Debt Rattle, June 20 2008: Rumors of Capitulation

Illustration: Michael Leunig

Ilargi: From time to time, there'll be people who question things I write. That is fine, and by no means unexpected. In fact, there's undoubtedly thousands of them. To wit: when the Dow goes up, attendance at The Automatic Earth goes down. No surprise there either.

I made a couple of calls March 7 and 8, The Day the Wheels Came Off and The Game is Over. Statements like that are always, necessarily, subjective and intuitive. Nobody in their right mind, and even myself, would expect the skies to come down from one moment to the other, and give us all a blue hat.

What I meant was that on March 7, I detected a profound change in the overall tone in the media concerning "the world of finance". March 8 was the day that JPMorgan warned of a ""systemic margin call" that may deplete banks of $325 billion of capital due to deteriorating subprime U.S. mortgages". That was the first time a major financial institution was that open and bleak, and that marked a watershed moment. No doubt then, none now.

In fact, what really surprises me about how I react to what we cover, is how dead-on I am in the vast majority of issues I think and write about. I can't control whether people are willing to think along those same lines, that's up to them. And when calling something a crucial event, there's always plenty of room to argue. I see what main media report as important, not because they're right, in fact they're doing a gruesome job, but because they reach far more readers than people like me, and other bloggers, do; no matter that we've often been far more to the point, and often for years.

And the fact that I'm mostly right, by the way, doesn't say anything about my brilliance, it simply means the material I cover is easy to grasp once you have an elementary idea of how systems, and people, behave, and once you see how poor the main media coverage is. This financial system is collapsing, and it makes no difference what anybody does to try and save it; we've passed a full bundle of points of no return. There are trillions of dollars worth of fake money that need to be accounted for, and there is no cure for that process.

Individuals and the communities they live in need to change their living conditions, as well as their views on future prospects, accordingly. The fact that that is not happening, at all, is what occupies me most these days, not whether there is a way to save what we've been living in so far. That game is over.


Day of reckoning is nigh in credit crisis

Perhaps, when it comes to money, we can trust the Scots — a thrifty, dour people not given to excess. And Royal Bank of Scotland's warning that the world as we know it will soon end has come at a time when financial markets are perilously close to another word that dare not be spoken: panic.

The bank has advised clients to brace for a fully fledged crash in share and credit markets over the next three months as inflation paralyses the major central banks. "A very nasty period is soon to be upon us — be prepared," says Bob Janjuah, the bank's credit strategist.

Meanwhile, authorities cannot respond with more easy money because oil and food costs continue to push headline inflation to levels that are unsettling the markets. The scope of the crisis is really being felt by big pressure on the monoliners, who insure bonds and are finding that through no fault but their own they are now, too little and too late, in the eye of the ratings agencies. In fact the giant Ambac has decided to fire Fitch as one of its rating agencies.

Fitch went honest and refused to be cowed by the threat of lost fees and instead issued ratings that were unacceptable to its client and more candid than Standard & Poor's and Moody's. Fitch was the first to downgrade Ambac to AA (although the newly established Moody's indicative rating scale, which shows the rating implicit in credit default swap spreads, shows both MBIA and Ambac to be junk credits).

But if Ambac goes bad, it would trigger clauses in $US400 billion of derivative contracts written to insure collateralised 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 $US2 trillion of debt that the companies guarantee, wiping out the value of the CDO insurance held by Wall Street firms, analysts at Oppenheimer & Co say.

This is not the perfect storm but the perfect maelstrom of the world's largest bond insurers no longer worthy of AAA credit ratings, which may be heading for the bottom of the scale. What does that do to the bonds and the companies dependent on Ambac to retain credibility, especially in the multitrillion CDO game? What do Fitch and Moody do as an encore? Fitch's managing director, Thomas Abruzzo: "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."

Others will follow suite. 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. New ratings will abound. The credit ratings of some CDOs have tumbled so far that the insurers have recorded combined unrealised losses of at least $US20 billion. Some companies' termination payments would eat up all their claims-paying resources, according to filings and rating company reports.

In a June 8 report, CreditSights' Haines wrote that "statutory surplus levels at some of the monoline financial guarantors are extremely alarming." Even in an insolvency, regulators may step in to halt the payments or banks may decide not to demand compensation, Abruzzo says. MBIA and Ambac may need to raise capital to avoid becoming insolvent if loss reserves continue at the recent pace, Haines says.

The companies were both cut to AA from AAA by Fitch and S&P. Moody's said on June 4 that it probably would also reduce its ratings. In the past two quarters, MBIA's insurance unit has set aside reserves of $US2 billion to cover losses on $US51 billion of guarantees on home-equity securities and CDOs backed by subprime mortgages. Ambac has booked about $US2 billion of loss reserves, leaving it with a statutory surplus of $US3.6 billion. It guaranteed about $US47 billion of CDOs and home-equity debt.

While both companies are above the regulatory capital requirements, S&P said in a February report that in a "stress case scenario", MBIA might be forced to pay a total $US7.9 billion in claims and Ambac might be forced to pay $US6.2 billion. "That's what puts these companies into the nightmare scenario," Haines says.

Enter Christopher Whalen, a sort of thinking man's Fitch or Moody's at Institutional Risk Analytics, the place you take good money if you fear the bad. On the subject of the demise of Bear Stearns, he observed this week: "If you look at the time line of events surrounding (its) collapse and subsequent brokers' earnings, it is obvious that the lies of the brokers not only saved them personally but were pivotal in changing market sentiment and dynamics, leading to a multi-month rally led by financial stocks."

But he adds that now we have moved on to Lehman Brothers facing similar problems: "The bubble has burst and no amount of spit and polish from CNBC, fraudulent analysts' upgrades and spin from CEOs can fix the financials again in our lifetime." Coming from a man whose job is to see the risk in institutions, the suggestion that "the financials" are more or less finished it is tempting to know more of what he thinks.

Next stop Goldman Sachs, and then comes the reckoning.

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Stocks Set For Bad Open As Financial Woes Linger

Stock futures pointed to a weak open for equities Friday, as worries over the financial sector lingered. Nasdaq futures gave up 19 points vs. fair value, S&P 500 futures lost 12 points and Dow futures tumbled 99 points.

