"Miss Louise Lester, in charge of mutilation of old money at Treasury Dept."
Ilargi: A wide overview today of what Merrill Lynch's CDO sale will mean for the rest of the banks and funds that sit on similar paper. Not pretty. Many banks will not be able to go that path and come out in one piece. The first $400 billion in writedowns was a lot easier, but now most of the flexibility is overstretched to the point of snapping.
And more warnings from the rest of the world: if you still think that your country or your state or your job or mortgage will be fine, 98 to 1 says you're dead wrong. Cut the delusion. Today it's New York State, California, Italy, Spain, France, Australia, New Zealand, and where ever it is you live will also soon be on the list.
I got to run, I'm getting a steroid shot this morning. It's getting close to the Olympics, after all.
Merrill Lynch’s CDO sale to double writedowns to $800 billion, more to come
The banking industry will be forced to take hundreds of billions of dollars of further writedowns on mortgage-backed securities after Merrill Lynch sold $30.6 billion (£15.5 billion) of collateralised debt obligations (CDOs) for only 22 per cent of their face value on Monday, according to a leading US ratings expert.
Freddie Mac and Fannie Mae, the financial groups that underpin America’s housing market, will be hit worst as they are forced into a combined writedown of about $100 billion, the Egan Jones Ratings Company believes. Mike Mayo, an analyst for Deutsche Bank, said that Citigroup would need to write down the value of its CDO portfolio by $8 billion in the third quarter, based on the Merrill sale price.
At present Citigroup values the securities at 53 cents in the dollar, more than twice the Merrill sale price. Merrill Lynch is among the biggest victims of the credit crunch and is selling high-risk assets such as CDOs, which are pools of mortgage bonds, in order to regain financial stability.
The CDOs that Merrill sold, which originally had a face value of $30.6 billion, had been marked down to $11.1 billion at the end of June. Less than a month later, the assets were sold for $6.7 billion to Lone Star, a private equity fund.
Sean Egan, of Egan Jones, called the sale a watershed moment, with implications that would trigger huge additional writedowns on CDOs and related assets worldwide. “This sends a loud and clear signal that the issue with CDOs is not liquidity in the market but problems with the value of their underlying assets,” he said.
Many owners of CDOs have marked down their value insufficiently, believing that such assets were sound and that the market’s appetite for them had dried up temporarily amid nervousness about all but the safest forms of debt.
Mr Egan said that Monday’s sale indicated that the problems were not temporary and that there needed to be widespread devaluation of CDOs. Mr Egan said: “The accountants will have to put significant pressure on their clients to write down these assets — Fannie Mae and Freddie Mac in particular — as this high-profile transaction has underscored the losses that are inherent in these kind of asset-backed securities.”
Freddie Mac disclosed at the end of March that it had $32 billion of losses on various securities that it deemed “temporary” and which were not reflected in its accounts. Fannie Mae reported $9 billion of similar losses at the same time. However, the writedowns will need to be much greater than that, Mr Egan said, in part because the market for CDOs has deteriorated significantly since March.
The extra losses that Mr Egan forecasts could double writedowns that financial institutions have taken so far in relation to the credit crisis, which stand at $400 billion. Merrill’s writedown lifted hopes that financial services firms were beginning to take action to draw a line under their sub-prime losses.
Those hopes boosted America’s stock markets, along with the announcement of strong second-quarter results by US Steel and a falling oil price. The Dow Jones industrial average closed up by 266.50 points at 11,397.60. Merrill’s shares rose almost 8 per cent to $26.25.
View of Merrill CDO Sale Darkens: None Of The Gains, All The Losses
Merrill Lynch & Co. gave up any potential gains on $30.6 billion of securities it sold this week while remaining "on the hook" for losses, Bank of America Corp. analysts said, revising their earlier positive view of the sale.
Merrill agreed to sell collateralized debt obligations to private-equity firm Lone Star Funds for about 22 cents on the dollar and to lend about 75 percent of the purchase price. Bank of America analysts, who said yesterday the sale "suggests the endgame" for banks' CDO risk, today wrote they had overstated the "positive implications" of the transaction.
A drop in the value of the CDOs by about a further 5 cents would wipe out the equity from Lone Star and "leave Merrill back on the hook for the exposure," said the analysts, led by Jeffrey Rosenberg in New York. Lone Star bought "the upside of the underlying subprime assets in the CDO pools" while Merrill retained "most of the downside," they wrote.
