Debt Rattle, July 20 2008: The Grief Cycle

Dorothea Lange In From The Fields August 1936
"Migrant cotton pickers at lunchtime. Near Robstown, Texas."

Ilargi: Since talk about the FDIC is in focus today, I'll start off with this quote from the weekend's Economist magazine:

"Coincidentally, the ratio of FDIC’s fund to the total amount of insured deposits is similar to the capital ratios set aside by Fannie Mae and Freddie Mac"

That’s so funny and dead on, it makes my day. Fannie and Freddie are leveraged some 62 times. If applied to the FDIC, that would mean that the $50+ billion in funds it holds now won’t be, to put it gently, entirely sufficient. Try $3 trillion.

Now, the US government could guarantee that, in theory. But issuing that much fresh credit would hit the US dollar so hard that if and when (two big questions) you’d get your money, it wouldn’t be worth much anymore. Plus, since you, the taxpayer, are ultimately on the hook for all government guarantees, it’d be not much different from taking money out of your right-hand pocket just to shift it to the left-hand one. The only real effect: it loses value in the process.

Today, our friend and longtime reader StrandedWind, at DailyKos (8,500 U.S. banks; many will die soon), calls the spade by its true name: The FDIC is an insurance operation, which means they do risk assessments, and charge premiums accordingly, in their case from member banks. After losing $4-8 billion over IndyMac (their own estimate), the FDIC now wants to increase those premiums. Which has me thinking:

1/ I need no clearer indicator of what the FDIC expects: a lot more bank failures. Their present $50+ billion war chest is not enough. IndyMac ate away 10%, and panic sets in.

2/ Isn’t perversion fun at times? For banks that are already in trouble, these higher premiums pose a serious risk of pushing them over the edge. But wait; don't they pay those premiums to prevent them from crashing?

Isn't this all hilarious? The FDIC devalues any deposits you think it guarantees, and it brings down banks while doing it. Truly, your bank account is nothing but an IOU. At least you get to laugh while losing it.

On another front, the SEC's actions to protect its Wall Street friends from naked short sellers are a prime candidate to top the FDIC in successfully merging irony with perversity. Their friends are the biggest naked short sellers!! Brilliant!

And while it's obvious that most attention will be for the US economy, there are also huge problems elsewhere. Yesterday, I talked a bit more about the UK, which is falling to bits, but still tries the "brave face" approach. In Spain, the government itself has given up on trying that one. Take out a few corner stones like these two from the EU economy, and it'll all come tumbling fat and fast, with political rifts thrown into the equation.


U.S. eyes higher premiums to replenish bank fund

Banks holding volatile deposits gathered by third parties may be charged higher premiums to bolster the fund used to insure deposits at failed banks, the head of the Federal Deposit Insurance Corp said on Friday.

"I think that is something we need to factor into our premiums and charge higher premiums to banks that fit that profile," FDIC Chairman Sheila Bair said in an interview with C-SPAN television. Bair said brokered deposits at IndyMac, seized by the FDIC a week ago, were a big factor driving up the cost to the fund that insures up to $100,000 per deposit and up to $250,000 per retirement account at insured banks.

The FDIC expects the third largest bank failure in U.S. history to deplete the $53 billion fund by between $4 billion and $8 billion. "Again, overwhelmingly, banks are safe and sound and healthy," so I think the industry will be able to absorb the additional needs to keep those reserves strong, she said.

Brokered deposits are short-term deposits accepted by banks to fund lending activity. But the deposits are considered volatile because investors chasing high returns can withdraw the money and move it to another institution. Well-capitalized banks are free to take such deposits, while those classified as adequately-capitalized need the FDIC's permission.

Undercapitalized institutions are prohibited from accepting brokered deposits. In the taped interview, to be aired on Sunday, Bair said the FDIC board, which includes the head of the Office of Comptroller of the Currency and Office of Thrift Supervision, will meet in September to weigh how to replenish the deposit insurance fund.

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Can bottom be seen for U.S. housing?

The U.S. government's pledge to rescue the mortgage finance companies Fannie Mae and Freddie Mac is about more than bolstering the floundering U.S. housing market. It is also aimed at shoring up the U.S. economy and, along with it, the global image of America Inc.

The dollar, in many ways a proxy for the state of the economy, appeared to be stabilizing after a March trough. But last week it once again approached record lows against other major currencies, including the euro. Financial market confidence is weakening after U.S. federal regulators took over the California bank IndyMac on July 11, making it the third-largest U.S. bank failure. Just a few weeks earlier, some analysts were declaring that the worst of the credit crisis was over.

Treasury Secretary Henry Paulson Jr. and Ben Bernanke, chariman of the Federal Reserve, explained the rescue plan to Congress. They noted that Fannie and Freddie were the only companies left with the financial clout to keep the mortgage market functioning properly and prevent the struggling U.S. housing market from stalling.

That is why the Treasury and the Federal Reserve thought they that had no choice but to offer an unlimited credit line to the two mortgage finance companies, along with a promise to buy a stake in them if needed. The announcement, made on July 13, was timed in part to ensure that buyers would not shy away from Freddie's debt offering the next  day. They did not, and the auction, a routine debt offering, was successful.

The rescue plan requires the approval of Congress, where Paulson received a chilly reception from some members who accused him of writing a blank check with taxpayers' money. David Rosenberg, an economist with Merrill Lynch, said the markets needed that government show of support to bolster confidence because the alternative could have been far worse.

"This solution, however extreme it may seem, is preferable to allowing the economic function these institutions serve to collapse," he wrote in a note to clients. "Additionally, if the creditworthiness of their debt were to come into question, it could lead to a loss of confidence in the U.S. financial markets more broadly." That would be harmful to the already weak dollar and prompt worrisome questions about whether the world was losing interest in cheaply financing U.S. debt.

Figures released last week showed that foreign buyers cooled on U.S. investment in May, although they still poured in enough money to cover a hefty current accounts deficit. But the mood on Wall Street has darkened considerably since then, casting doubt on the current investment appetite.

Brian Bethune, chief U.S. financial economist with Global Insight in Lexington, Massachusetts, said, "The recent weakness in the U.S. dollar indicates a pullback in overseas demand for U.S. securities, a situation that will not be resolved until the Treasury's plan for the stabilization of Fannie Mae and Freddie Mac becomes clearer and the free-fall of financial sector equities is arrested." "In the meantime," Bethune, added, "fasten your seat belts."

With the federal government's expressed backing, Fannie and Freddie found willing buyers for about $10 billion in debt they sold last week, a large portion of it to foreign buyers who are typically among the major holders. But their stock prices remained volatile, making it more difficult for them to raise more capital by selling equity. The best hope for their shares, and the prospects for the broader economy, is a housing market recovery.

Reports due this week should shed some light on whether the U.S. housing market is nearing bottom. On Thursday, the National Association of Realtors is scheduled to release its June report on existing-home sales, and the Commerce Department is to report on June single-family home sales on Friday.

Last week, U.S. housing starts showed a surprisingly robust 9.1 percent increase for June. But that jump was inflated by a rise in multifamily projects in New York, where builders rushed to get started before new rules took effect on July 1. Reports last week from major banks like Wells Fargo and JPMorgan Chase helped to lift shares of hard-hit financial stocks. This week, Bank of America, Wachovia and Washington Mutual are to report quarterly earnings. It may be another volatile week.

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Ilargi: As we expected, there had to be a follow-up to the SEC’s decision to ban short trading in 19 carefully selected financials, a ban justified by the assertion that short sellers and speculators "unjustifiably" target banks and spread rumors. First, now all banks want in. Second, the SEC has chanegd its original protection decree. I am NOT making this up. It has selected a group of financials eerily similar to those protected, and labeled them "market makers". These can now go on naked shorting each other unabated, while the rest of the market is on the sidelines.