MBIA tumbled 9% in the pre-market and Ambac Financial Group fell 7% after Moody's cut ratings on both bond insurers, citing a weak business environment. Banking giant Wachovia said its Evergreen Investments unit will shut down its mortgage-heavy Ultra Short Opportunities Fund due to poor performance. The fund has lost about 20% since its January peak. Wachovia lost 4% in the pre-open.

Washington Mutual fell 3% in the pre-market after announcing another round of layoffs. Late Thursday, the savings and loan said it would slash 1,200 jobs. WaMu has been hit hard by the ongoing mortgage crisis, announcing steep losses the last two quarters. In April, it announced a plans to raise $7 billion in capital.

Merrill Lynch said that bank stocks might be going into "capitulation". The broker expected dividend cuts from Wachovia, Bank of America and SunTrust. Freddie Mac dropped 3% and Fannie Mae 2% as Lehman Bros. cut earnings estimates on the government sponsored lenders.

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Citi Warning: Write-downs Ahead

Citi's got more pain in the pipeline. On Thursday, the financial firm's Chief Financial Officer Gary Crittenden warned of "substantial" write-downs related to subprime mortgages, leveraged-buy-out loans and other assets in the second quarter.

He also warned that costs linked to worsening consumer credit quality could hurt Citi's performance in the second half of the year. The bad news, broken during a call with analysts, pushed Citi down 4.0%. In a nervous credit environment, Crittenden's words also spiked the price Citi pays to protect its debts. The company recovered significantly on news that its will buy a Brazilian brokerage; during afternoon trading the company was down 1.8%, or 36 cents, to $20.04.

The company said it is buying Intra S.A. Corretora de Cambio e Valores with roughly $745 million in client assets in a quickly growing South American economy: "The purchase comes amid rapid expansion of Brazil's capital markets and increased appetite for financial activities by individuals," said Gustavo Marin, CEO of Citi Brazil. Word of continued write-downs follow a $5 billion first quarter loss and $1.5 billion in write-downs related to exposure to distressed bond insurers.

Chief Executive Vikram Pandit has been trying to whip the banking giant into shape. Current turmoil in the financial markets has made this task a formidable challenge. In a momentary boost to morale at several major banks, Bill Gross, who runs Pacific Investment Management, or PIMCO, said Thursday that he's holding onto debts belonging to Morgan Stanley, Goldman Sachs, Deutsche Bank and beleaguered Citi.

He said the "high-quality" paper represented a good long term investment while noting that the leveraging process will continue to be painful. Crittenden should watch his back. Lehman Bros. CFO Erin Callan got axed after she announced a week in advance that major losses related to subprime mortgages would drive the company's impending second quarter report. The firm has been on death watch ever since Bear Stearns made its last growl after was wholly swallowed by JPMorgan for roughly $10 a share.

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Citigroup Shares Fall on Writedown, Loss Forecast

Citigroup Inc., the bank that's lost more than any other in the collapse of the mortgage market, fell in New York trading after predicting "substantial" additional writedowns and more losses on consumer loans. The company, whose value has dropped by almost a third this year, declined 1.1 percent on the New York Stock Exchange after Chief Financial Officer Gary Crittenden made the forecast in a conference call with investors.

Citigroup has booked more than $42 billion of credit losses and writedowns since last year because of the credit market contraction, or about 10 percent of the $396 billion racked up by banks worldwide. Vikram Pandit, who took over as chief executive officer in December, has raised $44 billion in capital and outlined plans for the company to reduce assets by $400 billion over the next two to three years.

"We will continue to have substantial additional marks on our subprime exposure this quarter," Crittenden said on the call, which was sponsored by Deutsche Bank AG. "We may continue to see the magnitude of the marks decline, as the exposures that we have have declined." Citigroup, based in New York, fell 23 cents to $20.17 in composite trading at 4:15 p.m., after reaching $19.41 earlier today, the biggest decline among the top five U.S. banks.

Second-quarter markdowns related to subprime mortgages won't be as large as the $6 billion recorded for the first quarter, Crittenden said. Citigroup may also have to write down the value of assets backed by so-called monoline insurance companies such as Ambac Financial Group Inc., after they were stripped of their AAA credit ratings, the 54-year-old CFO said.

Citigroup last quarter recorded a cost of $1.5 billion to account for the reduced likelihood that the insurers will be able to pay. The company may have a "similar" cost in the second quarter, Crittenden said. "It is obviously another setback," said Marshall Front, who oversees $700 million as chief executive officer of Front Barnett Associates in Chicago, including Citigroup shares.

"The subprime issue is lasting longer than some had thought and may extend into 2009. It's difficult to know when we are going to see that begin to stabilize." Total credit costs, including loan write-offs and reserves for future losses, may exceed those reported for the first quarter, Crittenden said. The company had $5.6 billion of such costs in the first quarter, after a record $7.3 billion in the fourth quarter of last year, according to the firm's financial statements.

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Moody's cuts MBIA, Ambac top insurance ratings

Moody's Investors Service on Thursday stripped the insurance arms of Ambac Financial Group and MBIA Inc of their Aaa" ratings, citing their impaired ability to raise capital and write new business.

Moody's said earlier this month it was likely to cut the ratings of Ambac Assurance Corp and MBIA Insurance Corp as plunging share prices and the high cost of accessing the debt markets made it challenging for the two largest bond insurers to raise new capital. Demand for their insurance wraps has also effectively dried up on concerns over losses the companies will take from insuring risky residential mortgage-backed debt.

Standard & Poor's stripped both insurance arms of their top ratings on June 5. Moody's cut Ambac Assurance three notches to "Aa3," the fourth highest investment grade, and downgraded Ambac Financial three notches to "A3," the seventh highest investment grade, from "Aa3." MBIA Insurance was cut five notches to "A2," the sixth highest investment grade, and MBIA Inc was cut five notches to "Baa1," three steps above junk, from "Aa2."

The outlook for all companies is negative, due to uncertainty of their ongoing business plans. A negative outlook indicates an additional downgrade is more likely over the next 12-to-18 months. In a statement on Thursday, MBIA said it was "disappointed" and "baffled" by Moody's analysis and believed the company's financial condition is strong and supports a higher rating.

"With $16 billion in claims-paying resources...we have more than enough capital to meet obligations to policyholders," the company said. "This is an issue of ratings and not solvency." MBIA said Moody's action will give some holders of guaranteed investment contracts the right to terminate the contracts or to require that additional collateral be posted.

