Treasury Department Office of U.S. Treasurer.
Reserve vault cash room packages seen in picture contain over 80 million dollars.
Ilargi: Three large issues today:
- US home prices fall at a record pace
- Merrill Lynch takes a record hit on the sale of its CDO’s
- US banks and the Treasury launch a duck that’s dead in the water: covered bonds.
1/ Home prices are down, across the country, by 15.8%. In many places, it’s much worse. It translates into a wealth loss of about $3.25 trillion. In one year.
2/ It looks very likely that Merrill knew on June 27 that it would do the CDO sell-off. Still, in a July 17 conference call with analysts, CEO John Thain said: “Right now we believe we are in a very comfortable spot in terms of our capital.”
$30.6 billion in CDO’s are sold to a Lone Star affiliate for $6.7 billion. That means Merrill get 22 cents on the dollar. But Merrill itself finances 75% of the $6.7 billion (not an unfamiliar construction). So LoneStar puts in just $1.68 billion, and don’t be surprised if that too comes from somewhere close to Merrill. Hence, Merrill gets, at best, 5.5 cents on the dollar.
And I have good reason to argue that they are merely putting on a show in order to hide the fact that they get zero. All I would need to point out to make that case is that Lone Star’s collateral for the $5 billion loan to buy the assets ..... are those same assets.
We now find that it wasn’t National Australia Bank that initiated the sell-off of its US mortgage securities, last week, it was Merrill’s decision to sell that forced NAB to do the same. NAB sold at 10 cents on the dollar. The official 22 cents number reported today would make it look like Merrill gets twice as much, but as we’ve seen, they don’t get double, they get half of 10 cents. If that much.
Singapore’s Sovereign Wealth Fund Temasek invests another $900 million into Merrill, but that’s nothing but another deceiving number. When Temasek bought Merrill shares earlier this year at $48, Merrill agreed to make up for potential losses in value. The bank now trades at $24, and is forced to pay Temasek $2.5 billion for lost share value. Which will probably flow right back into Merrill, so Temasek will be close to a stake in the bank that is so large that Washington will get nervous.
For other banks, this sets a new benchmark. Citi today values its CDO’s at 53 cents on the dollar, but that has now become untenable. What may save others from an immediate writedown to 5% is a less urgent need to sell. But there will come a moment for all of them when shareholders will demand opening of books, or simply sell and walk away.
3/ Wall Street aims to win back investor confidence by introducing an unregulated version of covered bonds, a European investment instrument, that is not only strictly regulated in Europe, it’s also dead over there. Then again, if CDO's days as a financial instrument are indeed numbered, the consequences for the mortgage trade, and by extension the entire banking industry, will be devastating.
Merrill's CDO Sale 'Suggests Endgame,' Analysts Say
Merrill Lynch & Co.'s decision to liquidate $30.6 billion of collateralized debt obligations at a fifth of their face value "suggests the endgame" for CDO risk at financial companies, Bank of America Corp. analysts said.
The sale reduces uncertainty for brokers, banks and bond insurers, analysts led by Jeffrey Rosenberg in New York said yesterday in a report. Merrill, the third-biggest U.S. securities firm, also plans to sell $8.5 billion of stock and will book $5.7 billion of writedowns in the third quarter.
"Selling off the portfolio at levels below marks creates initial losses but relieves future uncertainty," Rosenberg wrote. "The capital raise, if ultimately successful, could indicate private capital raising ability more broadly for financials. Proving access to raising equity capital would be a clear positive for financial credit spreads, though not necessarily for stock prices."
Merrill is offloading its CDOs as issuance of the debt has tumbled to $89 billion so far this year, down from $870 billion in the same period of 2007, according to JPMorgan Chase & Co. data. Some AAA rated portions of CDOs have returned no money to investors in liquidations over the past eight months, according to Standard & Poor's.
In May, Zurich-based UBS sold $22 billion of mostly subprime and Alt-A mortgage bonds to a fund run by New York-based BlackRock Inc. for $15 billion, providing an $11.25 billion loan to finance the purchase.
Last November, Citadel Investment Group LLC paid 27 cents on the dollar to purchase $3 billion of mortgage-related securities from E*Trade Financial Corp. The deal coincided with a separate equity injection into New York-based E*Trade by the Chicago-based hedge-fund manager.
Merrill is selling stock after almost $19 billion of net losses in the past year. The New York-based firm has already raised $30 billion since December to keep pace with mounting charges on mortgage bonds. Standard & Poor's cut the firm's debt rating last month and signaled that more downgrades were possible.
Merrill agreed to sell $30.6 billion of CDOs -- the mortgage-related securities that have caused most of the firm's losses -- for $6.7 billion and provide financing for about 75 percent of the purchase price. The financing for the sale to Dallas-based private-equity firm Lone Star Funds is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion.
Merrill providing financing for the deal "suggests that the true value of the assets is quite a bit less," said Julian Mann, a mortgage and asset-backed bond manager at First Pacific Advisors LLC in Los Angeles, which manages $11 billion. "Until the true value and the mark to model converge it's going to be difficult for investors to have confidence in anything Wall Street management says," he said.
CDOs package pools of securities and slice them into pieces with varying risks and ratings. "If others were to follow such a playbook, writedowns on CDO positions could be larger than taken to date with the offset of reduced uncertainty going forward for broker and bank spreads and tightening spread implications for monolines considering their current distressed levels," Rosenberg said in the report.
US home prices drop record 15.8%
May home prices dropped a record 15.8% from a year ago, according to the S&P/Case-Shiller Home Price Index of 20 cities. It was the 22nd consecutive month of decline recorded by the index. Prices fell 0.9% from April to May.
Each of the 20 metro areas covered by the index posted annual declines; nine posted record lows and 10 cities recorded double-digit drops. The Case-Shiller 10-city Index posted a year over year decline of 16.9%, and a 1% month over month dip. Both the 10-City Composite Index and the 20-City Composite Index are reporting record annual declines.
"Since August 2006, there has not been one month where we have seen overall price increases, as measured by the two Composites," said David Blitzer, Chairman of the Index Committee at Standard & Poor's.
Case-Shiller has been tracking the 20-city index for 19 years, while the 10-city index is 21 years old. The current price decline streak has been unprecedented in both length and depth. Starting in April 1990, the 10-city index streaked down for 10 consecutive months. But that total loss was just 6.5%.
Since the 10-city index peaked in July 2006, it has plunged 19.8%. The 20-city is down 18.4%. The 20-city index's Sun Belt cities, which recorded the biggest price gains during the boom, have led the charge down. Las Vegas prices have plummeted 28.4% during the past 12 months; Miami prices fell 28.3%; and Phoenix homes lost 26.5% of their value.
Midwest metro areas, which have endured tough economic times for years, are also feeling the pain. Detroit prices are off 17.4% for the 12 months, and Cleveland is down 8%. Northeast cities like Boston, down 6.2% for the 12 months, and New York, off 7.9%, have been less volatile than the Sun Belt.
The smallest year-over-year declines were recorded by Charlotte, N.C. (down 0.2%), Dallas (down 3.1%), and Denver (down 4.8%). The soaring numbers of foreclosures are helping to push down prices. Banks tend to slash prices when selling repossessed homes, since they lose money every month a house sits vacant. They must pay property taxes, maintenance expenses and utility costs while getting nothing back in return.
Those sales, in turn, tend to bring down prices in the rest of a given neighborhood, creating a vicious cycle. Foreclosures accounted for a large - and growing - share of all existing homes sold in some markets. In California, for example, 40% of the existing homes sold during the three months ended June 30 were foreclosures, according to DataQuick, a real estate information provider. That's up from just 5.4% during the same three months in 2007.
Optimistic observers might point out that price declines appear to be slowing. The 10-city index's 1% month to month dip in May was less than April's, when it registered a 1.5% decline, while the 20-city index fell just 0.9% in May after dropping 1.3% in April. Can this be a sign of better times to come?
Patrick Newport, an economist with Global Insight, an economic forecasting firm, doesn't think so. He points out that seasonal variations may account for what appears to be a slowdown in the pace of the decline. "You can't go by monthly numbers," he said. "What I look at is the Census Bureau's inventory of vacant homes on the market. That hasn't budged much, although it dropped to 2.8% [of total homes for sale] in the second quarter from 2.9%."
"What's worrying me is that foreclosures are adding to inventory, and the inventory numbers tell you what to expect for the next couple of years," says Newport. "They're saying home prices will drop."
Merrill to Sell $8.5 Billion of Stock, $30.6 Billion in CDO’s, Write Down $5.7 Billion
Merrill Lynch & Co., the third- biggest U.S. securities firm, will sell $8.5 billion of stock and liquidate $30.6 billion of bonds at a fifth of their face value to shore up credit ratings imperiled by mortgage losses.
Temasek Holdings Pte., the Singapore-owned fund that became Merrill's biggest investor by acquiring shares in December, will buy $3.4 billion of the new stock, Merrill said yesterday in a statement. The New York-based company is paying Temasek $2.5 billion to offset losses on its earlier investment. Merrill will also book $5.7 billion of writedowns in the third quarter.
Almost $19 billion of net losses in the past year forced Chief Executive Officer John Thain to backtrack from assurances that the firm had enough capital to weather the credit crisis. Since taking the post in December, Thain has raised $30 billion in an effort to keep pace with mounting charges on mortgage bonds amassed by his predecessor, Stan O'Neal. Standard & Poor's cut the firm's debt rating last month and signaled that more downgrades were possible.
"It does mark an attempt at curing the problem but at a tremendous cost to existing shareholders," said Charles Peabody, an analyst at Portales Partners LLC in New York who recommends selling Merrill shares. "How can you be pleased by that? It's a necessity."
UBS AG analyst Glenn Schorr estimates Merrill will report a third-quarter loss of $4.80 a share because of "significant dilution" from the stock sale. Schorr, who has a "neutral" rating on Merrill, previously estimated earnings of 72 cents.