I have a few observations:

1. Why only banks? I’m sure GM and Ford will want in on the deal too. Where is the limit?
   
2. What, pray tell, is the origin of the "loss of confidence in the safety and soundness of this country's banking industry"? If the banks were all so safe and sound, how many people would be foolish enough to short them?
   
3. We’ll make you a good deal: any and all institutions and companies that want to be protected from shorting, an elementary element of the financial markets, need to fulfill one requirement first and foremost. And that is: open their books, and show how safe and sound their assets really are. When that is done, we’ll talk again. We don’t want to waste our energy and the taxpayers’ money on protecting what is already dead anyway.
   
4. A pivotal part of opening the books, other than a mark-to-market reality check on all paper held by the institutions, including Level 3 and off-balance sheet, needs to be a full disclosure of how much money the potential protectee has made in the past decade by shorting other companies. We won’t protect Tony Soprano from the enemies he made while killing their families.
   
5. Who am I still kidding? I’ve said it so many times before: this is a criminal enterprise, operating in broad daylight, while the nation is asleep.

U.S. banks ask SEC to expand stock trade protection

An emergency move by U.S. securities regulators this week aimed at curbing manipulative short-selling in some major financial firms should be expanded to all publicly traded banks, or it could erode confidence in the banking industry, a top trade group said.

A letter from the American Bankers Association to the Securities and Exchange Commission this week stressed that banks could be vulnerable as they are suffering from the financial turmoil stemming from the downturn in the U.S housing market.

"The emergency order could further exacerbate a loss of confidence in the safety and soundness of this country's banking industry," ABA President Ed Yingling said in a Thursday letter to the SEC. "As the commission is aware, it would be an understatement to say that short interest in financial services companies has greatly increased over the year," Yingling said.

On Friday the SEC, the U.S. markets watchdog, amended its action from earlier in the week but limited the protection to 19 firms including U.S. housing finance giants Fannie Mae and Freddie Mac whose shares plunged on concerns they were undercapitalized.

The rule also applies to the stocks of 17 Wall Street firms, primary dealers that have access to the Federal Reserve's discount window, such as Citigroup Inc and Lehman Brothers. Short selling is a legitimate strategy where the investor arranges to borrow shares they consider overvalued and sell them in hopes of profiting when the price drops. A naked short occurs when an investor sells stock that has not yet been borrowed.

Wall Street, which was thrown off guard when the SEC announced the emergency rule on Tuesday, and U.S. stock exchanges applauded the rule modifications and guidance. But the ABA wanted the SEC protection expanded to all banks and their holding companies that are publicly traded.

The emergency rule is the latest effort by the SEC to crack down on market manipulation. The agency has already announced plans to rein in those that are spreading false information amid complaints from companies and lawmakers that short sellers are driving down financial stocks.

The ABA said the majority of the 8,500 banks in the United States are well-capitalized and capital levels are not affected by their stock prices. However, it said people with bank accounts might equate stock drops with the safety of their deposits. The Federal Deposit Insurance Corp insures up to $100,000 per deposit and up to $250,000 per retirement account at insured banks.

The bank industry group said naked short selling has contributed to the increase in shorting of bank stocks.

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Ilargi: Moving forward, I notice I’m not the only one with questions about the SEC protection scheme.

Short Selling: Others Want Protection Too

As is now well known, this week the SEC announced that it plans to tighten short-selling rules on Monday for 19 financial companies, essentially limiting naked short selling by now requiring short-sellers to actually borrow the shares they plan to sell before shorting.

The new restrictions were loosened a little on Friday when the SEC said market makers wouldn't have to pre-borrow the stock, but would still need to deliver them within three days. Market makers had complained that the new rules would prevent them from providing the necessary liquidity for making an efficient market.

Upon first hearing of the rule change (or enforcement), in particular the listing of the gang of 19, I wondered in a post whether some companies on the list would prefer to not be included, given the attached stigma of needing Government intervention to prop up their shares.

After all, the rule is effectively an SEC induced short-squeeze. Of course, that was 3 days and +20% ago. Now other companies are wondering why they were not included. After all, they like +20% moves as well. As mentioned in a recent WSJ article, the Financial Services Roundtable, who represents 100 of the largest U.S. financial companies, wants the SEC to extend the order to include companies they represent as well.

Companies like Wachovia, reporting next week, are not currently included. Apparently they are either not big enough to fail, or are not yet in poor enough shape to fail. Given the recent investigation of Wachovia, and speculation about poor numbers next week, that may soon change.

If history is any indication, and it usually is - it is rarely different this time - then companies may want to be careful what they wish for. Research by Professor Charles Jones at Columbia Business School has found that similar moves by the SEC have some unhappy precedents. As mentioned in the WSJ article:
 

In 1932, the New York Stock Exchange announced that, effective April 1, brokers would need written authorization before lending an investor's shares. "This wreaked havoc on the securities lending market, but the effect was completely temporary," he [Jones] said, because the move only added extra hoops, and didn't prevent people from taking bearish positions if they wanted.

More regulation, and temporary results. Not necessarily what we need long-term, but what we will probably get regardless. Maybe with less next quarter, short-term, results-generated management, by both investors and the government, we would not need additional layers of regulation.

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Ilargi: And I see Mish is on the money as well. There is one option, though that I miss in his analysis. The SEC ruling, and its amendment, open the door for any of these "market makers" (or any combination of them) to launch a full frontal attack on any of the others in the group. That could now potentially be done unhindered. Since the ruling stands for 30 days, such an attack might happen soon.

SEC Issues Order To Protect Those Most Responsible For Naked Shorting

The naked short selling saga continues. If the SEC was attempting to initiate a short squeeze in financials during options expirations week, it managed to do just. See Short Squeeze In Financials Continues.

Fannie Mae is up another 25% today to $13.66 in the wake of Selective Enforcement of Regulation SHO and Bernanke's statement: "It's important for Fannie Mae and Freddie Mac bonds and stocks to rise so they can keep raising capital and aid the mortgage market."

As long as the investment banks and brokers were making money engaging in naked shorting of stocks, there was no problem. However, when the bears began using the tactic against the broker dealers and investment banks, it became time to selectively enforce the existing regulation. Today the SEC has gone one step further:

An emergency order issued by the Securities and Exchange Commission to impose new restrictions on short sales in 19 stocks will not apply to bona fide market makers, the SEC announced Friday.

The SEC amended the order at the recommendation of its staff to shield market makers from the new restrictions, which will take effect on Monday and could last for up to 30 days. It said the change was made to allow market makers "to facilitate customer orders in a fast-moving market without possible delays" that might come from complying with the emergency order "and to prevent substantial disruption to securities markets."

The SEC said the exemption covers registered market makers, block positioners and other market makers that sell short as part of their bona fide market making and hedging activities in the affected shares, as well as standardized options on the shares and exchange-traded funds that include the affected shares.

BNP Paribas Securities Corp, Bank of America Corp, Barclays PLC, Citigroup Inc, Credit Suisse Group, Daiwa Securities Group Inc. Deutsche Bank Group AG, Allianz SE, Goldman Sachs Group Inc, Royal Bank ADS, HSBC Holdings Plc ADS, JPMorgan Chase & Co, Lehman Brothers Holdings Inc, Merrill Lynch & Co Inc, Mizuho Financial Group Inc, Morgan Stanley, UBS AG

Anyone in the above list can continue to naked short with full approval from the SEC. No one else can. The implications are that the market makers will be accumulating massive quantities of financial shorts as everyone else is squeezed out.