The company said it has "more than sufficient" liquid assets to meet those requirements. Ambac also responded to Moody's action with disappointment and said in a statement on Thursday that it disagreed with the rating agency's "negative outlook designation." "The company's strong capital base, even under Moody's stress-case scenarios, will allow it to manage through the current credit crisis," the statement said.

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The end of MBIA and Ambac?

Moody’s downgrading of MBIA and Ambac should be a cathartic event. It means that the companies - in current form - will not write business ever again.

MBIA has been downgraded all the way to A2. It. is. not. a. viable. bond. insurer. Why? Well for a start, the underlying ratings on most of the bonds MBIA wraps - certainly the muni ones - are in many cases already better than that. Ambac is at Aa3, which isn’t much better. Why would you pay to have your bond guaranteed at Aa3 when - put simply - Warren Buffett can do it AAA?  Everything else should - theoretically - be moot.

None of the above, however, stops MBIA’s management from treading water - and involving themselves in a war of words between the great and the good of the blogosphere. As FT Alphaville noted yesterday, it’s now clear that - pace NYT - Eric Dinallo and the NYSID are fairly limited in the scope of the regulatory actions they can take against the monolines. The risk being that in doing anything, Dinallo may trigger termination clauses in CDS contracts and cause a run from policyholders.

So the issue is if Dinallo need do anything. If he did need to step in, then MBIA’s decision to withold $900m at the holding company level - the subject of a tangential debate between Smith and Salmon - would suddenly be relevant once more, since it would be needed - perhaps - to meet termination charges caused by desperate policyholders. It’s been said that policyholders wouldn’t run on the bond insurers -the comparison being made to ACA.

Banks granted a stay on ACA contracts because otherwise ACA would go bankrupt: ACA had defaulted on huge margin calls on CDS on CDOs. If the banks didn’t waive those margin calls, and ACA went bust, then the swaps written with ACA - used to hedge huge CDO positions on the banks balance sheets - would be worthless. Resulting in massive writedowns.

In the case of MBIA and Ambac, we’re not talking about bankruptcy or margin calls. Indeed in many cases, the value of the insurance written is already worthless - in the case of MBIA, many wrapped bonds have an underlying rating now higher than the wrapper. Policyholders, in other words, have everything to gain from terminating the insurance contracts.

The ball then, is in Dinallo’s court. Anything MBIA or Ambac say is smoke and mirrors. The situation is out of their hands.

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Ackman Foresaw MBIA Drop, Is Short Financial Security Ltd.

Hedge fund manager Bill Ackman, who correctly predicted shares of MBIA Inc. and Ambac Financial Group Inc. would tumble, said he now is betting against Financial Security Assurance Holdings Ltd.

Financial Security may be insolvent because it sold investment contracts backed by mortgage securities that have tumbled in value, Ackman, 42, told a conference hosted by law firm Jones Day yesterday in New York. Financial Security, a New York unit of Brussels and Paris-based Dexia SA, is one of two bond insurers to retain their AAA credit ratings after rivals were roiled by losses from collateralized debt obligations.

"The market has not woken up to FSA," said Ackman, who runs the $6 billion Pershing Square Capital Management hedge fund. Ackman says he will make hundreds of millions of dollars if MBIA and Ambac go bankrupt. "FSA is AAA stable, just don't look too close." Like Armonk, New York-based MBIA and Ambac and the other bond insurers, Financial Security expanded into guaranteeing and investing in mortgage securities, Ackman said.

Investors haven't scrutinized Financial Security's investments closely enough and the ratings companies are misjudging the risks, he said. The insurers expanded beyond municipal debt into insuring securities backed by subprime mortgages and other types of loans, a moved criticized by Ackman.

"It's a natural outgrowth of an industry that started in a low risk business," said Ackman. "Over time, you start taking risks that you shouldn't."

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Bank of America's Countrywide Bid Falls by $1 Billion

Bank of America Corp.'s offer for Countrywide Financial Corp., the biggest U.S. mortgage lender, has lost $1 billion, or a quarter of its value since January, as the housing slump points to additional losses for lenders.

After four months of falling share prices, Bank of America's stock swap is valued at $3 billion, compared with about $4 billion when the deal was announced on Jan. 11. While investors would get stock valued at $5.13 a share, Countrywide trades for 6 percent less. Investors are being scared off by weak home prices and legal risks, said Abigail Hooper, managing director of merger arbitrage hedge fund Havens Advisors.

Bank of America Chief Executive Officer Kenneth Lewis bailed out Countrywide after rising defaults and foreclosures left the Calabasas, California-based lender on the brink of bankruptcy. Bank of America said last month that it may not guarantee all of Countrywide's debt, increasing concern about a default. A federal investigation into lending practices could disclose more problems, said Hooper.

"If they were to find something that suggested fraud, this company could go into bankruptcy," Hooper said. "Right now people in the arb community don't want to take that kind of risk." Hooper said her New York-based firm has a "small position" in Countrywide.

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China and India watch money flood out to America over inflation fears

The world's fund managers are pulling their money out of China and India at a record pace on mounting fears of inflation and are now more pessimistic about global equities than at any time in the past decade. The latest survey of investors by Merrill Lynch shows that Europe has become the most unpopular region, while Britain is still trapped in the doldrums.

But the big surprise is the sudden change in view on the emerging powers of Asia, as overheating and spiralling oil costs spoil the boom. "World growth is slowing and yet central banks might still have to tighten monetary policy, that is what is scaring people," said David Bowers, the organiser of the survey. The vast majority of fund managers think earnings forecasts have lost touch with reality.

The exodus from China reached fever pitch this month as investors slashed their net "weighting" position to -58, down from -14 in May. The Shanghai bourse had already fallen by almost half since October. The fund managers have been slow to sense the danger.
 
India fell to -63 as investors took fright at the country's budget and trade deficits. There is concern over a relapse towards Nehru-era policies after Delhi halted trading in a range of commodity futures and restricted rice exports. The survey of 204 fund managers worldwide suggests that the love affair with emerging markets is going cold.

The net weighting was -63 for Chile, -47 for Taiwan, -37 for Korea and -32 for Poland. Mr Bowers said investors no longer believe that the bloc has a grip on inflation. They are discriminating between the commodity producers and those that rely on imports of oil, minerals and food. "Saudi Arabia is not the same as Turkey," he said.