Merrill rose 14 cents to $24.47 in German trading today. The company sold its 20 percent share of Bloomberg LP, the parent of Bloomberg News, earlier this month for $4.43 billion, 11 percent less than the $5 billion market value Thain placed on the stake in June. He also agreed to sell Financial Data Services, an in- house mutual-fund administrator worth $3.5 billion.
"While third-quarter results and the future capital raise would be yet another burden, we do believe there is light at the end of the tunnel," wrote Douglas Sipkin, an analyst at Charlotte-based Wachovia Corp. who has a "market perform" rating on Merrill, in a note to clients today.
In yesterday's statement, Merrill said it agreed to sell $30.6 billion of collateralized debt obligations -- the mortgage- related bonds that have caused most of the firm's losses -- for $6.7 billion. The buyer is an affiliate of Lone Star Funds, a Dallas-based investment manager.
"Our consistent focus has been to opportunistically reduce risk, and in order to take advantage of this sizeable sale on an accelerated basis, we have decided to further enhance our capital position," Thain, 53, said in the statement.
Merrill will provide financing for about 75 percent of the purchase price, according to the statement. The financing is secured only by the assets being sold, meaning Merrill would absorb any losses on the CDOs beyond $1.68 billion. The sale will result in a third-quarter pretax writedown of $4.4 billion, Merrill said.
Less than two weeks ago, the firm announced $3.5 billion of CDO writedowns for the second quarter that ended in June. Bank of America Corp. analyst Michael Hecht estimates Merrill will report a full-year loss of $11.55 a share and he cut his price target for the stock to $40 from $47, according to a note to clients.
"Why these assets are written down when you're selling them and weren't written down in your earnings is a question," said Ralph Cole, a senior vice president in research at Ferguson Wellman Capital Management Inc. in Portland, Oregon, which oversees $2.7 billion and doesn't own Merrill shares. "This kind of announcement is surprising and a little disheartening."
Merrill has lost almost 55 percent of market value this year. Only Lehman Brothers Holdings Inc. has fallen more on the 11- member Amex Securities Broker/Dealer Index, dropping 77 percent. Merrill fell 12 percent yesterday in New York Stock Exchange composite trading.
Thain, who worked as a mortgage trader during his 25-year career at Goldman Sachs Group Inc., said July 17 that he was "hopeful" that Merrill could sell its CDOs, while adding he didn't "want to do dumb things" by selling them too cheap.
In yesterday's statement, Thain said, "the sale of the substantial majority of our CDO positions represents a significant milestone in our risk-reduction efforts."
The CDOs Merrill sold to Lone Star were carried on the securities firm's books at about $11.1 billion, indicating they already had been written down to about 36 cents on the dollar. The Lone Star sale values them at about 22 cents. Merrill may sell as many as 356.5 million shares in the latest offering, the firm said yesterday in a presentation for potential buyers.
That represents a 36 percent increase over the number outstanding at the end of June. The price of the new shares will be set today, according to the presentation. The share sale is Merrill's fourth since Thain took over following O'Neal's ouster last October.
Thain raised $6.2 billion in December -- when Temasek bought its initial 9.4 percent stake -- and another $6.6 billion in January. That month, he told investors Merrill had attracted more than it needed. Since then, he has repeated that the firm's capital was sufficient. "We're very comfortable with our position," Thain said on Jan. 30. "We could have raised substantially more money. We turned people away."
Three months later he sold $2.55 billion of preferred stock. Then, after Standard & Poor's cut Merrill's credit rating to A from A+ on June 2, Thain announced he was considering a sale of Merrill's stake in Bloomberg. When the firm reported a $4.65 billion second-quarter net loss on July 17, Thain said the firm's resources were adequate.
"We believe that we are in a very comfortable spot in terms of our capital," he said on a conference call with analysts. In yesterday's statement, Thain said the new capital became necessary because the completion of the Lone Star deal meant additional losses had to be booked.
Merrill was contractually bound to compensate Temasek and other investors who bought shares in the December and January offerings. The stock has since plummeted almost 55 percent. So in addition to the new public offering, Merrill will pay $2.5 billion to Temasek and issue an additional 195 million shares to the other investors, according to yesterday's statement.
Losses on CDOs and the associated hedging contracts have accounted for about $27 billion of the total $41 billion of total writedowns taken by Merrill over the past year. The firm was one of the largest underwriters of CDOs before the credit crisis hit last year, and Merrill was stuck with more than $50 billion of them on its books when buyers fled the market.
The remaining CDOs may be less worrisome to investors. About $7.2 billion of the $8.8 billion left are hedged with "highly rated counterparties," the firm said in the statement. In addition to the losses from the Lone Star sale, Merrill said it will record a $500 million loss related to the termination of hedging contracts on CDOs with XL Capital Assurance. It took another $800 million maximum loss related to the potential settlement of hedges with other bond-insurers.
Moody's Investors Service affirmed Merrill's A2 credit rating today after the securities firm announced the asset sale. "We think they have taken care of much of their troublesome exposure in structured finance and real estate," said David Hendler, a bank analyst at CreditSights Inc. in New York.
2008 quotes from Merrill's Thain on capital needs
Merrill Lynch & Co Inc said on Monday it would raise $8.5 billion by selling new stock. But CEO John Thain has consistently denied that the investment bank would need to raise more capital. Here is a selection of comments by Thain or about his views since the end of last year:
"One of my first priorities at Merrill Lynch was to strengthen the firm's balance sheet, and today we have made great progress towards that by bolstering our capital position through these investments and our announced sale of Merrill Lynch Capital." (December 24, 2007 -- Thain in a statement when Merrill announced a $6.2 billion capital raising)
"...These transactions make certain that Merrill is well-capitalized." (January 15, 2008 -- Thain in a statement after selling $6.6 billion of preferred shares to a group that included Japanese and Kuwaiti investors)
"We're very confident that we have the capital base now that we need to go forward in 2008." (January 18, 2008 -- Thain as quoted by the New York Times).
"...Today I can say that we will not need additional funds. These problems are behind us. We will not return to the market." (March 8, 2008 -- Thain in an interview with France's Le Figaro newspaper)
"We have more capital than we need, so we can say to the market that we don't need more injections. We can confirm that we have tackled the problem." (March 16, 2008 -- Thain in an interview with Spain's El Pais newspaper)
"In 2007, we lost 8.6 billion dollars after tax, but we raised 12.8 billion dollars in new capital. We raised significantly more capital than we lost. And we did that on purpose so that we could say to the marketplace that we raised more than enough capital. We replaced all the capital we lost. We have plenty of capital going forward, and we don't need to come back into the equity market. The goal is to maintain our current ratings. No more capital raising; I'm sure we have enough capital." (April 4, 2008 -- Thain in an interview with Japan's Nihon Keizai Shimbun)
"We deliberately raised more capital than we lost last year ... we believe that will allow us to not have to go back to the equity market in the foreseeable future." (April 8, 2008 -- Thain to reporters in Tokyo, as reported by Reuters)
"John Thain has been very clear that we have sufficient capital and don't have a need to raise additional common equity for the foreseeable future. When we raised this capital in January, we had a lot of demand so we went beyond what we needed." (May 12, 2008 -- Merrill President Greg Fleming in an interview with the Times of London)
"Today on a pro forma basis we have about $44 billion of equity capital, which actually isn't very much below the all-time high that Merrill ever had. And our philosophy about this is that we are well-capitalized. We're comfortable with our capital position. We, like everyone else, are deleveraging our balance sheet." (June 11, 2008 -- Thain on a conference call hosted by Deutsche Bank)
"Right now we believe that we are in a very comfortable spot in terms of our capital." (July 17, 2008 -- Thain on a conference call after posting Merrill's second-quarter results)
Merrill’s Latest Misfire
The forecasters who thought investors should now pile into the financials, that the sector would start seeing an upward trend, now know the pain of betting on a false bottom.
Merrill Lynch’s shocking announcement after the market’s close yesterday that it will book a huge pre-tax $5.7 bn writedown from its toxic, risky debt offerings, plus raise another $8.5 bn in new stock on top of the dilutive $12 bn it’s already raised (a total of $26 bn in capital raised from equity offerings and asset sales), should make investors who piled into the shares just last week at $31 thinking the worst was over after Merrill reported its disastrous second quarter results feel totally blindsided.
It defies reason that Merrill did not know about this massive problem in its book of business, that it didn’t see this freight train of a writedown coming when just last week it disclosed $4.9 bn in second quarter losses due to $9.4 bn in writedowns for the period. Wall Street had expected lesser sums here, $1.8 bn in losses due to $6 bn in writedowns.
At minimum, do you really think it takes only about a week to convince foreigners to invest even more money at a time when the stakes they’ve already bought in Merrill earlier this year are now drastically under water?
The second quarter losses marked Merrill’s fourth straight quarterly loss, the tally at $19.2 bn and counting, and writedowns amounting to $40 bn. Now more losses are on the way for the third quarter, the fifth straight quarter, at Merrill.
On the July 17 conference call about its second quarter with analysts, analysts who were skeptical as they were expecting a loss of $1.8 bn, Merrill’s chief executive John Thain said: “Right now we believe we are in a very comfortable spot in terms of our capital.” Really? And 10 days later you announce both a massive writedown and another eye-watering, dilutive capital raise?
Earlier in the year, Thain also dismissed the notion that Merrill needed any more new capital after it raised $12 bn, saying it would not be necessary. Merrill to date has laid off 5,200 people. When did Merrill know it planned to unload this distressed debt and when did it know it had to do another $8.5 bn equity raise? Did it really come as a eureka moment just overnight?
Investors who bought in last week when it was said the worst was over at Merrill, when it was trading at around $31, are getting killed now. The stock is trending down toward $20. “Shareholders are seeing their positions diluted massively,” says Dennis Gartman of the Gartman Letter.
Gartman adds the blame should also be put squarely on Merrill’s former chief executive Stanley O’Neal, ousted last fall due to his mismanagement, who walked away with $161.5 million in compensation, compensation “that is not being written down even as the shareholders are having their positions massively corrupted,” Gartman says. “If there is a crime on Wall Street it is this.” That compensation effectively was paid out based on artificial profits made during the housing bubble.