Looking one step ahead, think what happens to the bid after everyone else is squeezed out and the market makers hold all the financial shorts. If the intent of the SEC was to force prices up, it is going to fail big time, in due time. If the SEC's intent was to temporarily increase the trading profits of the broker dealers, it will succeed.

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Spain’s Real Estate Crisis Threatens Entire Economy

Spain's economy is in trouble. Rising property values earlier this decade lured many Spaniards into the market. Now that the bubble has burst, the crisis is quickly spreading through the country's economy.

"I'll give you a good price," the man, who introduces himself on the phone as José, promises potential buyers. José has a flat in Seseña, a small town of 12,000 around 40 minutes by car from Madrid. Now, he wants to get rid of it -- regardless of the financial hit he might take. The real estate agent who sold him the property insisted it was a safe investment for the future. But those promises dissolved into thin air not long after José had signed the contract.

In total, 13,500 flats were supposed to be built in the new housing development where José's apartment is located -- homes for 50,000 people. Yet, only halfway through the building project, the plug was pulled. Several unfinished apartment blocks now blight the landscape. In the end, only 5,000 apartments were completed and a mere 750 people moved in.

And those who did move here now want to leave -- José's isn't the only balcony boasting a "For Sale" sign. He had hoped to be able to rent out the apartment to pay of his mortgage. But despite advertising his apartment for months in various publications, no one showed any interest.

Seseña, which until recently was the very symbol of the Spanish economic miracle, suddenly stands for something very different: the collapse of the building industry, one of the Spanish economy's key sectors. The golden years of the real estate business are now well and truly over.

What is worse, however, is that the crisis has by now infected the entire country. Nowhere else in Europe in the last decade did the construction sector boom as it did in Spain: Real estate prices shot up by as much as 500 percent. The country invested in property, betting that prices would rise and rise. But, now the bubble has burst and the losers are those who did not sell in time.

Even the major players in the real estate sector have been hit. At a recent trade fair in Madrid, the biggest in Spain, a downright discount battle raged. "One year without payments," "€12,000 ($19,000) worth of furniture," or "a compact car" were just some of the offers. The response from buyers was only lukewarm.

Recently published figures also reflect the depth of the crisis: In the first quarter of 2008, 28 percent fewer homes were sold compared to the same period the previous year. The price of newly built real estate has fallen for the first time in 10 years. According to a study by Deutsche Bank, prices will drop by 20 percent by 2011.

The crisis in the construction industry -- the motor of Spain's recent economic growth -- has caused unemployment to rise more rapidly than since the early 1990s. The jobless rate now stands at over 9 percent with 424,555 Spaniards registering as unemployed in the past 12 months alone. Over a third of them had worked in construction.

With bankruptcies in the building sector rampant, it is a number that promises to rise even further. The Organization for Economic Cooperation and Development (OECD) predicts, by the end of the year, the jobless rate will creep up another percentage point.

Two other important sectors of the economy -- tourism and the car industry -- are also suffering. In June angry truck drivers blocked Spain's main roads, because they see their livelihoods threatened by high fuel prices. Only this Thursday, airline Spanair announced it would lay off thousands of workers. Meanwhile, the number of automobile registrations plunges to new lows each month.

Even those who have jobs are losing confidence. The already low average wage is being eroded by a 5 percent rate of inflation driven, just as elsewhere in Europe, by high fuel and food prices. Consumption is way down as a result.
Spaniards are also worrying about interest rate rises: A peculiarity in the Spanish mortgage market means rate rises hit home faster than in other countries.

Unlike in Germany, for example, mortgage rates are not fixed for several years, but are constantly changed in line with the prime rate. As a result, even well-paid Spaniards are pushed right to the limits of what they can afford. On top of that, banks have tended to liberally hand out loans. And because of the seemingly guaranteed property price rises, many mortgage providers did not require deposits.

This has resulted in a high number of mortgage defaults. So far, the €6.1 billion ($9.7 billion) currently outstanding accounts for a mere 1 percent of home loans. But experts predict that the percentage will increase fivefold by the end of the year. Should that happen, the reserves kept by credit institutes will evaporate. "The number of holes in the balance sheets frightens me," Miguel Blesa, President of Spain's biggest savings bank Caja Madrid, said recently.

The first high-profile victim of this development is the established real estate firm Martinsa Fadesa. The company was unable to raise the comparatively small amount of €150 million ($238 million). In the end the company's market capitalization of around €680 million ($1.1 billion) was dwarfed by debts of €5.4 billon ($8.6 billion). The current situation being what it is, it is only a matter of time before further mortgage companies get into trouble.

Although far fewer Spanish investment funds funnelled money into products tied to US subprime loans compared to, say, German funds, the home-made crisis is at least as dangerous. Now these policies have come home to roost. In total, Spaniards have borrowed the equivalent of their country's gross domestic product. Mortgages make up 60 percent of the debt.

Those who do not pay their wages into the same bank as they got their mortgage from can expect a call soon. Worried lenders are inquiring in a friendly but firm manner, if it would not be possible for them to pay their wages into an account that secures their loans. Other banks -- especially Deutsche Bank -- are trying to reduce the share of bad debt by holding on to solvent customers by offering them favorable conditions.

The dramatic developments have only slowly started to register at Spain's most important address: For a long time Prime Minister José Luis Rodríguez Zapatero shirked away from calling it a crisis -- and that despite economists saying Spain's economy had slipped into recession in the second quarter of the year. "Difficult conditions," "complex situation" or "fall in the rate of growth" is how Zapatero characterized the developments.

The opposition in parliament jeered that the prime minister spent more time looking up synonyms for crisis than confronting the mounting problems. Zapatero finally caved in a few days ago: For the first time he spoke publicly about a "crisis." But that in no way reassured the markets.

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Fear of failure

By tradition, sequels are pale shadows of their forerunners. In this financial crisis, each episode in the saga seems even more potent than the last. While one arm of the American government tried to allay fears about Fannie Mae and Freddie Mac, another was busily orchestrating the seizure of IndyMac Bancorp, a large mortgage lender which collapsed on July 11th.

The Federal Deposit Insurance Corporation (FDIC) set up a new bank to take control of IndyMac’s insured deposits and assets, and will now try to sell what it can. Judged by the standards of Northern Rock, a British mortgage lender where the death throes lasted for months, the failure of IndyMac has been orderly. Its consequences were anything but.

Worried IndyMac customers queued in the sweltering Californian sun to retrieve their money, despite FDIC guarantees on deposits of up to $100,000 (of the bank’s $19 billion of deposits, $1 billion is uninsured). Investors in other banks showed far less decorum.

On July 14th the S&P500 banks’ index suffered its worst daily fall since its creation in 1989. Regional banks took the brunt of the punishment. Washington Mutual in Seattle and National City in Cleveland were both moved to issue statements reassuring panicking investors that they were well capitalised and had access to short-term funding.

Such tactics can easily backfire. Wachovia, the country’s fourth-biggest lender, also sought to soothe markets about its finances on July 15th, and watched its shares sink further. Wachovia, which has achieved infamy for an ill-advised acquisition that swamped it with adjustable-rate mortgages in California, has lost more than 75% of its value since the start of the year.

Reasoned analysis is a struggle in such circumstances. “Who is next?”, asked a July 13th research note from Dick Bove, a respected industry observer, which ranked banks on the basis of ratios of non-performing assets. His reassuring subheading, “Not as many candidates as one would think”, got lost in the stampede as investors shied away from banks anywhere near the top of the list. Mr Bove issued a hasty clarification on July 14th saying that the data had been misinterpreted.