Fund managers are still super-bullish on Russia, betting that the energy boom has life yet. A net 62pc are overweight oil and gas shares. The most hated trio are travel and leisure (-66), banks (-62) and property (-60). Karen Olney, Merrill's European equity strategist, said oil is nearing its cycle peak. "Is the trade too crowded? Probably. As long as fundamentals remain strong, we retain our overweight stance," she said.

The burning question is when to sell oil companies and move back to banks. "We resist the temptation. The time is nearer when inflation rolls over, towards the end of this year and certainly into 2009." A record number (net 29pc) are now underweight on European equities; many have switched into cash as they wait for the European Central Bank to inflict punishment - ever more likely after eurozone inflation reached an all-time high of 3.7pc in May.

The ECB's chief economist, Jurgen Stark, said yesterday that the price spike was a "cause for alarm". Mr Bowers said Europe is now facing a triple whammy as the downturn in global export markets combines with a strong euro and a monetary squeeze. "Eurozone retail sales have been worse than in the US on a year-on-year basis and eurozone GDP growth has also been worse," he said. "If you look at Spain and Italy, and even France, they are very weak.

"The Fed has eased dramatically, but the ECB hasn't eased at all. It intends to tighten regardless of the consequences on growth. This is what is eating away at confidence in Europe," he said. Merrill Lynch said fund managers were belatedly adapting to a global inflation shock that poses a serious danger to asset prices, and risks setting off "civil protest" in Argentina, Indonesia, South Africa and the Gulf states.

As the new story unfolds, America is coming back into favour, emerging as a sort of safe haven in a fast-changing world where trusted institutions command a premium. Investors are quietly rotating back into Wall Street - despite a chorus of pessimists. A net 23pc are overweight US equities, the highest since August 2001. The long awaited "decoupling" has begun. The United States looks like the winner after all.

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Wealthy Investors Shift Funds From Global Banks to Reduce Risks

High-net worth individuals, those coveted financial-services customers with at least $2 million to invest, are shifting assets from brokerages and large global banks to smaller, more conservative alternatives.

"For the first time in my career, I saw concern about the location of one's assets," said Robert Balentine, the head of Wilmington Trust Corp.'s investment management group. "We've seen tangible evidence of very wealthy clients shifting assets out of brokerage firms in great numbers."

Trust companies like Wilmington are benefiting from record subprime-infected losses at companies led by Zurich-based UBS AG, the world's biggest money manager for the rich. UBS clients probably withdrew a net $39 billion during the past three months after the company reported more than $38 billion of writedowns and credit-market losses in the past year, London-based analysts at JPMorgan Chase & Co. estimate.

Clients may say "if UBS can't manage its own capital, then what the hell are they going to do with mine?" said David Maude, a financial services consultant in Verona, Italy, who calls UBS the "Rolls Royce" of the industry. "It does tarnish their reputation, certainly."

UBS contacted 2.5 million Swiss consumer and wealth- management customers last month after losing 11.5 billion francs ($10.9 billion) in the first quarter and seeing a net withdrawal of 12.8 billion francs in its asset and wealth-management units.

The company has responded with "proactive, ongoing communication" with clients, said Jim Pierce, co-head of UBS's U.S. Wealth Management Advisory Group, in an e-mailed response to questions. UBS is "willing to have the difficult conversations," Pierce said.

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RBS stock market alert: Fund managers react

Fund managers have reacted strongly to the forecast by the Royal Bank of Scotland of stock market crash and warn investors not to act in haste and panic. The Royal Bank of Scotland has advised clients to brace for a full-fledged crash in global stock and credit markets over the next three months as inflation paralyses the major central banks.

"A very nasty period is soon to be upon us - be prepared," said Bob Janjuah, the bank's credit strategist. But Richard Buxton, fund manager at Schroders, says Mr Janjuah's comments are 'alarmist'. "If you strip out anything stocks related to oil, energy and mining in the FTSE you will see that the market is already down by 30 per cent over the past year. We are in a bear market which has been masked by the performance of those sectors."

Buxton points out that many UK shares closely connected to the slowing economy are down between 50 and 80 per cent over the year already and it is too late for investors who have yet to protect their portfolios. They will merely crystallise losses, he says.

"Yes, we are in for a tough time and there may be another sell-off but average earnings are cheap and an awful lot of the bad news is already priced in. It is too late to sell, investors need to look through the volatility - I am investing aggressively on downturns. Any falls will be temporary - the falls are simply pushing down on a spring in valuation terms."

Robin Geffen, chief investment officer at Neptune Asset Management says that he finds it 'amusing' that the grim outlook from RBS has emerged just days after the beleaguered bank completed its Rights Issue. He echoes Buxton's sentiments. "The RBS analyst is a bit late with his forecast, about a year and half late.

We have already had a bear market in many areas of the market. The guy has got the financial world confused with the real world where the consumer is real and the building of infrastructure is real. Any parallels to the stock market crash in the late 1920's are ga-ga."

Geffen argues that there is value and opportunities to be found - he has around 10 per cent in cash and is selectively adding to his portfolios. "I still like emerging market, oil, gas and mining stocks." The RBS report warns that the S&P 500 index of Wall Street equities is likely to fall by more than 300 points to around 1050 by September as "all the chickens come home to roost" from the excesses of the global boom, with contagion spreading across Europe and emerging markets.

Such a slide on world bourses would amount to one of the worst bear markets over the last century. "Cash is the key safe haven. This is about not losing your money, and not losing your job," said Mr Janjuah, who became a City star after his grim warnings last year about the credit crisis proved all too accurate. Yet Martin Walker, fund manager at Invesco Perpetual says the market has de-rated to such an extent that he can't envisage the market falling much from here.

"Much of the market is trading on historic low valuations, aside from the resource and basic materials. Even if those sectors fall by half it will not make a massive difference to the overall fall in the FTSE." Walker is keen on the pharmaceutical stocks such as GlaxoSmithKline and AstraZeneca because they are uncorrelated to the economic cycle.

"There are also great opportunities to invest in companies that are growing profits and growing sustainable dividends. BT is yielding 7.5 per cent - and it is a safe yield – that's fantastic value." Leading portfolio manager John Chatfeild-Roberts at Jupiter admits that the US economy which is teetering on the brink of a recession is a concern and that stagflation (stagnant economic growth and rising inflation) remains a real threat to all Western economies. But he is looking to invest and make the most of the volatility.