Yes, I have raised the question of what some analysts were saying, whether we were seeing a bottom in the financials. I also warned you that thinking that way would be like trying to hold onto a piece of Styrofoam in a typhoon. Merrill’s stock got pounded in after hours trading, closing down 12% to $24.33. Shares are down 54% this year, and are trading at their lowest levels in ten years.
Meredith Whitney, a top analyst at Oppenheimer, says Merrill’s pro forma book value per common share is more like $21 and that shares are still trading at levels that are “at a premium” and “expensive.” Whitney does think Merrill is getting closer to being fairly valued and that “the hardest work” is behind the company. Whitney now expects Merrill to post a loss of $10.50 per share for the entire year, versus the $8.37 expected earlier.
Last week, Merrill announced it would unload its stake in Bloomberg for $4.43 bn to raise capital. It had to unload this asset due to the fine print of an earlier $12 bn equity offering sold to Singapore’s investment fund Temasek and the Kuwaiti investment authority, which forces Merrill to remunerate them in the event of any further dilutive equity raises.
The new equity offering now forces Merrill to reset its earlier deals with Temasek and Kuwait, an issue I warned you would happen. Don’t be fooled by false bottoms in the financials. As economist Ed Yardeni points out, the financial sector of the S&P 500 jumped 31% “in a six-day short-covering rally that was interrupted by a 6.7% drop last Thursday, the biggest decline since a 7.7% decline on April 14, 2000.”
The jump came after Congress said it was close to signing the $300 bn housing bailout bill, which included the rescue of Fannie Mae and Freddie Mac. “The financials tend to rally following massive government programs to avert a financial meltdown,” Yardeni says.
Investors in Merrill should be notably concerned with what is happening at the country’s largest brokerage. Merrill was a repackaging factory for some truly toxic subprime debt, including those pumped out by Countrywide Financial. Countrywide pointed its conveyor belt of nasty loan products at Wall Street, and Merrill was first in line to gin them up into asset-backed securities.
Merrill’s latest writedowns resulted from the sale of a huge $11.1 bn slug of its asset-backed securities, creating the latest $5.7 bn pre-tax writedown. It also pulled the plug on hedges with troubled bond insurers, the two white hot zones on many financials’ balance sheets.
Watch how this deal to unload a whopping slug of Merrill’s distressed debt breaks down. Merrill said it sold $30.6 bn worth of distressed debt in the form of super senior asset-backed debt for just $6.7 bn. Merrill had just said at the end of its second quarter these assets were worth $11.1 bn, or just 36 cents on the dollar.
So, being that it has sold this distressed debt, called collateralized debt obligations, for just $6.7 bn to a unit of Lone Star Funds, a Dallas private equity firm, when you do the math, that’s about 22 cents on the dollar. That’s a writedown of 78%. Gasp. That created $4.4 bn of the writedown.
That’s what Merrill is now getting for its misplaced bets. That’s what you can expect other Wall Street houses to mark these investments to, with more writedowns coming. Watch out, Lehman Bros. Moreover, Lone Star only has to pony up $1.7 bn to seal the deal, borrowing the rest, or 75%, from Merrill. So Lone Star is effectively putting up just 25% of the deal, about six cents on the dollar, for the gross value of the deal.
“That does not sound very good for the about-to-be diluted shareholders, now does it?,” says Jill Schlesinger, executive vice president and chief investment officer for StrategicPoint Investment Advisors. The sale cuts Merrill Lynch’s total CDO long exposures from $19.9 bn at June 27, 2008, to $8.8 bn. Most of what’s left is made up of older vintage securities, dating back to 2005.
Take a closer look through Merrill’s books and you’ll still see problems. As of June 27, it said it had exposures of $33.7 bn to U.S. prime mortgages, $1.01 bn to U.S. subprime mortgages, $1.54 bn to “Alt-A” mortgages and $7.45 bn to non- U.S. residential mortgages. It’s also got a big $18 bn in exposures to subprime- and commercial-backed securities. Of that sum, its net exposure to subprime alone is $4.5 bn.
Citigroup has $22.5 bn in subprime securities exposures here, and UBS, $15.6 bn, both ranking the highest in this category, Oppenheimer’s Whitney says. Merrill has been in acute pain due to what it has had on its balance sheets, with 30 CDOs worth in the aggregate $32 bn for deals Merrill underwrote in just 2007 alone.
Some 27 of these have seen their top triple-A ratings downgraded to “junk,” Janet Tavakoli, a structured-finance consultant in Chicago, reportedly said. Their performance has been “dreadful,” she says. Merrill has about $41 bn in net worth, or shareholder equity against about $34.4 bn in illiquid level three securities, those securities it has price tagged itself because no one wants them.
The $8.5 bn capital raise will dilute existing investors by nearly 40%. Merrill has to compensate Temasek and the Kuwaiti Investment authority who both bought shares in Merrill earlier this year at a higher price.
Temasek had bought $5 bn at $48. As Merrill is now trending toward $20, Merrill has to pony up $2.5 bn to Temasek, and Temasek is expected to turn around and invest that remuneration into its new $3.4 bn investment in Merrill’s latest equity raise. Merrill also is in talks with the Kuwait Investment Authority to renegotiate the terms of its original investment. And Merrill’s management will buy 750,000 shares in the new offering.
How Merrill Lynch dragged NAB into an $830m writedown
The National Australia Bank's shock write-down of $830 million worth of collaterallised debt obligations (CDOs) can now be explained.
It was triggered by a move from struggling US investment bank Merrill Lynch to get rid of billions worth of CDOs in which the NAB was a co-investor. Merrill's took a decision to sell the CDOs at a written-down value and the NAB had no option but to follow suit. Its larger write-down than Merrill Lynch (90% vs. 78%) reflects its lower ranking of security.
The NAB was involved in a parcel of what’s called "super-senior" CDOs with a face value of $19.9 billion. NAB and the Australian stockmarkets were directly affected by the Merrill move, which reflects the US banker's desperate desire to quit as much of its toxic subprime mortgage related investments as it can, without regard to the flow on impact to other banks and markets.
In effect Merrill's move to sell these holdings of CDOs to a distressed debt fund investor, forced the NAB to write-down the value of its holding in the CDOs, a move which triggered a huge sell-off of Australian bank shares Friday and yesterday. Yesterday the ANZ revealed a completely unrelated set of write-offs and provisions, butr these had more to do with the slowing Australian economy.
At the same time, I understand that APRA, the Australian Prudential Regulation Authority, has been talking to the NAB and ANZ and were liaising with them on these moves and had a full understanding of both banks' actions. APRA has been actively talking to banks and other financial groups it regulates about their exposures to the US and to Australian corporate basket cases, such as Allco and Opes Prime.
Confidence in banks has been hit by the NAB and ANZ announcements, but not all banks are in that boat. Westpac revealed this morning it had successfully raised just over $1 billion from an issue of stapled securities to boost its regulatory capital. The bank said its previously announced offer of 10.36 million Westpac stapled preferred securities at $100 each to shareholders, broker firms and institutions has closed and was completed in full.
That shows the nervousness about banks in recent weeks hasn't stopped big investors making positive decisions: Westpac's issue was announced last month and finished in the turmoil of the past two days. Merrill's move, revealed this morning in a shock statement to Wall Street after trading closed was part of a $US8.5 billion emergency fund raising and another $US5.7 billion in write downs.
Merrill said it would sell CDOs with a nominal value of $US30.6 billion to Lone Star Funds, a distressed-debt investor. At the end of the second quarter, the bank had estimated the value of the CDOs at $11.1 billion. However, it said yesterday it was selling the securities for just $US6.7 billion, or about 22 cents on the dollar; and financing 75% of the purchase. This smacks of desperation:
On a pro forma basis, this sale will reduce Merrill Lynch's aggregate U.S. super senior ABS CDO long exposures from $19.9 billion at June 27, 2008, to $8.8 billion, the majority of which comprises older vintage collateral -- 2005 and earlier.
The pro forma $8.8 billion super senior long exposure is hedged with an aggregate of $7.2 billion of short exposure, of which $6.0 billion are with highly rated non-monoline counterparties, of which virtually all have strong collateral servicing agreements, and $1.1 billion are with MBIA. The remaining net exposure will be $1.6 billion. The sale will reduce Merrill Lynch's risk-weighted assets by approximately $29 billion.
It's that phrase in the above paragraph; "super senior ABS CDO" which reveals what happened. This sale was dated June 27 but only completed yesterday, but it preceded the NAB announcement on July 11 when it warned that there could be further write-downs.
Then last Friday NAB warned that there would be write-downs of $830 million (on top of the earlier $181 million), meaning it was cutting the value of its investment in the CDOs by 90%. It was a 'senior' ranked investor in the CDOs and when a super-senior ranked investor decides to liquidate or sell the CDOs at a lower value, the other investors have no say in the matter and have to follow suit.
Super-senior investors hold all the cards in these complicated deals. The NAB has super-senior securities among the $US4.5 billion of various derivatives still in its off-balance sheet investment conduit. If Merrill had not decided to liquidate its position and sell, the NAB would have been in all probability, still an investor today with a $181 million write-down.
Singapore's Temasek invests $900 million more in Merrill
Singapore sovereign wealth fund Temasek Holdings will pump an additional $900 million into Merrill Lynch as part of the debt-laden U.S. investment bank's latest $8.5 billion fund-raising effort.
Temasek said on Tuesday that Merrill will give it a rebate of $2.5 billion on its original $4.4 billion stock purchase following the U.S. firm's decision to sell new shares. Temasek will plough that money, plus another $900 million, back into new Merrill stock, potentially increasing the state-run fund's stake in one of the best-known U.S. banks to more than 10 percent.
The fund had been facing huge paper losses on its initial investment in Merrill at $48 per share as banking stocks slid this year amid writedowns on risky debt. The rebate, announced less than two weeks after Merrill posted a $4.9 billion second-quarter loss, effectively reduces the cost of Temasek's existing shares in the U.S. bank by more than half to $21 a share.