Is the panic justified? IndyMac’s fall matters for three reasons. The first is that it forcibly reminds investors and depositors that not every financial institution in America is too big to fail. With $32 billion of assets, IndyMac is set to be the country’s second-biggest bank failure. According to Chip MacDonald of Jones Day, a law firm, it is also likely to be the most expensive.

The FDIC reckons that the costs of cleaning it up will be between $4 billion and $8 billion, a big chunk of the agency’s $53 billion deposit-insurance fund. Coincidentally, the ratio of FDIC’s fund to the total amount of insured deposits is similar to the capital ratios set aside by Fannie Mae and Freddie Mac. Riskier banks will be asked to pay more in order to top the pot up, another drag on earnings.

The second lesson of IndyMac is that it underlines the speed with which banks can go under once confidence in them is lost. Plenty of analysts thought the bank was in severe trouble, but the government’s hand was forced by massive outflows of deposits that were themselves triggered by a public letter from Chuck Schumer, a spotlight-loving senator, expressing concerns about IndyMac’s health. Regulators did not bother to disguise their irritation with Mr Schumer’s intervention, but they cannot ignore the broader message: a lack of liquidity kills.

The third message from IndyMac is that the well of capital for ailing banks is not inexhaustible. Before it went under, the lender admitted that its efforts to shore up capital had come to nothing. Small regional banks, less diversified than their larger brethren and more exposed to riskier asset classes such as home-equity lines of credit and commercial real estate, are most at risk of running out of capital-raising options. That moment may now be arriving.

Estimates of the numbers of bank failures are rising as a result. Gerard Cassidy of RBC Capital Markets reckons that up to 300 banks are likely to fail over the next three years, compared with just three during 2007. This number is less frightening than it sounds. More than 1,000 banks failed at the height of the savings and loans crisis in the late 1980s.

“There are 8,000 banks in America and most people haven’t heard of 7,950 of them,” says Fred Cannon of Keefe, Bruyette & Woods, an investment bank. IndyMac was sizeable, of course, but its profile was unique. Its deposit-taking prowess rested on alluring interest rates rather than relations with customers. Bigger banks, with deeper branch networks and a broader range of products, are less susceptible to runs on deposits and better placed to use their deposit base to buttress earnings.

On the asset side of the balance-sheet, IndyMac’s lending zoomed from $29 billion in 2003 to a peak of $90 billion in 2006. More than two-thirds of its lending in that year was in Alt-A loans, a class of mortgages for borrowers who cannot document all their income and assets. As well as being riskier than normal mortgages, these loans are also more susceptible to abuse. IndyMac is reportedly under investigation by the FBI for fraud.

No part of the housing market is thriving, but lenders with less exotic portfolios can sleep a little easier. Wells Fargo, the country’s second-biggest mortgage lender, briefly lifted the gloom hanging over bank stocks on July 16th after it announced better-than-expected second-quarter results. The relief will probably be temporary. Investors may have been in denial about the depths of the hole banks are in up until now. If the next stage of the grief cycle—despair—is indeed setting in, times will get even more testing.

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Uncomfortable Answers to Questions on the Economy

In March, the Federal Reserve helped engineer a deal for JPMorgan Chase to buy troubled investment bank Bear Stearns. Many assumed the worst was over.

But, this month, the open distress of Fannie Mae and Freddie Mac — two huge, government sponsored institutions that together own or guarantee nearly half of the nation’s $12 trillion in outstanding mortgages — sent a signal that more ugly surprises may lie in wait.

To calm markets, the government last weekend hurriedly put together a rescue package for Fannie and Freddie that, if used, could cost as much as $300 billion. The urgent need for a rescue — together with another round of billion-dollar write-offs on Wall Street — has unnerved economists and investors.

“I was a relative optimist, but I’ve certainly become more pessimistic,” said Alan S. Blinder, an economist at Princeton, and a former vice chairman of the board of governors at the Federal Reserve. “The financial system looks substantially worse now than it did a month ago.

If the Freddie and Fannie bailout were to fail, it could get a hell of a lot worse. If we get more bank failures, we have the possibility of seeing more of these pictures of people standing in line to pull their money out. That could really scare consumers.”

In one respect, Mr. Blinder added, this is like the Great Depression. “We haven’t seen this kind of travail in the financial markets since the 1930s,” he said.

More than two years ago, Nouriel Roubini, an economist at the Stern School of Business at New York University, said that the housing bubble would give way to a financial crisis and a recession. He was widely dismissed as an attention-seeking Chicken Little.

Now, Mr. Roubini says the worst is yet to come, because the account-squaring has so far been confined mostly to bad mortgages, leaving other areas remaining — credit cards, auto loans, corporate and municipal debt. Mr. Roubini says the cost of the financial system’s losses could reach $2 trillion. Even if it’s closer to $1 trillion, he adds, “we’re not even a third of the way there.”

Where will the banks raise the huge sums needed to replenish the capital they have apparently lost? And what will happen if they cannot? The answers to these questions are unknown, an unsettling void that holds much of the economy at a standstill.

“We’re in a dangerous spot,” said Andrew Tilton, an economist at Goldman Sachs. “The big threat is more capital losses.” Banks are a crucial piece of the economy’s arterial system, steering capital where it is needed to fuel spending and power growth.

Now, they are holding tight to their dollars, starving businesses of loans they might use to expand, and depriving families of money they might use to buy houses and fill them with furniture and appliances. From last June to this June, commercial bank lending declined more than 9 percent, according to an analysis of Federal Reserve data by Goldman Sachs.

“You have another wave of anxiety, another tightening of credit,” said Robert Barbera, chief economist at the research and trading firm ITG. “The idea that we’ll have a second half of the year recovery has gone by the boards.”

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Why Buy Treasuries When You Will Be Able to Buy Fed/Treasury-Guaranteed GSEs?

On Sunday, July 13, the Federal Reserve Board voted to give Fannie Mae and Freddie Mac access to the discount window at the Federal Reserve Bank of New York. This action effectively transforms a perceived implicit guarantee of Fannie and Freddie liabilities into an explicit guarantee.

If Fannie or Freddie should have any problem funding their activities, they can now tap the New York Fed's discount window facility for funds. Also on July 13, the Treasury asked Congress for authority to increase its line of credit to the two government sponsored enterprises (GSEs) by an unspecified amount from the current $2.25 billion already in place for each.

Also, the Treasury asked Congress for authority to inject capital into the two GSEs. My bet is that Congress will grant the Treasury the authority to increase its line of credit and to inject capital into the two GSEs by a sufficient amount that will effectively guarantee to liabilities of the two. My bet also is that the Treasury will not have to actually lend a dime to Fannie or Freddie when the authority is granted.

And I suspect that Fannie and Freddie will not feel the need to avail themselves of the Federal Reserve's discount window generosity. Why? Because, as mentioned above, an implicit guarantee of these GSEs' is now an explicit guarantee. Once fixed-income investors know this, they will have no credit-risk qualms about buying Fannie's and Freddie's paper.

That was painless, wasn't it? Or was it? Now that Fannie's and Freddie's paper is guaranteed by the Fed and is likely to be guaranteed by the Treasury shortly, if you were inclined to buy Treasury securities, why not buy a near-perfect substitute that is paying a slightly higher yield?

In short, the yields on Treasury securities are likely to be higher than they otherwise would be as investors switch out of Treasuries into GSE paper. This means that the Treasury's debt service costs going forward also will be higher than they otherwise would be. And, this means that the current or future tax burden on U.S. taxpayers will be higher than it other wise would be.