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Paulson, Bair Want System for Investment Bank Closure

U.S. Treasury Secretary Henry Paulson joined Federal Deposit Insurance Corp. Chairman Sheila Bair in seeking a clear procedure for shuttering a failing investment bank in the aftermath of the Bear Stearns Cos. crisis.

The Federal Reserve and Securities and Exchange Commission are also close to an agreement on getting information about securities firms' capital and leverage in return for access to loans from the Fed. Meantime, Paulson today urged changes in the markets for derivatives and short-term funding markets so they can withstand the failure of a counterparty.

Regulators aim to limit the dangers that firms take on more risk in the confidence of a Fed rescue if their bets go wrong. Supervisors agree that stronger oversight of the industry is needed, including interim steps before Congress considers a longer-term overhaul.

"It makes me wonder if we haven't taken the Iraq strategy" with the start of Fed lending to investment banks -- "which is going in without an exit strategy," Joshua Rosner, managing director at Graham Fisher & Co, a New York research firm, said in a Bloomberg Television interview. Paulson said it needs to be made clear what happens to financial firms that aren't part of the commercial banking system and don't have access to the same safety net.

Market "discipline" must be strengthened, with firms not expecting that central bank aid will be "readily available," he added. "There still seems to be uncertainty surrounding the process by which a large complex institution is wound down and what impact it would have on the overall financial system," Paulson said. Regulators should determine whether to assign a specific agency to oversee resolutions, he said.

Bair, whose agency insures deposits at 8,534 commercial banks, told reporters yesterday the FDIC "would not turn it down" if Congress gave it the authority to shut down failing investment banks. She said last month the FDIC's authority to set up bridge banks to take over and sell assets of failed banks offered a "good model" for what's needed for investment banks.

Responding to questions after his speech, Paulson said Bair's idea for a resolution plan for troubled financial firms was "dead on." "We must limit the perception that some institutions are either too big or too interconnected to fail," Paulson said at the Women in Housing and Finance annual luncheon. "If we are to do that credibly, we must address the reality that some are."

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US jobless figures: 374,000. Per Week?!

Fears that the number of unemployed Americans is set to rise very sharply were raised today after new jobs data revealed that there are now more people out of work across the US than at the beginning of the last recession in 2001. While the number of Americans filing for unemployment benefit for the first time actually fell last week, over an eight-week period, the average number of people losing their jobs hit a new high of 374,000.

At the beginning of the last recession, which started in March 2001, the number of new unemployed Americans hit 362,000 a week, and then rose very fast before reaching its peak of around 490,000. Ian Shepherdson, chief US economist at High Frequency Economics, said: "The key point here is that the pace of layoffs is now quite high, with no prospect of any reversal or even a levelling-off in the near future.”

At the moment, around 5.5 per cent of the American workforce is unemployed. That number is expected to rise to about 6 per cent by the end of the year, a rate that would represent about 9.3 million Americans out of work. Unemployment numbers are watched very closely by economists as a key measure of the health of an economy.

Kevin Logan, senior economist at Dresdner Kleinwort, the investment bank in New York, said: "Recessions are all about unemployment. If you look at the last recessions in 2001 and 1990, you see that once the US moved into a recession, unemployment started to rise by about 20 per cent over a two-month period. This time round, the peak is yet to come. In a recession unemployment rises very rapidly and can spike up very quickly indeed."

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Median home price in California drops 30% in May

Foreclosures helped fuel the sharpest decline in California housing prices in at least 20 years last month, and that's attracting an influx of first-time buyers who had been priced out of the market or were waiting for prices to bottom out. The median home price in California plunged 30% to $339,000 in May, the steepest decline for any month going back to 1988, when DataQuick Information Systems began keeping records.

Home buyers are now seeing median prices they haven't seen since February 2004, when the price was $322,500, the firm said Wednesday. The statewide median home price, the point at which half the homes sold for more and half for less, peaked at $484,000 in May 2007. "All of a sudden, [homes] are in our price range," said Elizabeth Trezza, a paralegal in Oakland. Trezza has been on the hunt for a foreclosed property and placed offers on at least six in recent weeks.

The 24-year-old made an offer Tuesday on a two-bedroom, two-bath bank-owned home in Oakland listed at $234,000 -- just below her maximum spending limit, $250,000. "Right now our mortgage would be relatively close to what we pay for in rent," she said. For California, epicenter of the nation's housing boom and bust, the drop in home prices has sparked a home-buying rally that's beginning to reverse more than two years of monthly year-over-year sales declines.

Though observers are cautious to call the surge in foreclosure sales a bellwether for a wider turnaround, it suggests some buyers are feeling less skittish about diving back into the market. "Inland markets hit hardest by foreclosures and falling prices are now the most likely to post higher sales than last year," said Andrew LePage, a DataQuick analyst. "These communities have been attracting first-time buyers, first-time move-up buyers and investors."

Prices in those markets are now more in line with family incomes, and some buyers feel they are getting better deals, LePage said. Sue Ansel, chief operating officer of Gables Residential, a luxury apartment rentals operator, says she has seen an uptick this year in renters moving out to become homeowners.

DataQuick said a total of 33,024 homes were sold statewide in May, down nearly 11% from a year earlier. About 38% of the resold homes in May were foreclosed properties. Some foreclosure hunters are finding themselves having to bid against rival buyers on properties, said Richard Cosner, president of Prudential California Realty.

"Homes that are $200,000 to $250,000 today were $400,000 18 months ago," Cosner said. "For the first-time home buyers and for that bottom tier of homes, we've found what the bottom of the pricing is." Homes priced below $400,000 drove the surge in sales. Many were financed with loans backed by the Federal Housing Administration, mortgage brokers say. "FHA financing has really skyrocketed," said Dustin Hobbs, a spokesman for the California Mortgage Bankers Assn.

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UK government borrowing balloons by 50 percent

Government borrowing ballooned by 50 per cent in the first two months of this year compared with the same period last year, and could soon exceed £50bn. Analysis by the independent Institute for Fiscal Studies of the latest data on the public finances reveals tax revenues are growing much more slowly than the Government expected, while public spending is still on track.