Merrill, the third-biggest U.S. securities firm, has written down or lost almost $52 billion mainly on mortgage-backed CDOs since the third quarter of last year. Financial firms worldwide have marked down or lost $474 billion since the start of the credit crunch. Merrill yesterday raised $8.55 billion by selling new shares to cushion the loss on the asset disposal. The bank will have recourse only to the CDOs it sold should Lone Star fail to repay the loan, it said July 28.
Lone Star effectively "purchased a call option on the value of the subprime assets backing the CDO" for the $1.68 billion it paid from its own funds, or about 5 cents on the dollar, the Bank of America analysts wrote today. That is about the level indicated by the lowest-rated portions of the benchmark Markit ABX.HE BBB- indexes of mortgage-backed securities.
An option gives the holder the right and not the obligation to buy or sell a security at a stated price. A call option, which gives the right to buy, is a bet the price of a security will rise. The Bank of America analysts wrote yesterday that the sale "creates initial losses but relieves future uncertainty," before issuing its report today, titled "On Second Thought?"
The cost of protecting Merrill against non-payment of its debt fell 15 basis points to 265, according to credit-default swap prices from CMA Datavision in London. Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.
A decline indicates an increase in the perception of credit quality. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year. Merrill rose as much as 7.6 percent to $28.25 in New York trading and was at $26.67 by 10:22 a.m.
Merrill's sale "may set a benchmark that will be followed by other financials," BNP Paribas SA analysts wrote in a client note today, saying they "do not believe that other banks" have written off 75 percent of the value of their CDOs as Merrill has.
"As more firms follow, writedowns will inevitably occur," according to BNP.
Citigroup Inc., the biggest U.S. bank, will probably write down the value of CDOs by $8 billion in the third quarter, Deutsche Bank AG analyst Mike Mayo said yesterday. The company may be forced to raise more capital as a result, Mayo said. CDOs repackage bonds, loans and credit-default swaps and use the income to pay investors. Merrill spokeswoman Jessica Oppenheim in New York said the firm's policy is to decline to comment on analyst reports.
Fed Extends Emergency Lending Amid Continued Credit-Market Stress
Facing continued troubles in credit markets, the Federal Reserve said Wednesday it is extending its emergency lending to investment banks through January and expanding several other direct-loan programs created over the past year.
The moves are a recognition of the fragile conditions in financial markets that are threatening to worsen the credit crisis and restrain the overall economy despite a series of deep interest-rate cuts and other aggressive moves since last September. The central bank said in a statement that the steps are designed "to enhance the effectiveness of its existing liquidity facilities."
The lending to investment banks, started in March after the collapse of Bear Stearns Cos., allows investment banks to take overnight loans directly from the Fed's discount window. That program, known as the primary dealer credit facility, was set to expire in September. Its creation led the Fed to increase its oversight of major investment banks.
The Fed extended the program through January 30, 2009, but said "the facilities would be withdrawn should the Board determine that conditions in financial markets are no longer unusual and exigent." The central banks also extended a separate program, the Term Securities Lending Facility, through January. That $200 billion program allows investment banks to receive 28-day loans of Treasury securities.
In addition, the Fed said it authorized the auctioning of options of up to $50 billion under that program "for exercise in advance of periods that are typically characterized by elevated stress in financial markets, such as quarter ends." That may prevent further market stresses as investment banks remain under pressure.
The Fed said it would auction loans to commercial banks lasting 84 days in addition to the 28-day loans under the Term Auction Facility. That program was created as an alternate to the Fed's discount window, which is generally used by banks for last-minute funding needs but often carries a stigma from those banks the fear being seen as troubled.
The $25 billion auctions for 84-day loans will start August 11 and alternate with $75 billion in 28-day loans. The total credit available under that program will be $150 billion. The central bank also said it would increase the size of a swap line with the European Central Bank to $55 billion from $50 billion to accommodate an increase in the ECB's auctions of U.S. dollars.
The ECB and Swiss National Bank are extending 84-day loans in addition to 28-day funds. The Swiss central bank's swap line remains at $12 billion. The ECB last upped its swap line with the Fed back in May, to $50 billion from $30 billion. Since then, the central bank has held auctions of $25 billion in 28-day funds every two weeks. It debuted the swap line with auctions in increments of $10 billion last December.