As I have said on more than one occasion, there is no such thing as a free bailout. Some entity will pay. I don't know what will happen to Fannie and Freddie's stockholders, although I do have some opinions as a taxpayer as to what I would want. To the degree that the Fed and the Treasury are guaranteeing their debt, Fannie and Freddie stockholders benefit.

If Fannie and Freddie are more highly regulated, which will reduce their profitably even in "good times" and if Fannie and Freddie will be required to hold more capital to reduce their 68-to-1 leverage ratio, then new equity issued to the private sector will entail a high cost. Who wants to invest in a company whose profitability will be restrained? In this case, the dilution that current Fannie and Freddie stockholders will bear will be a bear.

Presumably, if the Treasury were to inject capital into these GSEs, political pressure also would dictate that current Fannie and Freddie stockholders bear a high dilution price.

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Given a Shovel, Americans Dig Deeper Into Debt

Just two generations ago, America was a nation of mostly thrifty people living within their means, even setting money aside for unforeseen expenses.

Today, Americans carry $2.56 trillion in consumer debt, up 22 percent since 2000 alone, according to the Federal Reserve Board. The average household’s credit card debt is $8,565, up almost 15 percent from 2000.
College debt has more than doubled since 1995.

The average student emerges from college carrying $20,000 in educational debt. Household debt, including mortgages and credit cards, represents 19 percent of household assets, according to the Fed, compared with 13 percent in 1980.

Even as this debt was mounting, incomes stagnated for many Americans. As a result, the percentage of disposable income that consumers must set aside to service their debt — a figure that includes monthly credit card payments, car loans, mortgage interest and principal — has risen to 14.5 percent from 11 percent just 15 years ago.

By contrast, the nation’s savings rate, which exceeded 8 percent of disposable income in 1968, stood at 0.4 percent at the end of the first quarter of this year, according to the Bureau of Economic Analysis. More ominous, as Americans have dug themselves deeper into debt, the value of their assets has started to fall.


Mortgage debt stood at $10.5 trillion at the end of last year, more than double the $4.8 trillion just seven years earlier, but home prices that were rising to support increasing levels of debt, like home equity lines of credit, are now dropping.

The combination of increased debt, falling asset prices and stagnant incomes does not threaten just imprudent borrowers. The entire economy has become vulnerable to the spending slowdown that results when consumers hit the wall.

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Congress seeks compromise on rescue plan for US lenders

Members of Congress and the US administration held an intense round of talks on Wednesday over the rescue plan for Fannie Mae and Freddie Mac as they tried to forge a compromise that would lead to its approval as early as next week.

A proposal by Hank Paulson, the US Treasury secretary, over the weekend to give the Treasury unlimited power to increase its credit line to the mortgage companies and invest in their equity has been met with some scepticism in Congress, particularly among Republicans worried about the potential risk to taxpayers.

One congressional aide said that Barney Frank, the Democratic chairman of the House financial services committee, who has supported Mr Paulson's proposal, was tentatively planning a vote on the plan in the House next Wednesday. Although that is later than initially envisaged, it is still in time for it to be approved in the Senate and then sent to President George W. Bush for his signature by the end of next week, the aide said.

Mr Paulson played down opposition to the plan, saying after a meeting with House Republicans: "I feel very confident and optimistic that there's broad-based support for moving quickly to get the reform done and I'd be very optimistic that we would get it done some time next week."

Shares in Fannie Mae and Freddie Mac rose for a second day yesterday, each up about 18 per cent in morning trading. Their debt yields over benchmark rates narrowed as improved earnings at other financial institutions eased concern that the mortgage companies needed a government bailout.

Mr Paulson has been negotiating on two fronts. First, he has to make sure Republicans, particularly in the Senate - where 60 votes out of 100 are needed to advance legislation - are comfortable with the proposal.

Second, in spite of securing the support of powerful Democrats such as Mr Frank for the outlines of the plan, a flurry of discussions is still taking place with the congressional leadership over changes to the plan and disagreements over the existing housing legislation that it will be attached to.

Mr Frank suggested giving the new regulator of Fannie Mae and Freddie Mac a greater say on executive compensation, making sure that any government stake in the lenders was high up in the capital structure.

Another issue that needs to be resolved is when the new regulator will take effect. Until recently, many Democrats had been pushing for a transition period of several months, but the administration and Republicans wanted it in place immediately. One aide said a compromise was emerging.

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Toxic fudge

Adam Smith thought that private companies chartered to fulfil government tasks had “in the long run proved, universally, either burdensome or useless”. That has not stopped them thriving. America has five government-sponsored enterprises (GSEs), set up to subsidise loans to homeowners or farmers.

(Sallie Mae, which deals with students, gave up GSE status in 2004.) Because they count as privately owned, GSEs are kept off the government’s books. For politicians that has made them irresistible ever since the Farm Credit System’s creation in 1916.

Fannie Mae and Freddie Mac dominate the GSE system, accounting for four-fifths of its total credit portfolio. Fannie was created in 1938 as a government corporation. In 1968 the Johnson administration decided to list its shares to reduce the budgetary pressures created by the Vietnam war, according to Thomas Stanton, of Johns Hopkins University. Freddie was born in 1970 and listed in 1989. Both companies aim to support the secondary mortgage market.

They have succeeded all too well: they own or guarantee about half of all mortgages. Their supremacy reflects their privileges. As well as an implicit state guarantee, which allows them to fund themselves cheaply, they enjoy exemption from some taxes. They run with far less capital than banks and have more latitude to include as capital dubious items such as preference shares and tax assets.

The capitalised value of these privileges is huge: between $122 billion and $182 billion, according to a 2005 study by the Federal Reserve. It gets worse. The same analysis concluded that shareholders, who enjoy turbocharged gearing without higher borrowing costs, siphoned off about half of the subsidy. Managers trousered an unseemly sum too: between 1998 and 2003, Fannie’s top five executives received $199m.

With so much at stake, no wonder the companies built a formidable lobbying machine. Ex-politicians were given jobs. Critics could expect a rough ride. The companies were not afraid to bite the hands that fed them: in 2004, the day before a congressional committee discussed the regulation of Fannie, the company ran a television advertisement attacking the committee.

Their regulator, the Office of Federal Housing Enterprise Oversight, says its powers were weakened during its creation in 1992: for example, its budget must be approved annually by Congress and thus depends on political goodwill. Accounting scandals in 2003-04 (the two firms restated earnings by a total of $11.3 billion) led to a change of management, and, supporters argue, of culture. The pace of balance-sheet expansion and accumulation of risky private-label securities has slowed.

Yet neither company can be accused of anticipating the housing crash. An end to GSE status looks unlikely: as truly private companies Fannie and Freddie would require unrealistically large injections of equity. The government wants to avoid nationalisation. That leaves the status quo, the public subsidy of private profit: a combination as toxic as it was in Smith’s day.

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Ilargi: The money (well, cashier checks) that customers get from IndyMac accounts these days is not really IndyMac. The FDIC is running the -former- bank’s assets through a newly formed unit. Which is backed by ... the credit of the FDIC. And here’s how much confidence other banks have in the Federal Deposit Insurance Corporation: WaMu, for one, doesn’t even want those checks at all.

What do you think would happen if you demand real money instead of a check?

Trouble persists for some IndyMac customers

The frustration didn't end for some IndyMac customers when they finally were able to withdraw their funds from the failing Southern California bank seized last week by federal regulators. Some people have run into more problems when they tried to deposit IndyMac cashier checks at other banks.

Sheryl MacPhee said she waited in line two hours Tuesday at an IndyMac branch in San Marino to liquidate a certificate of deposit. But when she took it to a Washington Mutual branch in South Pasadena to deposit, she said a manager told her their new policy was not to accept IndyMac checks. If the customer insisted, she said she was told, it could take eight weeks or more to access the full amount.