Borrowing has risen in April/May 2008 to £12.7bn, against £8.4bn in the same months last year. The IFS cautions against reading too much into the figures for a relatively short time, but says the Chancellor, Alistair Darling, "has virtually no room left to manoeuvre against the sustainable-investment rule over the next few years", meaning that net public sector debt could easily exceed the 40 per cent of national income set by the Treasury.

Government receipts in April and May 2008 were 3.6 per cent higher than in the same months of 2007. The 2008 Budget implied that revenues for the whole of 2008-09 would be 4.8 per cent above 2007–08 levels. Although the Government will receive some one-off windfall gains from North Sea oil taxation at a time of soaring oil prices, these will mostly be offset by the depressing effect the commodities boom is having on the economy as a whole.

"Taking all factors together, it is far from clear that there will be a net gain to the public finances from the higher oil price." Much depends on the prospects for growth. In his Mansion House speech on Wednesday, Mr Darling gave a hint that he will reduce his projections in this autumn's pre-Budget report.

Mr Darling said in his Budget in March that growth would be in the range of 1.75 to 2.25 per cent this year and between 2.25 and 2.75 per cent in 2009. Most independent observers agree with the bottom end of Mr Darling's expectations for the economy this year, but few are as optimistic about the ability of the economy to bounce back next year.

The CBI said on Monday that the UK would grow by 1.3 per cent, the lowest rate since 1992, with the nation facing a "very prolonged period of very sluggish growth". That figure was in line with an increasingly gloomy consensus, with some economists suggesting a full-blown recession would not take them by surprise.

A slowing economy will further depress tax revenues and push up benefit payments. Total Government debt is already predicted to be within a whisker of the 40 per cent ceiling ordained by the Sustainable Investment Rule, and the £2.7bn package of compensation for the 10p tax rate has made matters worse.

A reduction in growth of 1 percentage point boosts public borrowing by some 0.7 per cent of GDP, or roughly £10bn. Such an out-turn would push Mr Darling's public sector deficit well beyond the £50bn mark, a figure last seen during Norman Lamont's unhappy time at No 11.

A full-blown recession would see annual borrowing hit £100bn, with little chance of the budget being balanced over the economic cycle and, thus, the shredding of the "golden rule". Technical adjustments to the national accounts may help the Chancellor to a degree, but many feel that, with the scope for further tax rises effectively ruled out on political grounds, some trimming of public spending plans this autumn is inevitable.

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Bank of England's Mervyn King warns wages will stagnate and house prices will fall

Families will see their standard of living stagnate this year while the value of their homes will fall further, the Bank of England has warned. The coming months represent the biggest challenge for the economy for two decades, Mervyn King said, adding that some households will find them "particularly difficult".

In his most sombre message yet, Mr King said families were being squeezed hard by higher electricity and food prices on the one hand and slowly-increasing wages on the other. He told Alistair Darling and leading City dignitaries in London that the experience would be even tougher than the credit crunch, and warned that the "era of cheap mortgage finance... is over".

Mr King said: "This year our real take-home pay will rise at a slower pace than national productivity. Rising fuel, gas, electricity and food prices, mean that average real take-home pay will stagnate this year. "It will not be an easy time, and I know that some families will find it particularly difficult."

In a blow for The Chancellor of the Exchequer, beside whom he delivered his speech at the annual Mansion House banquet last night, he warned: "The squeeze on real take-home pay will arguably be an even more significant restraint on consumer spending this year than the credit crunch.

"And it will affect the housing market too – lower demand in the high street will go hand in hand with lower demand in the property market." The Governor said house prices would fall in comparison to families’ earnings - an indication that their values have some way further to drop.

The speech was the most austere yet delivered by Mr King, who has previously warned that the so-called NICE decade (standing for non-inflationary consistent expansion) was over. The comments come in a week inflation rose to its highest level in 15 years, outpacing wages and threatening to reduce Britons' standard of living.

Mr King was forced earlier this week to write his second letter of explanation to Mr Darling for allowing inflation to rise above target. However, the Bank Governor urged families not to panic, reassuring them that this tough period would be short-lived.

"These changes to our spending power and to the housing market are 'real' shifts that, although not easy to accept, we cannot side-step," he said. "We face the most difficult economic challenge for two decades. But I am confident that we can meet it. Inflation will fall back and growth will recover."

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Bank of England: The end of independence?

The granting of independence to the Bank of England in 1997 was the rock on which Gordon Brown built his reputation of economic competence. With so many other aspects of New Labour's economic record looking shaky, surely the Prime Minister would not be so foolish as to chip away at this foundation stone?

Some are picking up disturbing signals. The first of these was the announcement late on Wednesday evening of the premature departure of Sir John Gieve as deputy governor of the Bank of England. It was no secret that Downing Street had been unhappy with the Bank's handling of the implosion of Northern Rock.

And Sir John, by virtue of his specific responsibility at the Bank for overseeing financial stability, had taken much of the political flak for that failure. He was given quite a roasting by the Treasury Select Committee last autumn. It is perfectly true that Sir John, with no in-depth market or economic expertise, might not have been best suited to this role.

And he was not the first choice of the Bank's Governor, Mervyn King, when he was appointed two years ago. Yet under the 1988 Bank of England Act, deputy governors are not supposed to be fired. Some are interpreting this sudden personnel change, rightly or wrongly, as a sign that this is no longer the case.

The second worrying sign is the release yesterday by the Treasury of details of a new banking reform bill. The Treasury says this bill will give the Bank of England enhanced responsibilities for rescuing stricken retail banks such as Northern Rock. Yet at the same time, the bill will establish a "Financial Stability Committee" to advise the Governor in times of crisis. So is this another stealthy political encroachment on the Bank's independence?

We shall have to wait for the details of the committee's composition and personnel. In the meantime it is perfectly possible for ministers to make the case that there is no harm in giving the Bank of England another source of expert advice. And it is difficult for Mr King to reject it without appearing arrogant or ungracious.
But the Government should be cautious.

Even if the Bank of England remains as free today to exercise its own judgement as it was in 1997, it is the outward perception of independence that matters most for the financial markets and the public, in terms of the credibility of monetary policy. With the economy facing its most testing times in two decades, ministers jeopardise that perception at their peril.

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The bank bites the bullet

Whatever disagreements they may have had, the message from the Bank of England and the Treasury recently has been clear: financial stability will once again be placed at the centre of the Bank's activities.