Neither Merrill nor Temasek disclosed the price at which the new Merrill shares would be offered. Merrill shares fell 11.6 percent on Monday to $24.33. After the market close, the company said it will take a further $5.7 billion in debt-related writedowns in the third-quarter and raise $8.5 billion by selling new stock.
Sovereign wealth funds from Asia and the Middle East have become more influential in financial markets after pouring billions of dollars into Merrill and other big banks on Wall Street and Europe that were reeling from losses related to the U.S. mortgage market. But many wealth funds are now smarting from huge losses and facing growing public criticism at home as the value of those investments continues to slide.
Singapore's government has said the investments by Temasek, and by its larger sister fund GIC in banks including Citigroup and UBS would give good long-term returns. But another major Asian sovereign wealth fund, the Korea Investment Corporation (KIC), said it may shy away from further investments in U.S. banks, as it struggles to avoid losses from its $2 billion investment in Merrill.
KIC chief executive Chin Youngwook told a news conference on Tuesday that it had posted about $800 million in valuation losses before it converted its preferred Merrill shares into common stocks on Monday, more than two years ahead of schedule.
"We learned a lot of good lessons from the investment in Merrill Lynch," Chin said, when asked about its interest in Lehman Brothers and other U.S. investment houses. "I think we may have to approach cautiously."
Temasek had invested a total of $5 billion in Merrill Lynch in December and February, but Merrill shares have fallen by about half since then. The deal had a feature that required Merrill to compensate the Singapore investor should the U.S. firm subsequently raise new capital at a lower price.
"Temasek's point of view is that this opportunity is not going to be repeated," said Arjuna Mahendran, Singapore-based head of investment strategy at HSBC Private Bank. "From a long-term investor's point of view, getting access to the U.S. financials market is best done through strategic stakes," he added.
"Temasek confirms its commitment of $3.4 billion in the public offering by Merrill Lynch, a portion of which is subject to regulatory approval," spokeswoman Myrna Thomas said in a statement. "The commitment includes a sum of $2.5 billion arising from a re-set payment."
The sovereign wealth fund's latest purchase of Merrill Lynch shares is subject to approval by U.S. regulators as it could result in Temasek's owning more than 10 percent of the U.S. broker. According to Reuters data, the Singapore wealth fund owns 86.95 million Merrill Lynch shares, or about 8.85 percent of the firm.
But the Singapore fund's stake could rise to as much as 15 percent if other investors shun Merrill Lynch's latest fund-raising exercise. A stake of that size may raise some concerns among U.S. politicians about the level of foreign ownership at one of the nation's best-known banks.
"Merrill needs big, strong investors, and it will be good for sentiment. These are the guys who are unlikely to bail out at the first sign of trouble," said Singapore-based Song Seng Wun, regional economist at CIMB, Malaysia's largest investment bank.
"At the end of the day, we are unlikely to see the Merrills of this world collapse -- that will cause the depression of the 21st century," Song said. Temasek said it managed about $108 billion as of March 2007. According to Morgan Stanley, it manages $159 billion and is the world's seventh-largest sovereign wealth fund.
Merrill Aims to Raise Billions More
Merrill Lynch & Co. agreed to sell more than $30 billion in toxic mortgage-related assets at a steep loss, hoping to purge its balance sheet of problems that continue to plague the giant brokerage firm.
The move was described by a person close to Merrill as an effort to "lance the boil" that has resulted in more than $46 billion in write-downs since June 2007. Dumping the assets for just 22 cents on the dollar will result in a write-down of $5.7 billion. That is an ominous sign for other Wall Street firms and commercial banks trying to get rid of loans and securities in a market flooded with distressed assets.
Faced with another leak in its balance sheet, Merrill also announced late Monday it would sell $8.5 billion in new common stock. The sale will dilute existing Merrill shareholders by about 38% -- and is additionally painful because the firm will have to make extra payments to an investor that bought shares at a much higher price in an offering last December.
Meredith Whitney, an analyst at Oppenheimer & Co., said that while the "capitulation sale" and resulting stock offering will bring more short-term misery, they signal that Merrill might finally pull itself out of a financial tailspin that has haunted Chairman and Chief Executive John Thain since he took over in December.
"What has become increasingly clear over the past year is the longer you wait, the less the soured assets are worth," she said. "John Thain is cutting his losses." In a press release, Mr. Thain said the transaction represents a "significant milestone" in the firm's efforts to reduce risk.
The sale to an affiliate of private-equity firm Lone Star consists of collateralized debt obligations with a face value of $30.6 billion. CDOs are securities backed by pools of mortgages or other assets, but they have plummeted in value since the credit crisis erupted last summer. Merrill valued the CDOs at just $11.1 billion as of June 30.
Lone Star is paying $6.7 billion for the assets, triggering the write-down by Merrill. The New York company still has $8.8 billion in remaining exposure, but much of that is hedged. As a result, Merrill is much closer to ridding itself of the CDOs that fueled massive profits when the housing market was booming and Merrill pushed to become top CDO underwriter. But the CDOs have since caused losses far exceeding those gains.
Merrill's announcement came after a tumultuous day in stock and bond markets. The Dow Jones Industrial Average fell 239.61 points, or 2.1%, to 11131.08, bringing it down 16% on the year. All the blue-chip average's financial components traded lower, stung by the collapse late Friday of two small banks, First National Bank of Nevada and First Heritage Bank of Newport Beach, Calif. Asian stocks tumbled Tuesday morning, following the slide in U.S. financial stocks and Merrill's plans for a write-down.
State and federal officials took new steps to address the market's woes Monday. The Treasury Department said that four of the nation's largest banks -- Bank of America Corp., Citigroup Inc., J.P. Morgan Chase & Co. and Wells Fargo & Co. -- agreed to begin issuing a type of debt called covered bonds, which the Bush administration has been pushing as a way to help reinvigorate the housing market.
Meanwhile, New York's top insurance regulator, Eric Dinallo, helped broker a deal between troubled bond insurer Security Capital Assurance Ltd. and Merrill that would allow the insurer to terminate $3.74 billion of bond-insurance policies it has written by paying $500 million to Merrill.
Financial shares shot up in mid-July after the federal government offered help for mortgage giants Fannie Mae and Freddie Mac and announced steps to crack down on "short selling," in which investors seek to profit from a decline in shares.
But Monday's slide showed that many obstacles remain to a resolution of the woes that have gripped the market. "This is a financial crisis in slow motion," said Nicholas Bohnsack, operating partner at research firm Strategas Research Partners.
Citigroup To Write Down Additional $8 Billion
Citigroup Inc. probably will write down the value of collateralized debt obligations by $8 billion in the third quarter based on Merrill Lynch & Co.'s repricing of its CDOs, said Deutsche Bank AG analyst Mike Mayo.
Merrill sold its holdings for 22 cents on the dollar, while Citigroup currently values the securities at 53 cents, Mayo wrote in a report to clients today. Merrill is taking a $4.4 billion loss on the sale of $11 billion of CDOs -- the mortgage- related bonds that have caused most of the firm's losses.
"The good news is that that the actual sales can give confidence that Merrill is finally selling assets rather than merely marking them to market," Mayo said.
At Citigroup, the additional writedowns mean the bank probably will report a third-quarter loss of 59 cents a share and a full-year loss of 80 cents, said Mayo, who has a "hold" rating on the stock. He previously estimated the New York-based bank, the biggest in the U.S. by assets, would report a loss of 66 cents in 2008.
Mayo is estimating that Merrill, the third-largest U.S. securities firm, will report a full-year loss of $10.95 a share, compared with his earlier prediction of a $5.80 loss. Oppenheimer & Co. analyst Meredith Whitney estimates the company will report a loss of $10.50 in 2008.
UBS AG analyst Glenn Schorr estimates Merrill will report a full-year loss of $11.36 a share because of "significant dilution" from the plan to raise capital by selling about $8.5 billion of stock. Schorr has a "neutral" rating on Merrill.
"While we don't think Merrill's announcement necessarily implies a 40 percent writedown ($7.2 billion) for Citi, directionally we think investors should expect further incremental writedowns in coming quarters," Schorr wrote in his report to clients today.
Lehman Brothers Holdings Inc., the fourth-biggest U.S. securities firm, may have to sell "significant assets" to guard against further losses from its $65 billion of mortgage and real estate holdings.
Freddie, Fannie: The situation is much worse
Forget everything you've read about how woefully undercapitalized Fannie Mae and Freddie Mac are. The situation is much worse.
Unlike other companies, the two government-chartered mortgage financiers publish quarterly fair-value balance sheets showing what the real-world values of their assets and liabilities supposedly are. By this measure, both companies' net- asset values are much lower than what the government lets them show as capital, or what the accounting rules let them report as shareholder equity.
The companies' critics for years have pointed to the gaps between these figures as proof that the government's capital requirements are a joke. What I hadn't realized, until an astute reader tipped me off, is that the fair-value balance sheets overstate the companies' asset values, too.
The issue centers on the way Fannie and Freddie calculate their fair values for deferred-tax assets, which is really just a fancy term for deferred losses. If you believe the companies' numbers, the more money they lose, the more their deferred taxes are worth.
Deferred-tax assets consist of tax-deductible losses and expenses carried forward from prior periods, which companies can use to offset future tax bills. Under generally accepted accounting principles, they are valuable only to companies that are profitable and paying income taxes.
To the extent a company doesn't expect to have enough profits to use them, it's supposed to record a valuation allowance on its GAAP balance sheet. Fannie and Freddie so far have recorded no such allowances. The two companies, of course, are so profitable right now that they're on the verge of a government bailout.
By the government's main capital measure, Fannie had "core capital" of $42.7 billion on March 31, or $5.1 billion more than required, while Freddie had $38.3 billion, or a $6 billion surplus. Meanwhile, on a fair-value basis, Fannie said its net assets were worth $12.2 billion, while Freddie showed negative $5.2 billion.