"Sure, IndyMac will give you a check," MacPhee told the Los Angeles Times, "but what good is it if no other institution will accept it?" WaMu spokeswoman Olivia Riley said her bank is accepting IndyMac checks, "but depending on the specifics, funds will be subject to an extended hold period." Officials at the Office of Thrift Supervision said that regulating agency is investigating complaints about the checks.

Wells Fargo is placing holds of up to nine business days on many IndyMac checks. That hold policy applies to checks from other banks, just not as often as those from IndyMac, Wells Fargo spokeswoman Mary Trigg said. Her company is concerned that "people could be taking advantage of this situation by creating fraudulent checks," Trigg said.

The Office of Thrift Supervision transferred control of IndyMac to the Federal Deposit Insurance Corp. on Friday because it didn't think IndyMac could meet depositor demand. Over the weekend, it became IndyMac Federal Bank, FSB, and by Monday morning the scramble by bank customers to recover their money was on.

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Ilargi: There are a lot of references this weekend to a recent report from Merrill’s Dave Rosenberg. It might be good to post a short article from last week. The main point, in my eyes, is that Rosenberg predicts a 10-year recession in the US.

Rosenberg on strike, fed up trying to pinpoint U.S. recession

"We published our last recession piece on Monday," says David Rosenberg, chief North American economist at Merrill Lynch. "We field too many questions on when the recession began, and when we expect it to end, all for trying to time the optimal date to leap back into the equity market."

Rosenberg has consistently held one of the more pessimistic views on Wall Street, arguing the housing slump and credit crunch will exact a heavy toll on U.S. consumer spending. He believes the data will eventually show the recession started in January.
But he adds it's not the peak-to-trough decline in real GDP that's important but the duration. Trouble is, the duration could be Japanese-like (about a decade).

Just like Japan, he says a series of rolling recessions is possible for the next three to five years, making it extremely difficult to time the market.  Japanese equities got trashed through the process. At the 1998 post-bubble lows, Japanese bank, construction, real estate and transport stocks were all down 80%, retail stocks were down 50%. The only place to hide was bonds, notes the bond bull.

"We are nervous that we have ended up following in Japan's footsteps due to the inept fiscal response to the problem," he said. "A temporary tax rebate from Uncle Sam to buy iPods tackles a real estate deflation and credit crunch as effectively as the LDP's (Liberal Democratic Party) 'solution' in the early 1990s to build bridges and pave river beds that nobody needed."
Sweden, by comparison, used buckets of government money to refloat its banking system quickly in the early 1990s.

On a more upbeat note, Rosenberg said on Monday that the ultimate indicator for the end of a U.S. recession is when the National Bureau of Economic Research declares when a recession has started. He found 75% of the time, the recession has ended within a month of the official declaration of when it began. The NBER is the official arbitrator of U.S recessions.

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Ilargi: As everyone knows who regularly reads The Automatic Earth, talk of inflation is based on misguided misunderstandings. Since today the money supply hardly increases, if at all, there can be no inflation either. There can be price increases in certain products, but that is not the same; shortages too cause increases. That even serious analysts now talk about "price inflation" really takes the pits. What kind of term is that? As I said months ago, if the price of cookies goes up because bakers go on strike, we do NOT speak of "cookie inflation" either.

The money supply increased hugely in the past decade (but no longer), and so did inflation. Only, it all went into housing. And since that is conveniently named "value increase", nobody noticed. For the same reasons, the plunge in home prices is not recognized as deflation, while a higher gas price is called inflationary, even though -in my calculation- on average Americans lose 16 times more in the value of their homes then they pay extra for gas.

Don’t worry, soon everyone will agree with me. Estimates are that $8 trillion in credit vanished so far from the markets. It’s irreversible.

Inflation Readings May Be Inflated

"The cynic knows the price of everything and the value of nothing," Oscar Wilde famously said. Perhaps, but Americans may be rightly cynical after watching prices rise and being told inflation is under control. No more. The consumer price index jumped 1.1% in June and is up 5% from a year ago, the most since 1992.

No wonder the Federal Reserve has elevated the threat from inflation to equal status with the weak economy. Inflation is like a low-grade fever that gradually builds. Last summer, the CPI was only growing at a 2% annual rate. And that's for the overall number, not the nonsense "core" inflation that excludes food and energy prices, which have been the bane for most consumers' budgets.

Indeed, only economists and policy makers have been fooled by the official inflation numbers. The "hedonic" adjustments for improved quality have helped hold down the CPI. And, to be sure, the quality of automobiles has vastly improved in recent years. So, too, has the performance of computers jumped while their prices fell. Yet, to realize those ongoing improvements fully, a consumer has to buy a new car and computer every month.

According to Shadow Government Statistics (www.shadowstats.com), if the CPI were calculated as it was prior to the Clinton Administration, it would show retail prices rising at more than an 8% year-over-year rate. And the CPI is figured in a way that would boggle the mind of anybody who didn't wear a pocket-protector in school.

I am indebted to Rob Arnott, the head of Research Affiliates and anything but a nerd (he collects classic motorcycles as a hobby for one thing), for this explanation. The CPI uses geometric averages, a concept lodged in brain cells that somehow haven't survived since high school.

As Rob explains, if you have an increase of 10% and a decline of 10%, the arithmetic average logically is nil. Their geometric average would be the product of the two -- 1.1 times 0.9, or 0.99; that is, a decline of 1%. So the geometric average of plus 10% and minus 10% isn't zero, it's minus 1%. That result bias the CPI to the downside.

For my part, my problem with the CPI relates more to how it calculates the cost of one of necessities of life, shelter. Excluding food and energy costs is one thing; but the government's notion about the cost of putting a roof over your head is just bizarre.
It starts with the reasonable premise that nobody goes out and buys a house every month.

So, why should the rise in the value of your house each month affect your cost of living? Instead, economists tried to tease out the value of the service you got from your house as opposed to its change in value as an asset. To do this, economists suggested estimating how much it would cost you to rent your house; that would be the value of the housing "service" you derived from your home.

Back earlier in the decade when inflation seemed under control -- or that deflation even loomed -- these imputed rents were falling. That was in part because house prices were rising and everybody wanted to get into a house that would only rise in price. Homeownership hit record levels and the demand for rentals fell. Soaring house prices tended to lower the government's inflation numbers because fewer people wanted to rent.

Now, the situation is reversed. Just at the time when the CPI is soaring, house prices are plunging, which is tending to push up this inflation measure. Whether by choice or necessity, more people are renting a relatively tight supply of rental units. That's likely to change.

As Citigroup economist Steven Weiting points out, this "owner's equivalent rent," which comprises 30% of the core CPI, is up 2.6% from a year ago despite large declines in home prices. True, the selling price of houses isn't directly comparable with rents. But he says the huge number of vacant houses should put downward pressure on shelter costs.

More fundamentally, there's a real question if price increases can stick given the state of consumer demand. The latest retail sales report for June showed an anemic 0.1% increase even as consumers cashed their tax rebate checks. Most of that money went to the filling stations; excluding gasoline, retails sales were off 0.5% last month.

Let's put this another way: soaring energy and good prices, which have pushed the key inflation measures, are apt to crimp consumers' real purchasing power significantly, and thereby rein in inflation. With a weak labor market, there's little indication that workers are able to get raises. And companies can't pass along their cost increases, which means shrinking profit margins. So labor and capital alike suffer.

This, by the way, is the opposite of the European situation. Unions there represent entire industries and have the power to get pay hikes to compensate for rising prices. That's far less so in the U.S. with a far less unionized workforce. That, in turn, may explain the differing responses by the Fed and the European Central Bank. The ECB, whose only mandate is to preserve price stability, has raised its benchmark rate, to 4% from 3.5%.