Demand for the dollar funding has been rising at each auction since May. In the most recent auction Tuesday, 63 banks bid more than $101 billion for the $25 billion auction. That was the highest number of institutions to bid, and the highest ration of demand to the amount of funds available, since the ECB opened its swap line with the Fed in December.
As the deflationary process unfolds
A trader friend opined to me yesterday that he “hears” that there are lots of “shorts” in the credit markets and it could get “squeezed”. Minyans need to look past this type of talk. As the deflationary process unfolds, we're going to be exposed to all kinds of such talk, innuendo, and mis-information.
First of all the credit markets are not really structured like that. There are very few ways to “short” it. There are a few indexes, which may be crowded because of the lack of them, that people can short to hedge their exposure or bet on declines in price, but the relative notional shorts compared to the longs is insignificant. But this is not really the point.
The big picture is this. For the last twenty years the Federal Reserve has used the banking system to expand the credit base of the economy. They kept interest rates low to encourage borrowing. Beginning in 2001 and 2002 the Federal Reserve went into overdrive, driving real interest rates negative and thus encouraging massive speculation in credit. The result is a money supply six times normal relative to GDP but more importantly one bloated with debt with virtually no relative savings to support it.
The system is now broken as evidenced by the TAF facility: the very definition of this is “the financial system has no more capital left and the TAF is the only way the Federal Reserve can get capital back in the system. So the Federal Reserve has taken bad debts in exchange for capital onto their balance sheet. This makes them very nervous.
It's not a far fetched thought to believe that the new SEC rules were specifically implemented to drive financial stocks up in order to allow them to raise capital through stock offerings. The capital would make it more probable that these banks are eventually able to take the bad debt back from the Fed. This serves as a warning to those who are tempted to fall for this and buy financial stocks on these secondary stock offerings.
Again, we hear from apologists that banks selling stock will "heal" the system. But again that's not how it works. It only transfers wealth from one part of the system to another because wealth is not being created. There's no production, only transfer. It's a hallmark of deflation that companies sell stock.
That is deflationary. People have to use cash to buy stock. So cash goes from investors who have less cash to buy things with, to banks who use it to write down debt. But the point is banks selling stocks to investors reduces liquidity, it does not increase it.
The government’s strategy is to buy time. It always is. Time allows it to slowly drain wealth from the poor/middle class and re-distribute it to the rich who own the financial system. The only important thing to me and what I think Minyanville is all about is to try to help people not be one of them.
As risk grows, lower yours. Stay out of risky assets. Stay out of debt. Don’t be tempted by the trading types. All their little “tells” sound good but they don’t work in a market like this. Don’t bottom fish unless you have excess capital you're willing to lose.
There will be opportunity at some point, and you're going to want to have savings when that occurs, but it's far from here and you will know when it happens. You'll be able to find an investment where the returns are adequate to low risk. Today we only have returns subject to very high risk (possible high returns or possible negative returns versus high risk).
Risk is high. Keep yours low. Be patient.
Banks under pressure to follow $30 billion Merrill cut-price debt sale
Global banks including Citigroup and UBS faced pressure yesterday to write down or sell billions of dollars in toxic assets following Merrill Lynch's disposal of $30bn (£15bn) in mortgage-related securities at a cut price.
Shares in Merrill and other financial companies rose on investors' hopes that the sale of collateralised debt obligations for $6.7bn, or 22 cents on the dollar, heralded similar deals by other banks to purge their balance sheets of bad assets. However, the low price paid by Lone Star Funds, a distressed debt investor, for Merrill's CDOs also sparked fears that the financial system could enter another spiral of writedowns followed by highly dilutive capital raisings.
Merrill yesterday raised $8.5bn - to offset $5.7bn of writedowns caused by the CDO sales and other losses - by selling shares at $22.50, a 7.5 per cent discount to Monday's close. Mike Mayo, a Deutsche Bank analyst, said Merrill's action, which was announced on Monday - a fortnight after John Thain, chief executive, said it did not need more capital - "raises ongoing credibility issues for the industry".
William Tanona, a Goldman Sachs analyst, said that if Citi were to write down its $22.7bn of CDOs to the levels implied by the Merrill deal, it would take a $16.2bn hit. Citi said this month that it valued its CDOs at about 61 cents on the dollar. Citi declined to comment.
