bad news came as little surprise: this year, each trip to the retail brokerage has left her feeling queasy.

"Everything's falling, and my shares are falling too. I feel a bit ill because of the money I've lost," she admitted with a wince. The retired supermarket administrator, who did not want to give her real name, is one of millions of Chinese investors to discover that shares can go down, and down, and down, as well as up.

Last year, as stocks soared, people stampeded into the market. Customers at her brokerage, a CITIC Securities branch in east Beijing, rose five-fold to 25,000 between the start of 2006 and the end of last year. Its manager, Gu Xiaoyi, estimates that 60 million Chinese people now trade shares.

In a little more than six months, the benchmark Shanghai composite index doubled, passing the 6,000 mark in October. Since then it has nosedived to less than half that level - yesterday closing at 2941. Many analysts believe it would have sunk further by now had the government not intervened. Small shareholders have been badly hit; some have lost their life savings. A few have even killed themselves in despair as their losses mounted.

Most seem unable to stay away from the brokerages. On a busy day, 500 cram into the dingy CITIC room. Regulars sit from open to close of each session, bringing cushions to pad the hard red plastic chairs. Keeping half an eye on the screen, they chat, sip tea from flasks and play cards. Other investors crowd around terminals, using swipe cards to check their own stocks or offering advice to friends and strangers alike.

Zhou began trading here last year, seduced by glossy brochures on stock issues and the hope of better returns than a savings account - particularly with inflation outstripping interest rates. "I read loads of material and it said the next decade would be the golden years for the Chinese stock market because the economy was developing," she explained.

"We started buying stocks and it was very, very good. When the index reached 5000 I didn't sell because it was still growing. But then it fell by 10% - then another 10%, then another. "I tried to break even by buying more, because I thought the cheap stocks would go up again. So when the index hit 4,000 I bought. Then it went down to 3,000. "Now I just want to sell them off and stop dealing. It's too much of a risk."

So far Zhou's investments have lost her 10,000 yuan (£740), more than two-thirds the average annual income in urban China. Despite her disenchantment, she has yet to bail out; maybe, she said, the index would hit 6,000 again in a year or two. Gu acknowledged that many customers know little about buying shares or reading the market. "Last year, loads of people just ran in and started buying stocks because someone had told them it was a great time to do it," he said.

"Ninety-five percent of them didn't know what they were doing or what they were buying. It was only when it dropped so dramatically that they realised it was actually quite risky." He argued that the ups and downs were typical growing pains for a new market, suggesting that investors were becoming more sophisticated and regulation improving.

"In the west you have hundreds of years of history in the stock market and it wasn't always stable ... It's through the highs and lows that you learn," he added, suggesting that the market was "basically stable" now. Several analysts suggest that it is settling down now that last year's bubble has burst. Others believe that assessment is optimistic, and argue the downward trend will continue.

"The economy is slowing down ... The stock market will also continue to slide," said one analyst, who asked to remain anonymous. Certainly, there is widespread anxiety about the economy and in particular inflation. Last week, Stephen Green - the influential head of China research at Standard Chartered - warned: "The golden years are over, at least for the moment."

Yan Yuanrun at West China Securities argued: "Although the market is not very mature, it is still very much connected to the macroscopic economic development." Others argue that it bears little relation to the overall outlook, or even the performance of individual companies, and has clear links to government policy.

"If you want to invest in the Chinese market, the only thing that matters is what the government will do tomorrow," said Michael Pettis, a former banker and now professor of finance at Peking University. "Don't waste your time trying to figure out who's profitable and who's not - it doesn't matter."

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