The Fed, meanwhile, has cut its fed-funds target to 2% from 5.25% last September. As a result of falling real incomes, Merrill Lynch chief North American economist David Rosenberg and his associate, Cheryl King look for a sharp reversal. "With the consumer likely on the verge of the first recession in 18 years, we believe that a large and deflationary gap is in the cards -- the largest deflationary impulse unleashed in the economy since the early 1980s," they write.

The break in crude oil and other energy prices corroborate this deflationary impulse. Consumers are tapped out, and even more so after their rebate checks are sent. These doleful trends should take care of inflation without the Fed having to do a thing.

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Spotlight falls on the dark dealings of the tax havens

As Alistair Darling mingled with the press at the Treasury's summer drinks party last Tuesday, officials expressed alarm at steep falls in UK bank share prices, compounding the ever-deepening financial crisis.

When asked whether any reform of the financial system would feature a fundamental review of tax havens and offshore financial centres - the places where the world's banks parked most of their mortgage-backed securities and structured investment vehicles - officials and ministers replied that it was not a priority.

The secret world of offshore financing, it seems, is the shadow bank system the UK government wants to ignore. But not everyone agrees. Last month, the Treasury Select Committee began an inquiry into the role played by tax havens in financial instability.

In the US last Thursday, the powerful Senate Investigation Committee published a devastating 114-page report on how giant Swiss bank UBS, a secretive Liechtenstein bank and rich individuals allegedly hid billions of dollars from tax authorities. 'We are determined to break through these iron rings of deception,' said the Senate subcommittee chairman, Democrat Carl Levin.

And last month, the Bank for International Settlements, the organisation that watches over the world's central banks, asked in its annual report: 'How could a huge shadow banking system emerge without provoking clear statements of official concern?'

Traditionally, the shadow banking system centred on places such as the Cayman Islands, Bermuda, the Channel Islands and Panama. But new centres have emerged, such as Ireland. It has over the past 20 years become a favoured location for quoted funds linked to banks' debt vehicles. Among its attractions is its famous light-touch regulation, and the cost of listing a fund in Dublin is far cheaper than London.

It has been said that if relevant documents are provided to the Irish authorities by 3pm, the fund will be authorised to trade the next day. 'Even if the regulator worked late on that day, it would be extremely difficult to assess the fund adequately in order to carry out its duties as a regulator,' argues Jim Stewart, senior lecturer in finance at Trinity College, Dublin.

A year on from the first signs of the credit crunch, there are a growing number of funds based in Dublin now facing serious difficulties. At least 19 have been identified. But the true figure could be hundreds. Bear Stearns had two investment funds and six debt securities funds listed on the Irish stock exchange.

And there has been anger in Germany at how four banks with funds quoted in Dublin required a state bail-out of €16.8bn (£13.3bn) as a result of the losses they incurred. Arguments rage about whether their demise is caused by the structure of German banks or lack of Irish regulation.

There is now a sense that the Irish banking world is on the edge. Its banks have played a massive part in the huge surge of investment in property and housing over the past 15 years. Concern is mounting that Irish Nationwide and Anglo Irish will require emergency funding to withstand plummeting valuations of their loans.

'The encouragement of a lack of restraint may well backfire because banking relies on security and there has to be a responsibility to shareholders,' agreed a senior Irish investor. 'That probably has never been taken on board because of the perceived gain. I'm not convinced Ireland is sophisticated enough to be a credible banking economy.'

Ireland is not alone as a repository for wealth. In 50 years, the number of holding companies in Luxembourg has grown from less than 2,000 to more than 14,000. Last week, a report by the European Fund and Asset Management Association (EFAMA) confirmed the disproportionately large share of funds hosted by tiny Luxembourg and Ireland. In fact, nearly a quarter are located in Luxembourg and Ireland has nearly 10 per cent of the total funds.

Concern that new banking centres have acted as recipients of toxic financial instruments will prompt fresh investigation from senior US legislators. Last week, it became clear that the US Senate is serious in cracking down on offshore banking when it revealed Australian Frank Lowy, the biggest individual shareholder in giant quoted property firm Westfield, as a client of the notorious Liechtenstein bank, LGT.

It accused him of hiding taxes worth $68m (£34m), a claim Lowy catergorically denies. The effect of US investigations into UBS has forced the Swiss bank to stop opening Swiss bank accounts for Americans, as it battles to retain its licence. The Treasury, it seems, is becoming somewhat isolated in its attitude to the shadow banking world.

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Ilargi: Another cheerleading attempt from Canada, where this week even the central bank’s president decleared the credit crisis "over". I call BS on this story, for "baloney supreme". Listen, the CHMC insures mortgages, right? So what do you think will happen when Canadians start having trouble paying off those mortgages? And when home prices start plunging?

It’s already clear that Canada has entered the first phase of decline: sales are way down, and prices have begun to falter. Soon the market will be where the US was 2 years ago. But I tell you: Canada’s decline will develop much faster than the one south of the border. The reason for that is that the overall state of the global credit markets is much worse than when the US housing market started its fall.

Canada: CMHC not likely to see Fannie, Freddie fate

The pressure Washington is under to save U.S. mortgage finance providers Fannie Mae and Freddie Mac from collapse rekindles thoughts for those with long memories in Ottawa of less-than-prosperous times for Crown-owned Canada Mortgage and Housing Corp.

About three decades ago, thanks to double-digit interest rates, depressed property values and a plan aimed at boosting home ownership that ran amok, claims at the mortgage insurer skyrocketed. It forced CMHC to borrow heavily, more than $200-million, to stem the cash drain. The controller acknowledged at the time the Crown corporation was in technical bankruptcy.

That was then. In the years following, federal governments tried to right the CMHC ship by, among other things, getting the agency out of the business of building housing units. What a difference 30 years makes. For the each of the past three fiscal years, CMHC has posted net profit of more than $1-billion, largely the result of an incredible bull market in the housing market that saw more Canadians take out mortgages -- and the required mortgage insurance CMHC sells.

And the percentage of Canadian mortgages in arrears for three months or more continues to be at lows not seen since 1990. Even though CMHC is a different beast compared with the struggling Fannie Mae and Freddie Mac and, for the time being, not under the same financial pressure, questions are nevertheless being asked about the role of the Crown corporation in light of the U.S. housing crisis.

Some cite its part in driving people who otherwise couldn't afford a home to buying real estate by offering insurance on mortgages with 40-year amortizations or zero down. Others wonder whether the government should be in the business of selling mortgage insurance or securitizing mortgages when it could be done, perhaps more efficiently, by the private sector.

"It did a lot of good things, and got into things it shouldn't have," says says Larry Smith, professor emeritus of economics at the University of Toronto. He was a deputy chairman of a 1979 federal task force that examined future roles for CMHC, and recommended, among other things, that it cease its insurance operations. He believes some of the CMHC's responsibilities should be shifted to the private sector.

"[But] it was very instrumental in removing a lot of the imperfections that existed in the mortgage and credit markets," he said. "So it played a major role." For instance, he said, there was a time when chartered banks did not issue mortgage loans. But that changed with the arrival of CMHC and its government-backed insurance.

Established in 1946, CMHC is responsible for housing and is the top provider of mortgage loan insurance, which is required under Canadian law if the down payment is 20% or less in an effort to protect lenders from default. It is also the major player in mortgage securitization, through mortgage-backed securities and mortgage bonds, which analysts say has improved the availability of low-cost mortgage funds that the banks can access for prospective clients.