UBS, which had $6.6bn in CDO exposure at the end of March, declined to comment. Merrill's capital raising will dilute shareholders. However, Temasek, the Singaporean sovereign fund that invested $5bn in Merrill last year, will receive $2.5bn to compensate it for the paper loss on its investment.
Australia faces worse crisis than America
The world's financial storm has swept through Australia and New Zealand this week amid mounting signs of contagion across the Pacific region.
Financial shares were pummelled in Sydney on Tuesday after investor flight forced National Australia Bank (NAB) to slash a £400m bond sale by two thirds. The retreat comes days after the Melbourne lender shocked the markets by announcing a 90pc write-down on its £550m holdings of US mortgage debt, an admission that it AAA-rated securities are virtually worthless.
In New Zealand, Guardian Trust said it was suspending withdrawals from its mortgage fund owing to "liquidity difficulties in the market". Hanover Finance - the country' third biggest operator - last week froze repayments to investors. The company said its "industry model has collapsed" as the housing market goes into a nose dive. Some 23 finance companies have gone bankrupt in New Zealand over the last year.
It is now clear that the Antipodes are tipping into a serious downturn. Australia's NAB business confidence index fell to its lowest level in seventeen years in June. New Zealand's central bank began to cut interest rates last week on fears that the economy may have contracted in the second quarter, and is now entering recession. Housing starts slumped 20pc in June to the lowest since 1986.
Gabriel Stein, from Lombard Street Research, said Australia could prove vulnerable once the global commodity cycle turns down. It has racked up a current account deficit of 6.2pc of GDP despite enjoying a coal, wheat, and metals boom, effectively spending its resources bonanza in advance. Household debt has reached 177pc of GDP, almost a world record.
"It is amazing that in the midst of the biggest commodity boom ever seen they have still been unable to get a current account surplus. They have been living beyond their means for 10 years. What worries me is that productivity growth has been very low: they have coasting after their reforms in the 1990s," he said.
Australia's Reserve Bank has had to grapple with vast inflows of Asian capital, especially Japanese money fleeing near zero rates at home. Short of imposing currency controls, it would have been almost impossible to stop the inflows.
"The easy money went straight into real estate," said Hans Redeker, currency chief at BNP Paribas. "Australia will now have to generate 4pc of GDP to meet payments to foreign holders of its assets," he said. This is twice as high as the burden faced by the US.
Both the Australian and New Zealand dollars have fallen hard in recent days and now appear to be breaking down through key technical support against major currencies, including the US dollar. "The Aussie is going down, big time," said Mr Redeker.
The picture is darkening across the Pacific Rim. The Bank of Japan's deputy governor, Kiyohiko Nishimura, said its economy may now be falling into a "technical recession". Household income dropped 2.1pc in June compared to a year earlier and manufacturers are the gloomiest since the deflation crunch in 2003.
The decision by National Australia Bank to make drastic provisions on its US mortgage debt could have ramifications in the US itself. It opted for a 100pc write-off on a clutch of "senior strips" of collateralized debt obligations (CDO) worth £450m - even though they were all rated AAA. No US bank has admitted to such fearsome loss rates.
Bush signs housing rescue plan into law
As home foreclosures rise and property values slump, U.S. President George W. Bush on Wednesday signed into law a rescue package that includes emergency backstops for mortgage financing companies Fannie Mae and Freddie Mac.
Despite opposition to a provision that offers $4 billion in grants to states to buy and repair foreclosed homes, Bush reversed his opposition to the overall legislation because it included numerous other key housing reforms.
The new law boosts oversight of Fannie Mae and Freddie Mac, which own or guarantee almost half the country's $12 trillion in home mortgage debt. It also expands a temporary line of U.S. Treasury credit and gives the government the option to buy shares in them if they ran into trouble.
"We look forward to put in place new authorities to improve confidence and stability in markets, and to provide better oversight for Fannie Mae and Freddie Mac," said White House spokesman Tony Fratto. Bush signed the measure in the Oval Office shortly after 7 a.m. EDT with his economic team on hand, including Treasury Secretary Henry Paulson who helped negotiate the package with the Democratic-controlled Congress.