One reason the core-capital figures are so much higher is that the government lets Fannie and Freddie exclude tens of billions of dollars of pent-up losses on mortgage-related securities they're holding for sale, solely because the companies have deemed the losses "temporary."
Another reason is that core capital includes deferred-tax assets. Commercial banks, by comparison, normally don't get to count these in their capital, because they can't be sold by themselves and, thus, can't be used as a cushion against losses.
Here's where it gets tricky: On their fair-value balance sheets, Fannie and Freddie included adjustments to their deferred taxes that added billions of dollars to their asset values. Without the boosts, the companies' fair-value tallies would have looked even uglier.
Start with Fannie. As of March 31, it showed $17.8 billion of net deferred-tax assets on its GAAP balance sheet. Fannie's fair-value balance sheet doesn't show a separate line for deferred taxes. Instead, Fannie included them in an item called "other assets," to which it assigned a GAAP carrying value of $45.5 billion and a fair value of $60.7 billion.
Using the methodology described in Fannie's footnotes, I was able to estimate that about $14.3 billion of that $15.2 billion differential came from adjustments to the company's deferred-tax assets. The way this works is the company calculates the tax effects on the difference between its shareholder equity at fair value and under GAAP; it then includes these in other assets.
Without that $14.3 billion of tax adjustments, the fair value of Fannie's net assets would have been negative $2.1 billion, by my math. Exclude deferred-tax assets entirely, and it would have been negative $19.9 billion as of March 31. (Fannie raised $7.4 billion of additional capital in May.)
As for Freddie, it showed $16.6 billion of net deferred-tax assets under GAAP as of March 31. Like Fannie, it put deferred taxes in "other assets" on its fair-value balance sheet. Freddie said its other assets had a GAAP carrying value of $31.6 billion and a $42.5 billion fair value.
By my calculations, using the methodology in Freddie's footnotes, it looks like Freddie wrote up the deferred-tax assets on its fair-value balance sheet by about $10.1 billion. So, take out the tax write-up, and Freddie's net assets had a fair value of negative $15.3 billion. Exclude deferred-tax assets entirely, and that falls to negative $31.9 billion.
In its latest quarterly report, Fannie said "we anticipate that it is more likely than not that our results of future operations will generate sufficient taxable income to allow us to realize our deferred tax assets." Hence, no valuation allowance.
Freddie gave a similar explanation in its July 18 registration statement with the Securities and Exchange Commission. The company also cautioned that "if future events differ from current forecasts, a valuation allowance may need to be established which could have a material adverse effect on our results of operations and capital position."
It's fishy enough to say no valuation allowances were needed under GAAP. Yet it seems beyond the pale to claim that, on a fair-value basis, their tax assets actually were worth more than what their regular balance sheets said. My guess is they're worthless now.
Brace yourselves, taxpayers. Uncle Sam soon may have to write a very large check.
Banks Throw Weight Behind Paulson Covered-Bond Plan
Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co. and Wells Fargo & Co. threw their support behind Treasury Secretary Henry Paulson's effort to spur covered bonds as a new source of mortgage financing.
"We look forward to being leading issuers as the U.S. covered bond market develops," the banks said in a joint statement in Washington. They applauded Paulson's release today of guidelines for issuers of covered bonds, which detail the types of loans that should go into the securities and how their payments ought to be made.
The banks stopped short of announcing specific plans for issuing the bonds, illustrating how the market may be slow to take off in the U.S. in the aftermath of the mortgage meltdown. Even in Europe, where covered bonds are a market in excess of $3 trillion, investors are shunning the debt amid a collapse in appetite for investments in housing.
"Mortgage-backed securities investors are not in the mood right now to buy bonds with anything less than government backing," Kenneth Hackel, managing director of fixed-income strategy at RBS Greenwich Capital Markets in Greenwich, Connecticut, said in an interview, referring to debt guaranteed by Fannie Mae and Freddie Mac. While the market is "not yet" ready for covered bonds, "the concept is certainly more interesting now than it has been in a very long time," he said.
Paulson said the four U.S. banks are "ready to go" and that sales by the largest banks can help encourage smaller mortgage lenders to proceed. "Covered bonds have the potential to increase mortgage financing, improve underwriting standards and strengthen U.S. financial institutions," he said.
Covered bonds offer greater protection to investors because banks keep the home loans on their books, and must make up shortfalls if homeowners fail to pay. The Treasury's guidelines exclude riskier types of mortgages that contributed to the crisis of the past year, including loans made without documenting the borrower's income and those involving higher debt compared with property value.
Bank of America, based in Charlotte, North Carolina, and Seattle-based Washington Mutual Inc. are the two U.S. issuers of covered bonds so far. We will look to amend our program to make sure it's fully compliant" with the guidelines, Paul Baalman, a structured finance executive at Bank of America, told reporters at the Treasury in Washington today. He declined to comment on when the bank may next sell the bonds, adding that it will take some time to adapt to the new regulations.
Paulson said covered bonds will help provide financing to a U.S. mortgage market that now depends on Fannie Mae and Freddie Mac and other government-linked institutions for more than 70 percent of funds. Fannie and Freddie slid to their lowest levels in more than 17 years this month on concern they lacked sufficient capital to offset losses and writedowns. Fannie Mae and Freddie Mac buy mortgages and package them into securities sold to other investors. They also borrow to invest in home-loan debt.
Covered bonds achieve higher ratings than regular notes by augmenting the issuer's pledge to pay with a group of assets such as mortgages that can be sold in a default. The extra security allows lenders to pay less interest. While the securities are backed by loans and bank assets to get AAA ratings, most are valued, on average, as if they were three levels lower.
The Treasury's guidelines spell out a formal definition for covered bonds. The bonds should have maturities of at least one year and no more than 30 years. Home loans in covered-bond pools would have a maximum loan-to-value ratio of 80 percent. Today's announcement is part of Paulson's strategy of pushing banks to proceed with sales without waiting for legislation to be enacted by Congress.
In Europe, which has a covered-bond market of more than $3 trillion, many countries have laws spelling out the ground-rules for issuance. Federal Reserve Governor Kevin Warsh backed Paulson's plan to support covered bonds, highlighting that the central bank would accept them as collateral at the discount window for direct loans to commercial banks.
"Highly rated, high-quality covered bonds would generally fall within that broad range as eligible collateral," Warsh said in a statement. The Federal Deposit Insurance Corp. already has issued new regulations on how covered bonds would be handled in the event of a bank failure. FDIC Chairman Sheila Bair said Paulson's best practices augment the FDIC's efforts to lay out clear guidance for the industry.
"Covered bonds can be a useful tool to help restore confidence and stability to the housing industry, as well as to the mortgage finance system," Bair said today. The success of Paulson's strategy of pursuing issuance without legislation depends on how well the guidelines prove to have been written, said former FDIC general counsel John Douglas, now with the law firm Paul Hastings in Atlanta.
"Certainly a law is better than a regulation, but regulation seems to be plenty of comfort in a lot of areas," Douglas said. "The real issue is if it's substantive enough for the market, not the form in which it comes." Treasury officials held discussions with almost 60 market participants, including investors such as Pacific Investment Management Co., Blackrock Inc. and TIAA-CREF, the retirement annuity provider.
In Britain, Prime Minister Gordon Brown's government this year put in place legislation on covered bonds, joining Germany, France and Spain among European countries setting rules on how the securities are issued. "It needs a very strict and very clear legislation. Otherwise I don't think the investors will buy it," said Louis Hagen, executive director of the Berlin-based Association of German Pfandbrief Banks. Covered bonds are known as pfandbrief in Germany.
Europe's covered market was started by King Frederick the Great of Prussia in the 18th century to help rebuild after the Seven Years War, according to the Web site of the German association of pfandbrief banks. Rules for the securities differ by country, including the amount of capital required to back the bonds.
A New Way to Generate Mortgages
The financial establishment came together Monday in search of a new way for banks to come up with cash for home mortgages. Regulators, bankers and traders, led by Treasury Secretary Henry M. Paulson Jr., all pledged to do their best to get a “covered bond market” going in the United States.
Covered seems to be a synonym for collateralized, but it also has other meanings that may be appropriate in this effort to salvage the housing market. Think of covered wagons, which can be circled in times of crisis. With banks reluctant to lend their own money for mortgages, and the private securitization market quiescent if not dead, the cost of mortgage loans has been rising even as housing prices fall, making a bad situation worse.
At best, a covered bond market would provide a cheaper source of financing for banks while reassuring investors that their money is safe. Essentially investors would buy into a pool of mortgages that would be kept on the balance sheet of the bank that made the loans. These would be high-quality loans, and at the first sign of trouble in the underlying mortgages, those mortgages would be replaced in the mortgage pool.
Thus, investors would be assured of repayment unless the underlying mortgages suffered major losses and the issuing bank failed. That might make investors burned by existing mortgage securities more willing to return to the market. At best, a covered bond market would provide a cheaper source of financing for banks while reassuring investors that their money will be safe.
It is highly unusual for the government to take such a major role in getting a market established, but Treasury officials said their action was needed to get more money into housing loans. “We spoke to 50 or 60 market participants,” a senior Treasury official said, speaking on condition of anonymity because he was not authorized to describe the process publicly. “It became clear that if we took the lead, we had a real chance to kick-start this market.”
In Washington, Mr. Paulson said that “as we are all aware, the availability of affordable mortgage financing is essential to turning the corner on the current housing correction. He was joined by officials from the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Office of Thrift Supervision.
“We are at the early stages of what should be a promising path, where the nascent U.S. covered bond market can grow and provide a new source of mortgage financing,” Mr. Paulson said. Four major banks — Bank of America, Citigroup, JPMorgan Chase and Wells Fargo said they hoped to issue such bonds, and a larger group of investment banks and brokerage firms pledged to establish desks to trade the securities.
What remains to be seen is if there will be buyers. Mr. Paulson said the bonds appeared to be attractive to major banks, which would be able to pledge them to obtain loans from the Fed, and to some institutional investors. The F.D.I.C., which takes over failed banks, promised to respect the terms of the bonds, so that bondholders would be repaid from the value of the mortgages, even if other bondholders in the failed bank suffered major losses.