Unlike the CMHC, Fannie Mae and Freddie Mac hold mortgages that they trade in an effort to maximize profit, says Tsur Somerville, a business professor at UBC's Sauder School of Business in Vancouver and an expert in real estate finance.
CMHC, he says, does not undertake such trading activity and, instead, should be compared with Ginnie Mae, the U.S. agency under the Department of Housing and Urban Development, which securitizes mortgages that are insured by the U.S. Federal Housing Administration.

"Freddie and Fannie are private companies with government support. That's the worst possible scenario because you have institutions who have every incentive to maximize profit with guarantees from moral hazard," Mr. Somerville says, referring to the U.S. government's backing. "The reason you won't find CMHC running into the same problems is because CMHC does not have the structure to go into portfolio trading, and doesn't have the private-sector incentive for profit maximization."

The insurance business is the main profit driver at CMHC, and the corporation is estimated to hold two-thirds of the Canadian market, with $333-billion of policies outstanding. According to its 2007 annual report, it recorded $1.42-billion in revenue from premiums and fees (the premium varies from 0.65% to 2.75%). It paid out $315-million in net claims -- more than the $238-million it expected but less than the $552-million it set aside on its balance sheet as a provision for claims.

In CMHC's forecast looking at the 2008-2012 period, profit from insurance is to grow 28% by the end of that period, to $1.33-billion; the number of approved policies to drop, from 578,000 to a low of 571,000; and claims expenses to increase to a high of $314-million, just below what it paid out last year.

The money CMHC and its long-time private-sector competitor, Genworth Financial Corp., are drawing from mortgage insurance has attracted new players, and over the years competition has been fierce. In reaction to new entrants, CMHC and Genworth introduced insurance for mortgages with amortizations of up to 40 years, and that covered 100% of the home prices, or 0% down.

At the time, the CMHC's move into such products drew the ire of then-Bank of Canada governor, David Dodge, who said the Crown corporation risked stoking inflation and perhaps stoking a housing bubble. Last week, two years after Mr. Dodge's comments, the Department of Finance reacted. It introduced rules that would see Ottawa backstop insurance on mortgages with amortizations of no more than 35 years and a minimum 5% downpayment.

Jim Flaherty, the Minister of Finance, said the moves were meant to avoid a U.S.-style housing meltdown, although the department acknowledges the low level of mortgage defaults in Canada. "They shouldn't be out there competing or discouraging private-sector participation, because when you have a mixture of public sector and private-sector functions intermixed, you will inevitably end up with what the Americans have in Freddie Mac and Fannie Mae," said Mr. Smith, the former member of the CMHC task force.

Moreover, he added, "they are again enticing people into mortgages without a theoretical perspective as to why they should be artificially stimulating housing demand." Mr. Somerville also questions whether CMHC needs to remain in the mortgage insurance business, and whether that element could be spun off to the private sector at a handsome profit for Ottawa.

Nevertheless, Mr. Somerville said CMHC may be needed because of its role in mortgage securitization. Under its Canadian Mortgage Bond Program, established in 2001, financial institutions originate mortgages, pool them and sell them as packages in the form of mortgage-backed securities to an entity called Canadian Housing Trust.

The trust, which is advised by CMHC, issues bonds that pay interest similar to Government of Canada bonds, using the cash flow from the mortgage-backed securities to make the payments. A 2005 Bank of Canada analysis suggested the CMHC-led securitization had "improved the supply of low-cost mortgage funds in Canada" from which lenders can access.

"If you did get rid of CMHC, who would securitize the mortgages?," Mr. Somerville asks. "Would you trust one of the investment arms of the big banks to securitizing the mortgages they hold?" It's an interesting question, given the state Fannie Mae and Freddie Mac are in.

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Citigroup Puts Its Money Where Its Name Will Be

The Citi Field sign above the main scoreboard at the Mets’ new ballpark, the first of several to be raised by April, is nearly complete. The white and red letters that are in place offer ample evidence of the 20-year, $400 million agreement to make Citigroup’s name synonymous with New York baseball.

When the deal with Citigroup, the banking and financial services giant, was made in November 2006, it had just ended its third quarter with net income of $5.3 billion. But a year later, as the subprime mortgage meltdown began to roil the economy, Citigroup’s finances began to suffer.

In the past three quarters, it has lost $17 billion — including a $2.5 billion loss reported on Friday — caused by $38 billion in credit losses and write-downs for bad mortgage investments. Since early 2007, the company has cut about 28,000 jobs. The Shea name never had such troubles.

Losses or not, there is no stopping the Citi Field deal, even if some of its laid-off employees may not be able to afford to take their families to a game, or even if some of them could have been retained with the $20 million a year being spent on baseball.
Even in the flush times during which it was signed, the deal seemed questionable.

With high name recognition and a place among the world’s banking leaders, Citigroup hardly needed the Citi name plastered on a ballpark to enhance itself. Will fans move their C.D.’s to a Citibank branch because of the Mets relationship, any more than air travelers will consider flying American Airlines because its name is on two professional arenas?
Will the corporate suite-holders at the Mets’ new home want to do more or new business with Citigroup because they share deluxe accommodations at Chez Wilpon?

Rob Julavits, a Citigroup spokesman, said Friday that Citi was “strongly committed” to the deal as part of its local and global marketing efforts, and that the deal represented a “redirection of our existing and budgeted marketing funds.” In addition, he said, it “provides an incredible platform to promote our world-class brand, enhance our relationship with current clients, attract new clients and expand our considerable community efforts.”

Dave Howard, the Mets’ executive vice president for business operations, would not say whether Citi has an escape or buyout clause, or whether the bank has begun to make any payments. Citi has shown no jitters and sought no financial relief, he said.
“Just the opposite,” he said. “They’re very excited about the relationship and enthusiastic about being our partner as we get ready to open the ballpark with their name.”

He said the Mets had no concerns about Citigroup’s long-term finances. “We’re confident and ecstatic about having them as our partner,” Howard said. There is a valid case for continuing to market companies strongly in difficult times. A financial colossus does not stop advertising, even amid enormous losses. And for a company as big as Citigroup, $20 million a year for naming rights is pocket change.

Still, the spending is symbolic. It’s on a baseball stadium in a gloomy economy, an investment that seems to thumb its nose at laid-off workers. “They will have to clearly articulate to their shareholders why this will drive their business going forward,” said David Carter, the executive director of the Sports Business Institute at the University of Southern California. “They have to demonstrate that they will get a return on their investment and not be sheepish about it.”

He said the main value for Citigroup was in the business it could develop with companies in other suites. “You’re not closing a deal if you’re Citi only because your name is on the field,” Carter said. “But doing business there, and the relationship with the Mets, might lead to a deal.”

Another bank, Barclays, followed Citigroup by a few months with its 20-year, $400 million naming-rights deal for the Nets’ arena near downtown Brooklyn. Barclays, based in Britain, lacked Citigroup’s substantial presence in the United States and viewed the arena — whenever the Barclays Center’s long-delayed construction starts — as part of an aggressive domestic brand-building plan.

But like Citigroup, it has had problems in the credit market, with $6.5 billion in write-downs on its banking scorecard. To shore up its capital position, Barclays recently sold $8.9 billion in new stock. The bank, which sponsors the Premier League and a PGA Tour event in the FedEx Cup playoffs, is still linked with the Nets, who are seeking a 2010 arena opening if construction starts soon.

On Friday, Brett Yormark, the president of Nets Sports and Entertainment, called Barclays a “stable and dynamic institution that is thriving in a very challenging marketplace.” Brandon Ashcraft, a bank spokesman, said, “Barclays is fully committed to its relationship with the Nets.”

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