The new measures come as prices of U.S. single-family homes plunged at a record pace in May from a year earlier. The closely-watched Standard & Poor's/Case Shiller composite index of 20 metropolitan areas fell 0.9 percent in May from April, bringing the measure down 15.8 percent from May 2007.
The new law also sets up a $300-billion fund under the Federal Housing Administration to help distressed homeowners get more affordable, government-backed mortgages and get out from under exotic mortgages they cannot afford.
"The Federal Housing Administration will begin to implement new policies intended to keep more deserving American families in their homes," Fratto said.
The bill also offers tax breaks to spur home-buying; sets up the first national licensing system for mortgage brokers and loan officers; and raises the limit on the size of mortgages that federal agencies can guarantee.
Home Prices In May Took A Steep Fall
Home prices registered their sharpest annual declines in at least two decades as consumer gloom about the labor market deepened, according to two closely watched surveys.
The S&P/Case-Shiller index, which tracks prices in 20 U.S. markets, found that in the 10 metropolitan areas it has tracked since 1987, prices declined 17% in May compared to the same month a year earlier, the largest annual decline since the survey began. Home prices in 20 metropolitan areas followed since 2000 dropped 16% in May from a year earlier, with a decline of 23% since the peak in July 2006.
On a month-to month basis, the 10-market survey declined 1% in May and the 20-market survey dropped by 0.9% Not all the data were negative. Of the 20 markets tracked, house prices rose in seven in May from April. But many economists said the housing market has yet to bottom out nationally because home supply still outstrips demand.
Las Vegas and Miami, once hot housing markets, had the biggest drops in value, declining 28.4% and 28.3%, in May from a year earlier. Prices in those areas also fell 2.9% and 3.6%, respectively, in May on a month-to-month basis. Charlotte and Dallas were the only two markets to have three straight months of rising house prices.
"It's not all a matter of tighter financial conditions scaring borrowers," said Alan D. Levenson, chief economist for T. Rowe Price Associates. "Borrowers don't want to borrow as much because the expected returns aren't as great."
Separately, the Conference Board said its consumer-confidence index rose slightly to 51.9 in July from 51.0 in June, the first increase after six months of sharp drops. But consumers' assessment of their job prospects worsened somewhat, with those saying that jobs are harder to find increasing by about 0.6 percentage point.
About 16% of respondents now expect their family income to decrease in the next six months, up from 9.8% at the start of 2008. That is the highest reading since the survey began in 1967.
The gain in the overall index came from slightly improved expectations, which rose to 43.0 from 41.4, as gas prices edged downward and the stock market improved. Ian Shepherdson, chief U.S. economist for High Frequency Economics, said consumer confidence was still "extraordinarily weak."
U.S. mortgage applications fall to 2000 levels
Applications for U.S. home mortgages dropped to their slowest pace since December 2000 as loan rates hovering near one-year highs compounded the housing market's woes, according to data from an industry group on Wednesday.
The Mortgage Bankers Association said its seasonally adjusted index of mortgage application activity declined 14.1 percent to 420.8 in the week ended July 25. The decline was the most severe move in percentage terms since May. The MBA's seasonally adjusted index of refinancing applications plunged 22.9 percent to 1,074.4 last week. The MBA's gauge of loan requests for home purchases fell 7.8 percent to 309.5.
Fixed 30-year mortgage rates averaged 6.46 percent in the week, compared with a one year-high of 6.59 percent in the prior week, the MBA said. While concerns of faster inflation have boosted the market rates that influence mortgages, the credit crisis has hurt banks' ability to support the market for mortgage-backed securities, applying upward pressure to the rates that lenders charge to consumers.
A slowing rate of applications suggests potential homebuyers may be expecting better deals in the future as rising foreclosures and a softening economy nudge home prices lower. Prices of U.S. single-family homes measured in 20 major metropolitan areas have dropped about 16 percent in the past year, with few signs of recovery, according to S&P/Case Shiller Home Price Index on Tuesday.
Sales of existing homes in June also dropped to their slowest pace in 10 years, the National Association of Realtors said last week.
Ilargi: Charles Hugh Smith writes a nice blog, and in this piece says a lot of the right things. Yet, he fails to draw the entire conclusion. He moves into the direction of my "80% or more" prediction concerning losses on US home values; why he thinks it’ll stop at 66%, I have no idea.
What seems to have been solved when prices are down to $70.000, namely affordability, will in fact not be solved at all: affordability is not a fixed number, it is a direct function between available capital and credit on the one hand, and prices on the other.