Covered bond markets exist in many European countries. In some of them, laws make the legal standing of such bonds clear, but Mr. Paulson and the other agencies concluded that no legislation was needed, and that policy statements by regulators would suffice. It is expected that Bank of America will be the first issuer. Bank of America has issued such bonds in Europe, and did one $2 billion American offering of covered bonds in June 2007, before antipathy to mortgage securities intensified.
The covered bond markets in some European countries have suffered to some extent from house price declines, but the markets have not closed down as the private-label securitization market has in this country. In the United States, those securities were backed by mortgages that were not guaranteed by either the federal government or by Fannie Mae and Freddie Mac, the two government-sponsored housing finance enterprises.
Fannie and Freddie became the principal buyer of mortgages after the private securitization market closed down, but their own financial health has deteriorated, and provisions for their own bailout, if necessary, are pending. In normal times, an American covered bond market would bear little resemblance to traditional mortgage securitizations, in which the investors are paid from the interest and principal payments on underlying mortgages (and thus suffer all the risks involved in such loans).
Instead, a bank that issued such bonds could do so on any terms it and investors agreed on. The bond payments would come from general corporate funds, and would not have to be tied to terms of the mortgages. Under a set of “best practices” issued by the Treasury and rules issued by the F.D.I.C., the bonds could have maturities from one year to 30 years.
The mortgages securing them would be of high quality, and for no more than 80 percent of the home’s market value. That market value would be adjusted according to regional trends in home prices; if home prices declined, mortgages covering those homes might have to be replaced in the pool.
Any mortgage on which payments were at least 60 days overdue would also have to be replaced, so at least in theory the pool would always include good loans, and their value would have to total at least 105 percent of the outstanding bonds. The mortgages would remain on the books of the bank that issued them, and the bank would stand to lose if the loans went bad.
That was not the case in recent years when mortgages were sold to securitization pools.
Banks Act to Aid Mortgage Lending
Four of the nation's largest banks will begin issuing a type of debt the Bush administration has been pushing as a way to help reinvigorate the housing market.
On Monday, Bank of America Corp., Citigroup Inc., J.P. Morgan Chase & Co. and Wells Fargo & Co., said they would begin issuing so-called covered bonds, a popular method of financing in Europe that could make more mortgage financing available in the U.S.
The move came as federal regulators announced a set of voluntary industry guidelines intended to provide clarity to issuers and investors about the types of assets banks must hold if they issue such bonds and how investors would fare in the event of a bank failure.
"As we are all aware, the availability of affordable mortgage financing is essential to turning the corner on the current housing correction...covered bonds have the potential to increase mortgage financing," Treasury Secretary Henry Paulson said at an event to announce the agreement.
The move is the latest step by the Bush administration to aid the beleaguered housing market. Two weeks ago, the Treasury unveiled a plan to shore up mortgage titans Fannie Mae and Freddie Mac by creating an unlimited line of credit for the firms and getting authority to invest in the companies.
The two firms are critical to the housing market because together they own or guarantee about $5.2 trillion of U.S. home mortgages -- nearly half of all those outstanding. The firms have seen their shares pummeled by investors concerned about their capital levels.
Washington's interest in pushing covered bonds stems from the success of Europe's $2.75 trillion covered-bond market. Such bonds are the primary source of mortgage-loan funding for European banks. Some analysts have predicted that a covered-bond market in the U.S. could grow to $1 trillion over the next few years. There are currently $11 trillion in home mortgages outstanding in the U.S.
Covered bonds are backed by mortgages but they are considered safer investments than the products that fueled the housing boom and landed many Wall Street banks in trouble. That's because the bonds stay on a bank's balance sheet and are backed by a "cover pool" of high-quality mortgages that must meet certain criteria, such as being up to date in their payments.
Investors are also protected because if the mortgages go bad, the bank must step in to ensure that bond holders get their interest. U.S. banks can issue covered bonds but only two have done so: Bank of America and Washington Mutual Inc. The market in the U.S. has been hampered in part because of regulatory uncertainty surrounding the products.
Investors have worried about where they stand in the event of a bank's demise and issuers have wanted clarity about the types of assets they must hold, among other things. The voluntary guidelines announced by the Treasury and supported by the Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and the Office of Thrift Supervision outline the types of collateral issuing banks must hold and the types of disclosure banks must make to investors.
Among other things, the guidelines require that mortgages backing the debt be underwritten with fully documented income, current when added to the pool, replaced if they become more than 60 days delinquent and held on an issuer's balance sheet. The guidelines are intended to reassure investors who have kept money on the sidelines after suffering heavy losses on bonds backed by subprime mortgages over the past year.
At the same time, most banks and financial institutions, which have also incurred losses and write-downs on similar assets, have been unwilling to create or underwrite new mortgage securities. Providing an alternative method of financing could help the housing market since investors would provide money to banks to make home loans. How much it could help remains to be seen and federal officials said they don't expect covered bonds to solve the housing problem.
"There are no magic bullets to solve the housing crisis," said FDIC Chairman Sheila Bair.
Why America's debt makes it a dangerous place
The US government now has $2061 billion of Treasury bills in circulation.
This is effectively the size of the loan it has taken from the rest of the world in order to finance its economy and is one of the reasons that the US dollar has depreciated so significantly against many other currencies over the last few years.
Since 2001 the US dollar has depreciated 43% against the Swiss franc and 47% against the euro. This depreciation has been fairly orderly but there are increasingly important reasons why a disorderly depreciation, or even a run on the currency, could occur.
The largest holder of T-bills is Japan with $592 billion, closely followed by China with $502 billion and the OPEC members who between them officially have $154 billion. However, a lot of OPEC members also own T-bills via proxy that are held in the UK. The high oil price has seen the foreign exchange reserves of these countries swelled with dollars, as oil is primarily priced in US dollars.
China has accumulated their holdings due to the huge levels of trade that are carried on with the rest of the world using dollars. Japan has long been a keen buyer of T-bills but has recently started to reduce its holdings (by 3.6% in the last year). Asian central banks don't publicise the allocation of their currency reserves but they hold about $4.35 trillion in total foreign exchange reserves and about 70% of these are thought to be dollar-denominated.
US dollars and dollar-denominated assets are held in a wide range of foreign countries, some of whom have strained political relations with the US due to the aggressive foreign policy of the Bush administration and one has to wonder how far they will bend to the will of a financially weak and economically exposed America. There are several reasons why the US dollar is exposed to geopolitical and investment risk in a way that hasn't been seen before:
1) Several countries are now pursuing a policy of diversification away from the US dollar in their foreign exchange reserves as they are still worried about further depreciation due to the declining economic environment in the US. The euro is a potential beneficiary, or a basket of currencies could be adopted. If everyone starts diversifying at the same time there is the risk of flight from dollar assets that begins to become obvious to markets and which could cause other investors to panic.
Whilst sovereign wealth funds are usually slow to act, they have indicated greater interest in investments in Europe and emerging markets as a way of diversifying their currency allocation as well as their asset allocations.
2) There is talk of the US losing its top investment grade rating and if this were to happen there could be a crisis of confidence in the dollar. A downgrade would require the US to offer higher interest rates, which in turn is not good for the economy and could cause further dollar weakness.
The US has held a triple-A rating since 1917 but healthcare and social security costs are rising with no sign of a solution to their spiralling costs. The cost of financing military excursions in Afghanistan and Iraq also adds to the problem. America has been spending beyond its means for some time (hence the huge volume of T-bills in circulation) but there is a strong possibility that this strategy may have serious repercussions one day.
3) Several Middle-Eastern and Asian countries have pegged their currencies to the US dollar and have had to lower their base rates in line with US rates, in spite of the fact that they are experiencing very high levels of inflation. Qatar is struggling with 14% inflation, Egypt 19%, Dubai 20%, Saudi Arabia 10% and the UAE 11%. They are not suffering from the same economic woes as the US, so interest rates of 2% are totally inappropriate.
Middle-Eastern countries have been forced to lower rates just as their economies are booming on the back of oil receipts and domestic investment is running at record levels. This divergence in economic fortunes has placed great strains on the dollar peg and there is a chance that some countries might have to break it at some point, which could be extremely dollar-negative.
4) The size of its outstanding debt to the rest of the world makes the US vulnerable to pressure in global political matters. If, for example, China wanted to have its way on an important political issue, it could imply that it was going to reduce its dollar holdings due to lack of confidence in the currency. This kind of declaration would have hugely negative ramifications for the dollar and the US economy, and is something the US would be keen to avoid.
It is this fourth point that I wish to expand on. China is often seen as seen as the main threat to US domination in global politics due to its size, its economy and its military might. It now has a major bargaining advantage in its creditor status. Since China's rise to prominence as a global economic power, its partial embrace of capitalist culture and its accession to the World Trade Organisation, there hasn't really been a significant dispute with the US. But what if this were to change one day?
In the same way that Russia has become more confident and more belligerent as its economic wealth has grown, China could also adopt a more aggressive stance towards the US.
In some ways the economic strength of the US and its influence on the world stage has been sold out from underneath it by the sale of so many Treasury bills. A country such as China, which holds 19% of all the T-bills in circulation, might be able to dictate terms to the US or else it could threaten to sell off its holdings under the auspices of diversification or lack of confidence.
Whilst this would mean that the value of all China's dollar-denominated foreign reserves were pummelled, it would ultimately survive. However, there would be a run on the US dollar and it would decimate the US economic system. In one single bound China could overtake the US as the world's most important economy and as the world's premier superpower.
If China were to sell its US dollar holdings at an accelerated rate, then the value of the dollar would collapse and interest rates would be forced up in order to support the currency. High interest rates would almost certainly send the US into a severe recession. It would also likely lose its triple-A credit rating which would exacerbate the problem.