Since operational independence was granted a decade ago and the responsibility for banking supervision was passed to the Financial Services Authority, the Bank's vestigial responsibility for financial stability – ensuring orderly markets and preventing systemic risk – was clearly secondary to its work in setting interest rates and controlling inflation.

Indeed, in the Memorandum of Understanding between the tripartite authorities – Bank, FSA and Treasury – the Bank is only required to "contribute" to financial stability. During the credit boom the Bank' s research teams produced report after report illustrating the dangers in colourful graphs with blood curdling gradients, and the Bank's officials warned of the dangers – to little avail when the credit crunch arrived and Northern Rock collapsed.

If financial instability was appearing on the horizon, the Bank had no legal, statutory obligation to do anything about it, except perhaps to speak out. Now, in the reforms to the Bank announced by Chancellor yesterday, it will be obliged to act, and given the tools to do so. The Bank may have lost a deputy governor, but it has gained clarity.

The court of the Bank, its governing body, will be streamlined and a new committee of court – the Financial Stability Committee – set up to supervise and advise on policy. This innovation must have been unwelcome to some in the Bank. Its very existence looks like an admission of failure. The resignation of Sir John Gieve, the deputy governor for financial stability, also seems a thinly disguised exercise in scapegoating.

The Governor and his two deputy governors are supposed to have statutory security of tenure under the Bank of England Act: the essence of independence. The rumoured horse-trading that led to this and an interlocking web of quid pro quos does not look like a proud, independent central bank setting its own course. Of all the sub-deals, the most valuable win for Mr King may well be the promotion of his protégé, Charlie Bean, to be deputy governor for monetary policy.

The perception that independence has been eroded matters greatly. Still, given all that, the Bank seems to have effectively tamed and internalised the FSC. It will, crucially, be chaired by the Governor and have an advisory rather than executive role – it will "guide" the Bank, in Mr Darling's phrase. In that, it will differ markedly from the Monetary Policy Committee.

Less encouragingly, there will be no definition of "financial stability", merely a "high-level statutory objective". Perhaps, like an elephant, you don't need to define it because you know what it is when it hits you. Yet there might be an unhelpful assumption that the Bank's job is to prevent market crashes, and thus market booms, rather than deal with the consequences of such inevitable events.

The Chancellor says that the Bank will have "an improved framework for the provision of liquidity, through alterations to disclosure rules". The Special Liquidity Scheme, as Mr King has hinted in the past, will become more permanent.

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UK mortgage lending to worsen after 19% slump

Mortgage lending slumped by 19 per cent in the year to May, as first-time buyers faced increasing difficulties in securing new home loans from cautious banks. Gross mortgage lending reached an estimated £25.5 billion, signalling a 19 per cent fall compared with May 2007 when it totalled £31.5 billion. Compared with April, gross lending in May fell by 2 per cent.

The Council of Mortgage Lenders (CML) said that remortgaging activity remained strong, implying that existing homeowners are supporting a market where first-time buyers are being forced to pay more to secure mortgages at increasingly expensive rates.
Times Online revealed yesterday that UK mortgage lenders have raised interest payments and arrangement fees on a two-year fixed rate loan by nearly £1,300 in just six months, with banks changing their deals as many as 19 times since January.

In April, the average deposit paid by first-time buyers rose to 13 per cent - the highest level in over three years, according to the CML. Earlier this year, the Bank of England set up a £50 billion Special Liquidity Scheme which the Government hoped would encourage lenders, hampered by the high cost of borrowing between banks, to cut rates for their customers. Michael Coogan, director general of the CML, said: "The remortgage market remains on track to meet our forecast for growth this year, demonstrating the resilience of the market despite recent bad news.

"However, by comparison, the next few months will remain very weak for house purchase activity for the funding reasons which are now well rehearsed. "We still await first signs of the Bank of England’s Special Liquidity Scheme indirectly helping to ease the current log jam.”

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UK house prices forecasts get bleaker with prediction of 35 percent drop

House prices may fall up to 35pc over the next three years, Capital Economics has warned, in one of the bleakest forecasts yet for the UK's property market. Economists Roger Bootle and Ed Stansfield said the slowdown has turned into a "full-scale slump", since the turn of the year with unemployment set to reach a 12-year high as the economy slows.
 
According to Capital Economics, the number of mortgages approved is a good indicator of the direction of house prices and "mortgage approvals for new house purchases are already below the troughs seen at the end of the early 1990s recession and we are not optimistic that mortgage demand will recover soon."

Compounding the gloom, figures out today from the Council of Mortgage Lenders reveal that gross mortgage lending in May fell 2pc on the previous month, and tumbled 19pc compared with the same period last year. Michael Coogan, director general of the CML, said: "We still await first signs of the Bank of England's Special Liquidity Scheme indirectly helping to ease the current logjam.

"The next few months will remain very weak for house purchase activity for the funding reasons which are now well rehearsed." Capital Economics said the speed of the fall in mortgage approvals, as well as the scale of house price falls in the past two months, has taken most analysts, including them, by surprise.

According to Nationwide, average house prices across the UK fell back 4.3pc in the three months to the end of May. Meanwhile, Halifax figures showed a 6.3pc drop in the same period. Britain's largest mortgage lender, Halifax warned today that house prices across the country will fall by as much as 9pc this year, on the back of a projected 45pc drop in transactions volumes.

Capital Economics said the timing of the housing market correction is "hugely uncertain". However, Mr Bootle and Mr Stansfield said they would expect a 15pc drop in prices this year, falls of 12pc in 2009 and 10pc in 2010. As a result, average house prices could fall 35pc from their peak late last year.

The two economists have long been calling the end of the housing boom. Among the first to warn of a "speculative bubble", Mr Bootle and Mr Stansfield had anticipated a major correction in 2004. Today, they said: "For a time during 2004/05 it looked as though we were right. But, of course, the market recovered strongly on the back of the August 2005 interest rate cut.

"With hindsight, it is also clear that we significantly underestimated how much higher house prices would be driven by buy-to-let demand and looser mortgage credit conditions. "However, with credit conditions now tightening, our earlier forecasts may yet prove to have been rather more prescient than widely believed."