If prices fall by 66% from the 2006-7 peak, and capital/credit also falls by 66%, the problem remains the same. Today's prices are already too high for today's available capital. If capital falls, prices will therefore have to fall more.
And since banks, governments and individuals are all heavily in debt, with much more to come, available capital is certain to come down enormously. No matter the bail-outs, they change nothing but a tiny fraction of money flow -and push citizens even deeper into debt in the process.
In the 1930's nobody had access to any credit, except for the already well-to-do (who didn't need it). That is where we are heading. And that is why home prices will plunge well over 66%.
How the Median House Price Will Fall from $215K to $70K
I am constantly amazed (yes, I know I shouldn't be) by how many otherwise intelligent people expect housing to "recover" next year. I shouldn't be surprised, of course, because fantasy and hope are the key traits of all post-bubble busts.
Thus we had analyst after analyst in 2001 and 2002 calling "the bottom" in the Nasdaq, even as it fell from 5,000 to 3,000 to 2,000 and then finally to 1,000. In a similar fashion, we now have a nearly universal belief that oil and commodities have "topped out" and the recent decline is a new trend.
Happy days are here again, oil is heading back to $75/barrel, hoo-ha! In a similar fashion, we should not be fooled that a brief market reaction is the start of a new trend, i.e. "housing will soon bottom." On the contrary, I predict the median price of a house in the U.S. will fall from $215,000 all the way down to $70,000.
According to the National Association of Realtors, the median home price was $215,100 in June 2008. These data sources suggest the median is around $230,00 and the average around $300,000: US: Median Price of Houses Sold including Land Price and US: Average Price of Houses Actually Sold.
Whatever number you pick, I predict a 2/3 decline from here, based on these long-term trends and historical patterns:
1. A further 30% decline is required to bring rents and the cost of ownership back into the long-term historical range/ratio. The only reason to buy a house/dwelling which costs far more than renting the equivalent residence is the investment belief that appreciation of the property will exceed (after all the tax benefits are calculated in, etc.) the appreciation of other asset classes. (Note: the ratio varies depending on locale, but in general it is still out of whack from the mean.)
In other words, it's an investment decision, not a decision about owning a place to live. If real estate proves to be a poor investment which only depreciates year after year, this belief (currently a near-religious belief of stupendous power in the U.S., based on the past 25 years of debt-fueled speculative frenzy), then housing will decline back to the historical ratio.
Now if rents are set to rise 30% above inflation, then the argument could be made that housing will not decline; but with wages in a long-term decline and the economy souring, what rise in income is foreseeable which would fuel a rise in rents? It is more likely that rents will decline in most markets as well, further pressuring the decline in housing values.
2. The cost of money will rise for a generation. The two keys to appreciation in real estate are: cheap, easily available money/mortgages, and a highly liquid market in which any property can be quickly bought/sold. Guess what's disappeared and won't be coming back: cheap, easy money and a liquid market. If you are fearful that you can't sell the house you're about to buy, then it's a Capital Trap you will want to avoid.
And if money becomes tight again, then a 20% down will be standard once again--and in a recession which has strangled credit, asset values and the economy, how many people will have saved up that much cash? How many will be willing to sink all that cash into a Capital Trap? Relatively few compared to the hordes who "qualified" in the era of liar-loans, no-down, interest-only loans, etc.)
3. Oversupply and vast overbuilding render the market illiquid. With almost 20 million empty dwellings (of which perhaps 4-5 million are true "vacation/second homes") and huge numbers of empty rooms in existing housing, the number of homes for sale will exceed the number of qualified buyers for a long time to come.
PIMCO's Bill Gross went on record recently suggesting 1 million homes should be dynamited; good idea, Bill, but that still leaves 15 million empty dwellings. Please don't tell me about population growth: Immigration is already slowing because jobs are drying up, and household size in the U.S. can easily rise, enabling more people to live in the same number of dwellings.
The overbuilding was not the result of meeting demand for housing, it was all about meeting the demand for speculative vehicles. Once the speculators are slowly roasted year after year by declining prices, then eventually nobody will be thinking that housing is a "great investment."
Once that belief system has been eradicated via everyone who acted on it being destroyed financially, then housing will once again be viewed as shelter rather than a speculative vehicle for investment or "get rich quick" deals.