A stable currency is essential for any country to attract foreign investment and the dollar has been propped up for a long time by the continued purchases of T-bills by overseas investors, particularly China, due to the size of its holdings. It currently requires $2billion a day to finance the current account and if sovereign wealth funds stopped buying dollars the deficit could balloon to unmanageable proportions. America's role as the greatest economic power in the world would be at an end.
Other holders of dollar-denominated assets, such as Japan and the OPEC members, would also suffer and they would certainly condemn China for taking such action. But are their concerns enough for China to pass up the chance of moving up the rankings in the global economy? Wars have been started for less.
Whilst the chance of an economic attack on the US by China as described above might be considered fantasy, the fact remains that the US has put itself in a position where it is theoretically possible that such a strategy could be carried out and where the very hint of a threat by the Chinese could be extremely damaging.
Sino-US relations have never been particularly friendly and the two countries have traditionally been seen as opponents, if not enemies. Maybe the struggle between communism and capitalism hasn't completely disappeared after all and the Chinese have been merely biding their time.
The US has been quite vocal about the way it thinks China should manage its currency but it is not really in a position to dish out advice on a subject in which it is clearly not an expert. The current Bush administration continues to officially support a strong dollar policy but the reality is somewhat different - and they are kidding no-one. Either the US has no control over its own currency or the huge depreciation in the value of the dollar was what they wanted all along.
However, today the US has clearly lost a large degree of control over its currency, and by association its economy, because it has put itself in the position of debtor to China (and to other countries) and this makes the US a riskier place to invest than is widely perceived, regardless of its current credit rating.
A rapid sale of US treasuries by China might seem like a black swan event but it is one that is theoretically possible and which can be foreseen. If it ever occurs then you don't want to be holding US dollars. Even without any action on the part of foreign holders of US Treasuries, the balance of power has certainly changed and the US has placed itself in a vulnerable position.
Banks' Woes Made Worse By Big Bets On Banks
It isn't just souring loans that are giving banks fits. A number of small lenders also gambled too heavily on bank stocks. The 45% swoon by bank stocks from their October highs is hurting the investment portfolios of many small U.S. banks, which usually are much more heavily concentrated in financial stocks than the portfolios of the largest banks.
Write-downs to reflect the fallen stock prices essentially erased second-quarter profits at some banks, deepening the misery caused by bad loans. "It's almost like doubling down," said Gerard Cassidy, a bank analyst at RBC Capital Markets. "At times like this, you're getting hit twice as hard."
Fulton Financial Corp., the Lancaster, Pa., parent of 11 local banks, took a $24.7 million pretax impairment charge related to the declining value of its bank stocks. Those holdings are the only stocks in Fulton's $3 billion investment portfolio. Companies are supposed to take an impairment when they determine an asset has lost enough value that it isn't likely to rebound quickly.
"We really feel like we know bank stocks, since we're in the business," said Charles J. Nugent, Fulton's chief financial officer. In the past decade, Fulton reaped $89 million in gains and $22 million in dividend income from its bank stocks, which typically generate about 3% to 7% of Fulton's overall profit.
Causing some of the sharpest pain are Fannie Mae and Freddie Mac. Investments in the two mortgage giants have been especially popular among banks. The companies' preferred shares churn out rich dividends, and their debt enjoys high ratings and is viewed as safe. But with the futures of Fannie and Freddie cloudy, owning the shares has become far riskier than most banks bargained for when they barreled into them.
At Webster Financial Corp, a write-down of $53.7 million tied to the Waterbury, Conn., bank's investment portfolio included a $7.7 million hit from the beaten-down values of the mortgage companies' preferred shares. Both stocks are down by more than 70% since the start of 2008.
Webster declined to comment. The bank had a net loss of $28.9 million in the second quarter. The losses are piling up despite the recent rebound in financial stocks. While the bounce is showing signs of fizzling, a sustained rally could allow banks to recoup some of their losses when they report third-quarter results.
Ilargi: Ambrose Evans-Pritchard missed the target by a wide schasm yesterday: "World markets are poised for a major relief rally today". Ouch.
Or how about Sen. Dodd: "This bill is going to make a difference almost immediately".
Fannie Mae and Freddie Mac: Congress backs rescue package
World markets are poised for a major relief rally today after the US Congress met in a rare weekend session to pass the most far-reaching rescue package for America's financial system since Franklin Roosevelt's New Deal.
The emergency bail-out gives the US Treasury sweeping authority to inject capital into the giant mortgage lenders Fannie Mae and Freddie Mac, which together own or guarantee half the country's $12 trillion stock of home loans. The ceiling on the US national debt has been lifted by a further $800bn, giving the Treasury almost unlimited resources to prop up the two lenders.
In parallel, the Federal Housing Authority (FHA) is to guarantee up to $300bn of fresh mortgages for struggling homeowners trapped with soaring loan costs, often the result of "honeytrap" contracts. The scheme aims to avoid an avalanche of fresh defaults as the housing market continues to deteriorate. Over 740,000 homes fell into foreclosure in the second quarter.
The new bill - reluctantly endorsed yesterday by the White House despite lashings of lard for Democratic special interests - should help to calm the markets after wild gyrations last week. Global bourses have suffered the worst mid-summer sell-off since the early 1930s.
The share prices of Fannie and Freddie, the world's two biggest financial institutions, have dropped by almost 85pc. The rating agency Standard & Poor's said it may downgrade a $19bn chunk of subordinated debt issued by two agencies despite the Treasury plan, citing "heightened financial risks". This raises implicit concerns about the credit worthiness of the United States itself, though S&P denies any plan to cut the US sovereign rating at this stage.
Hank Paulson, the US treasury secretary, brushed aside complaints that the rescue package amounts to a taxpayer bail-out for shareholders, insisting that the new authority to buy stock is merely intended to reassure investors and may never be activated if all goes well. The authority expires at the end of 2009.
A vocal minority on Capitol Hill now fears that the US government is shielding Wall Street from the consequences of its own folly. The risk of default has been taken over by society as a whole, while investors alone stand to gain from any recovery. "This bill has moral hazard written all over it: we are letting a monster loose," said Jeff Flake, a Republican Congressman.
The majority of President George W Bush's own party voted against the package in the House. A new regulator will take charge of Fannie and Freddie, but this addition has the look of an afterthought. Critics say Washington should have adopted the sterner methods of Norwegian and Swedish regulators during the Scandinavian banking crisis of the early 1990s, when shareholders received nothing after the banks were seized.
Mr Paulson is concerned that such Draconian methods could aggravate the crisis by making it harder for US banks to attract fresh capital. The financial system remains extremely fragile. The Federal Deposit Insurance Corporation (FDIC) intervened late on Friday to take over two more bankrupt lenders, First National Bank of Nevada and First Heritage Bank. It follows the seizure of California's IndyMac two weeks ago.
Christopher Dodd, chairman of the Senate banking committee, said the new package was vitally needed. "We are in the midst of the most serious economic crisis to face our nation in many years. This bill is going to make a difference almost immediately," he said.
Paul Ashworth, US strategist at Capital Economics, said US bank credit had been contracting for the last quarter. While the fiscal stimulus package helped to keep the economy afloat in the second quarter, this one-off boost is now largely exhausted. "The economy is likely to slide into a more severe recession during the rest of the year as the credit crunch gradually begins to have a more pronounced impact on the economy," he said.
Some 400,000 homeowners are expected to benefit from the FHA's new mortgage facility, which is confined to those trying keep up with their payments. This is a small proportion of the estimated 11m American households now facing negative equity, a figure that is certain to rise much further as house prices deflate. The overhang of unsold houses on the market has reached 11.1 months supply.
BNP Paribas said the new danger is that banks in other parts of the world will soon find themselves in similar difficulties as the long-term effects of the credit crunch bite deeper. "The epicentre of the financial market sell-off will switch from the US into Europe and Oceania. Most of Euroland has entered a recession. A synchronised global downturn is on the agenda," it said.
Ilargi: This is so funny, I have nothing further....
"[The] study predicts that house prices in England will rise by 25 per cent over the next five years".
Housing slump will end by 2010, says report
The property market will bounce back from its current slump by 2010, research suggests. National Housing Federation (NHF) study predicts that house prices in England will rise by 25 per cent over the next five years.
It predicts the average home in England will cost £274,700 by 2013, with prices rising by 5.2 per cent during 2011 and by more than 9 per cent a year in both 2012 and 2013. In the short-term, it expects prices to fall by a further 2.1 per cent in 2009, before beginning to increase in 2010, edging ahead by 1.3 per cent.
The research, which was carried out for the group by Oxford Economics, said that despite the current crisis, demand for property is still growing, while the supply of new housing is falling. It said only 75 per cent of the new homes that are required are actually being built each year, with 167,577 new homes completed in 2007, and the figure likely to fall to just 120,000 this year.
But an estimated 223,300 new households are expected to form each year between now and 2026. The NHF, which represents housing associations in England, said the report showed that it was critical that the Government continued to invest in new social housing.
David Orr, chief executive of the NHF, said: "Our report shows that despite concerns about the current housing market downturn, house prices will increase substantially over the mid to long term."
He called on the Government to support housing associations in buying up unsold properties that have been built by private developers, as well as helping them to develop mortgage rescue schemes for people in danger of losing their homes.
Ilargi: Meanwhile, in the part of the world where the drugs are less potent and hallucinatory.., the numbers keep getting worse.
UK mortgage approvals plunge 68.4% to new low in June
Homeowners have been warned to brace themselves for further falls in the value of their houses after figures from the Bank of England showed mortgage approvals have plummeted by more than two thirds in a year.
The Bank said the number of approvals slumped 68.4pc to 114,000 year-on-year in June. They were down from 41,000 in May to just 36,000 last month, the lowest level since records began in 1993.
Economists, who had forecast a reading of 37,000, said the figures are the latest evidence of how borrowers are being hit by the credit crisis, which has forced banks to curb lending and insist on bigger deposits before offering new loans.
Howard Archer, chief UK and European economist at Global Insight, said: "This is yet more very disturbing mortgage data that heighten concerns over the potential depth and length of the housing market correction.