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BCE deal faces long road ahead

Even if the Supreme Court of Canada blesses the takeover of BCE Inc. this afternoon, shareholders face months of waiting before the deal closes and they are paid, sources close to the deal said yesterday. "Realistically I'd be happy if we got it done by Christmas," said one source close to the transaction.

After markets close today, Canada's highest court will rule on whether the $52-billion takeover of telecom giant BCE can proceed as planned. The outcome will be a landmark ruling for Canadian corporate law, setting out whether directors need to take into account the rights of all stakeholders in takeovers, or merely those of shareholders.

In March, Quebec Superior Court Justice Joel Silcoff approved the deal, dismissing challenges by bondholders of BCE subsidiary Bell Canada who felt their interests were unfairly disregarded, given the heavy debt load that will come with the leveraged buyout.

But the Quebec Court of Appeal overturned Justice Silcoff's ruling, siding with the bondholders. If the Supreme Court -- which heard arguments only three days ago -- sides with the appeal court, the deal is likely to die. But even if the original ruling stands, shareholders, who voted last fall for the $42.75 per share deal, should not expect their cheques anytime soon.

While the buyer group and BCE have until June 30 to satisfy the deal's closing conditions, the actual closing will likely drag on much later. That is because the banks and buyers have to hammer out final, complex credit agreements. That could easily spill into September or beyond, sources close to the deal said.

Negotiations between the buyer group, led by Ontario Teachers' Pension Plan, and the banks funding the buyout -- including Citigroup Inc., Deutsche Bank AG, Royal Bank of Scotland, and Toronto-Dominion Bank -- stopped in their tracks a month ago with the appeal ruling.

The resolution of the Clear Channel Communications Inc. takeover -- in which the U. S. company and private equity buyers agreed to cut the price paid to shareholders to satisfy the strained banks after an impasse led to court action--may strengthen the hand of BCE's lenders as they negotiate final terms on the $32-billion in debt they agreed to finance last summer. The bank group includes some of the same banks as the Clear Channel syndicate.

Even if the banks and buyers reach an agreement, it would be followed by a 35-day marketing period when BCE, the buyers and banks try to sell the debt to the market. "You don't do a $52-billion transaction rushed, and everybody's more careful than they used to be," the source said. "To some degree we're in uncharted waters."

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What Does Obama's 'Love of Markets' Mean for Our Economic Future?
By Naomi Klein

Barack Obama waited just three days after Hillary Clinton pulled out of the race to declare, on CNBC, "Look. I am a pro-growth, free-market guy. I love the market." Demonstrating that this is no mere spring fling, he has appointed 37-year-old Jason Furman to head his economic policy team.

Furman is one of Wal-Mart's most prominent defenders, anointing the company a "progressive success story." On the campaign trail, Obama blasted Clinton for sitting on the Wal-Mart board and pledged, "I won't shop there." For Furman, however, it's Wal-Mart's critics who are the real threat: the "efforts to get Wal-Mart to raise its wages and benefits" are creating "collateral damage" that is "way too enormous and damaging to working people and the economy more broadly for me to sit by idly and sing 'Kum-Ba-Ya' in the interests of progressive harmony."

Obama's love of markets and his desire for "change" are not inherently incompatible. "The market has gotten out of balance," he says, and it most certainly has. Many trace this profound imbalance back to the ideas of Milton Friedman, who launched a counterrevolution against the New Deal from his perch at the University of Chicago economics department. And here there are more problems, because Obama--who taught law at the University of Chicago for a decade -- is thoroughly embedded in the mind-set known as the Chicago School.

He chose as his chief economic adviser Austan Goolsbee, a University of Chicago economist on the left side of a spectrum that stops at the center-right. Goolsbee, unlike his more Friedmanite colleagues, sees inequality as a problem. His primary solution, however, is more education -- a line you can also get from Alan Greenspan. In their hometown, Goolsbee has been eager to link Obama to the Chicago School. "If you look at his platform, at his advisers, at his temperament, the guy's got a healthy respect for markets," he told Chicago magazine. "It's in the ethos of the [University of Chicago], which is something different from saying he is laissez-faire."

Another of Obama's Chicago fans is 39-year-old billionaire Kenneth Griffin, CEO of the hedge fund Citadel Investment Group. Griffin, who gave the maximum allowable donation to Obama, is something of a poster boy for an unbalanced economy. He got married at Versailles and had the after-party at Marie Antoinette's vacation spot (Cirque du Soleil performed) -- and he is one of the staunchest opponents of closing the hedge-fund tax loophole.

While Obama talks about toughening trade rules with China, Griffin has been bending the few barriers that do exist. Despite sanctions prohibiting the sale of police equipment to China, Citadel has been pouring money into controversial China-based security companies that are putting the local population under unprecedented levels of surveillance.

Now is the time to worry about Obama's Chicago Boys and their commitment to fending off serious attempts at regulation. It was in the two and a half months between winning the 1992 election and being sworn into office that Bill Clinton did a U-turn on the economy. He had campaigned promising to revise NAFTA, adding labor and environmental provisions and to invest in social programs. But two weeks before his inauguration, he met with then-Goldman Sachs chief Robert Rubin, who convinced him of the urgency of embracing austerity and more liberalization.

Rubin told PBS, "President Clinton actually made the decision before he stepped into the Oval Office, during the transition, on what was a dramatic change in economic policy." Furman, a leading disciple of Rubin, was chosen to head the Brookings Institution's Hamilton Project, the think tank Rubin helped found to argue for reforming, rather than abandoning, the free-trade agenda.

Add to that Goolsbee's February meeting with Canadian consulate officials, who left with the distinct impression that they had been instructed not to take Obama's anti-NAFTA campaigning seriously, and there is every reason for concern about a replay of 1993.

The irony is that there is absolutely no reason for this backsliding. The movement launched by Friedman, introduced by Ronald Reagan and entrenched under Clinton, faces a profound legitimacy crisis around the world. Nowhere is this more evident than at the University of Chicago itself. In mid-May, when university president Robert Zimmer announced the creation of a $200 million Milton Friedman Institute, an economic research center devoted to continuing and augmenting the Friedman legacy, a controversy erupted.

More than 100 faculty members signed a letter of protest. "The effects of the neoliberal global order that has been put in place in recent decades, strongly buttressed by the Chicago School of Economics, have by no means been unequivocally positive," the letter states. "Many would argue that they have been negative for much of the world's population."

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