"Very low mortgage activity suggests that house prices will continue to head south at a pretty rapid rate," he added. He warned those people who took out 100pc or even 100pc plus mortgages within the last three years were particularly vulnerable to falling into the negative equity trap.
Simon Rubinsohn, chief economist at the Royal Institution of Chartered Surveyors (RICS), said: "The latest numbers from the Bank of England demonstrate in the clearest possible way the consequences of the credit crunch for the residential property market.
UK homeowners will struggle to get mortgages until 2010, report says
Homeowners may struggle to get mortgages for the next three years, an eagerly-awaited Government-backed report has warned.
The ability of banks to offer mortgages will be "severely constrained" until 2010 with first-time buyers with deposits of less than 25pc of their property's value particularly badly hit. The mortgage shortage is likely to hit house prices and consumer spending on the high street. The warning has been sounded by Sir James Crosby, the former chairman of HBOS bank, in a detailed analysis for the Treasury.
He also predicts there will be an increase in the number of people defaulting on their mortgages over the next two to three years raising the spectre of tens of thousands of homeowners having their properties repossessed. The news comes as homeowners have been warned to brace themselves for further falls in the value of their houses after figures from the Bank of England showed mortgage approvals have plummeted by more than two thirds in a year.
The Bank said the number of approvals slumped 68.4pc to 114,000 year-on-year in June. They were down from 41,000 in May to just 36,000 last month, the lowest level since records began in 1993. The Government is studying plans put forward by Sir James to kickstart the mortgage market by offering finance for new mortgages.
Government-backed bonds could be offered to Britain's mortgage lenders to allow them to offer home loans to people. An announcement on the plans will be made in the autumn. In his interim report, Sir James said: "Given that more of their [lenders'] existing mortgage-backed borrowings will need to be repaid over the next three years, their capacity to make new mortgage advances therefore looks severely constrained.
"In my opinion, such a shortage of mortgage finance will persist through 2008, 2009 and 2010." He warns that people seeking to borrow more than 75pc of their property's value or those without regular employment will find the "availability of finance…considerably reduced."
S&P 500 Firms’ Pension Plans Plunge by $170 Billion
The value of pension plans for S&P 500 companies has plunged by $170 billion thus far this year, reducing a $60 billion surplus from 2007 to $110 billion deficit, according to research by Credit Suisse.
Defined-benefit pension plans have been stung by the turbulent equity and bond markets this year. Plans rely on solid returns to meet their payout obligations, so declining asset values hits them especially hard.
With the steep decline in asset values so far this year, "pension plans may have given up some of the hard earned gains from the past five years," the report said. The most painful impact may be on the balance sheets of corporate pension sponsors. The funded status of pensions appears on company balance sheets and must be marked-to-market annually, showing the extent of a fund's decline.
Also, pension costs that rise beyond expectations could put added pressure on earnings, and companies may have to contribute more to the plans, according to the report. In turn, that could detract from money that could otherwise be used to pay dividends or service debt.
"If the plans get weaker the companies that sponsor them could get hit from a number of angles," the report said.
Struggling pension funds affect all companies differently, depending on their exposure, the researchers observed. Some companies, such as General Motors, Ford, Eastman Kodak, and Goodyear have benefit obligations that are larger than their market capitalizations, according to Credit Suisse.
Credit Suisse's projections for 2008 are based on market performance so far this year, in which equity prices are down by 10 percent. Companies have been shifting where they allocate their pension fund assets in the last year, reducing their exposure to the equity markets and investing heavily in fixed income.
This year's pension problems began in January, when 100 of the biggest U.S. companies saw their defined-benefit plans lose more than a full year of 2007 gains in the first month of the year, when funded status fell by $63 billion, according to Milliman, a pension actuarial firm.
Last year companies with big pension plans enjoyed the income-statement effects of a hefty cut in plan costs. With big asset losses of 1999 through 2002 having mostly worked their way through the pension system, plan expenses dove by $19 billion, boosting company earnings by $8 billion, Milliman found
Is Singapore the canary in Asian economy mine?
It was the night before Singapore's Finance Minister was due to talk to The Times and a more internationally recognisable voice of the city-state was out and about in full, hectoring flow.
Lee Kuan Yew, the octogenarian statesman who looms over the Singaporean Government as its “Minister Mentor”, was opening an event at one of the city's swish hotels. If voters were ever gripped by the “sheer madness” of electing a member of the opposition, Mr Lee said, in a typical bit of carrot-and-stick politicking, it would take “only five years” to ruin Singapore completely.
It is tempting to believe that the old man must be wrong and that there is far more resilience in Asia's smallest country than its patriarch suggests. Singapore's affluent skyline bears every sign of the city-state's sustained economic vibrancy. Where there are not recently finished skyscrapers, there are cranes building more.
There is a fledgeling biotechnology industry and a fourth university has just opened. The host of expatriates, sucked first towards the city's financial district for work, cram a swelling new ghetto of clubs and bars after hours. Even Cabinet ministers admit that the place is much more interesting than it used to be. Singapore appears, at least on the surface, to be a country with enough momentum and vivacity to survive the election of a few MPs from outside the monolithic ruling party.
But there is little doubt that Singapore's business model is under threat. According to the Finance Minister Tharman Shanmugaratnam, it always has been. And now it has a number of hungry, growing cities in India and China breathing down its neck as viable financial hubs.
Because of Singapore's minuscule size, the openness of its markets and its dependence on exports and the financial services industry to drive growth, a country that appears to have prospered through doctrinaire social manipulation is, in reality, disproportionately at the mercy of monetary and fiscal policy.
“I would say that starting from the premise that we are vulnerable is not a bad thing in a whole sphere of policies,” Mr Tharman said. “The fact is that we are vulnerable ... psychologically, it is both a liability and an asset.” He describes the need for a place such as Singapore to build resilience to the “unknown unknowns” that the global economy may throw in a finance minister's path. In the 21st century, he argues, unpredictable shocks are becoming more frequent.
Latitude in monetary and fiscal policy is crucial - and yet when the softly spoken, British-educated Mr Tharman talks of Singapore's striking economic vulnerabilities, he emphasises the need for social cohesion, a force, he says, that has helped to make his country so attractive for investment and without which one of South-East Asia's most impressive economic stories would surely unravel.
Although that emphasis on social cohesion as economic panacea is textbook Singapore stuff, Mr Tharman believes that the Government's attitudes are too readily simplified. It is easy, he smiles, to parody Singapore - and the farther from Singapore you go, the easier it is. Instead, Mr Tharman sees himself as being in charge of the finances of a complex society with a “surprising amount of fringe”.
Nor does he see paradox within the Government as it struggles to ferment new ideas and a “fertile crescent” for business and science. When he returned from a recent visit to Israel, Mr Tharman remarked on that country's ability to nurture innovation within what he called an unruly democracy.
It is not outside Singaporean culture to be questioning people, he said, but there was more evolving to do. He adds his belief that the Government should not try to control the internet because of the impossibility of doing so effectively - a comment at odds with a continuing legal action against a foreign blogger critical of Singapore's justice system.
“It is not every man for himself and every idea for itself and we all live happily ever after,” Mr Tharman said. “We have to preserve this compact, but never be trapped by our past.” Singapore's need for social cohesion, Mr Tharman believes, arises from its size. If Singapore were like London or San Francisco and other cities within larger economies, he argues, it could afford to be more of a free-for-all.
“In those cities you have the weight of a middle country out there where established norms are sustained and persevered with and values evolve only gradually,” he said. “Our middle country is two or three subway stops from the centre of the financial district. Everyone is part of the same neighbourhood. You have to look after not just your software programmer, your financial derivatives trader and your creative class, but the people who are clearing the refuse and serving in the McDonald's outlets, the technicians, secretaries and engineers.
“That is why you need a certain degree of consensus-building, a degree of constraint in your social norms.” Cohesion, therefore, remains the stated goal and Mr Tharman insists that the global economic tide has made securing it even more vital. The balance of policy-making, he says, is even more delicate. Singapore's traditional use of exchange-rate policy to respond to the economy's various headwinds faces limitations in the current climate, he feels.
A dramatic strengthening of the Singapore dollar might bring some temporary relief from $120-a-barrel oil prices, but it would hurt the country's already slowing exports. Singapore's extraordinary rise was crafted in an era of far more favourable terms of trade. With that era over, the burden on the monetary and fiscal navigators is even heavier.
With the exception of eggs, Singapore imports all its food and energy, so it has found itself in the front row for soaring commodity prices and the resultant inflation. Mr Tharman says that the most critical task he faces is ensuring that corporate Singapore does not unleash a second, more destructive, spiral of inflation via wage rises.
The tripartite tradition of annual pay talks, which puts the Government at the same table as employers and unions, goes a long way to ensuring that the State's views on the matter are heard.Morever, Singapore's wrestle with inflation is teaching lessons that should be heeded abroad. Singapore's unique catalogue of exposures, Mr Tharman says, means that it is behaving like an ultra-sensitive barometer for the rest of Asia.
With very little in the way of padding from price shocks, Singapore is facing in the immediate weeks what others will be forced to cope with in coming months. Mr Tharman said: “We have not had the luxury of even contemplating insulating ourselves from global prices. We are a small, highly open economy, a textbook case of a country that cannot insulate itself from global prices and trends.
How we behave and how we respond to the crisis is, in a sense, something that all countries will have elements of. Ultimately, as you are finding across Asia, sustaining subsidies is an expensive proposition.” Given Singapore's reputation as a land of strict rules with a top-down vision of how the state should look, many people would expect its Government to dictate its way through any given crisis.
Mr Tharman is adamant, though, that Singapore's response will bear no such hallmarks. “It's really not an economy that can be characterised in any sense as having command features,” he said. “If we are interventionist, it is in the social sphere in the way we shape our housing policies ... in the effort to achieve social cohesion and ethnic cohesion in our neighbourhoods.
“Singapore is one of the freest economies in the world. We make no bones about the fact that we do intervene in the social sphere to ensure a degree of mobility and cohesion that would not naturally come about through the free workings of the market.”