Fannie Mae, Freddie Mac Live to Die Another Day
Two weeks ago, with their stock prices plummeting and accusations of insolvency swirling through the marketplace, Fannie Mae and Freddie Mac, the two giant mortgage-finance companies, stared into the abyss.
What looked like a black hole turned out to be a blank check from the U.S. Treasury: an unspecified and unlimited credit line, borrowing privileges at the Federal Reserve's discount window, and a pledge of a capital injection from the government if needed. The Securities and Exchange Commission coughed up additional protection, tightening the rules for short-selling of Fannie and Freddie, along with 17 other financial stocks.
Mission accomplished? With the government making explicit the implicit guarantee of the two government-sponsored enterprises, which together own or guarantee $5.2 trillion of the nation's $12 trillion of mortgage debt, the hope is that Fannie and Freddie won't have to tap the emergency backstops. The fear is that the needed makeover will stop there.
If these public-private hybrid companies are too big to fail -- and everyone from the Bush administration to Congress to businesses and homeowners agrees that they are -- then by definition they are too big to survive in their current state, a paradox voiced by William Poole, former president of the Federal Reserve Bank of St. Louis, in a July 27 New York Times op-ed.
The lame-duck Bush administration, no fan of Fannie and Freddie until recently, has neither the clout nor the interest to refashion the companies. Treasury Secretary Hank Paulson has said repeatedly that Fannie and Freddie, which play "a central role" in the housing finance system, "must continue to do so in their current form as shareholder-owned companies."
Congress, for its part, isn't interested in an extreme makeover. As part of the Federal Housing and Economic Recovery Act of 2008, awaiting presidential signature, lawmakers provided for a "world class" regulator for the GSEs, according to the Senate Banking Committee's summary of the legislation. (Quotation marks theirs.)
An interesting choice of words. Regulators get their mandate and powers from Congress. Lawmakers, by their own admission, seem to be saying the current GSE regulator, the Office of Federal Housing Enterprise Oversight, is a bantam weight. If Ofheo is, then it's of Congress's choosing: a choice heavily influenced by one of the most effective lobbying machines in Washington.
Earlier this month, Senator Jim DeMint, Republican of South Carolina, said that any federal bailout of Fannie and Freddie should include a ban on their "lobbying and political activities." "Any legislation exposing taxpayers to this risk should include a serious debate on long-term reforms, and a ban on lobbying must be included," DeMint said. "
DeMint tried to hold up Senate passage of the bill last week by forcing a vote on an amendment to curtail lobbying by the GSEs, the only government agencies to engage in such a practice. The Senate leadership rejected his request. Congress isn't known for its long-term thinking.
To the extent that the immediate crisis abates -- borrowing isn't a problem now that Fannie's and Freddie's debt carries the full faith and credit of the U.S. government -- it will reduce the impetus to seek a long-term solution, which is exactly what's needed. A "world class" regulator isn't the solution. Eliminating the asymmetric risk/reward from Fannie and Freddie is.
If the taxpayer is going to shoulder the burden for bailing out Fannie and Freddie, the taxpayer should stand to benefit. It makes no sense to guarantee the debt of a private company, the benefit of which accrues to the shareholders, and not own the equity.
And it isn't only a bunch of right-wing, free-marketeers pushing for a re-evaluation of the role of the GSEs in the 21st century. Former Treasury Secretary and Harvard University Professor Larry Summers, who is an economic adviser to Democratic presidential candidate Barack Obama, said the priority should be protecting the taxpayers and financial system, with the stockholders and subordinated-debt holders taking the hit.
Summers's idea is to run the GSEs as public corporations for a few years, after which their government and private functions could be divided, with the latter sold off. Fannie Mae, created in 1938 and re-chartered as a shareholder-owned company in 1970, and Freddie Mac, chartered in 1970, have strayed far afield from their original mission, which was to provide liquidity, affordability and stability to the housing market.
Nothing in there about "using its cost-of-funds advantage to lever its balance sheet," said Josh Rosner, managing director at Graham Fisher & Co. in New York. "Buying manufactured housing, aircraft lease equipment, Alt-A mortgages: the taxpayers should not fund the non-corporate businesses."
What's more, only 7 basis points of the GSE subsidy benefited the home buyer, according to a study by Federal Reserve economists. Now that Congress has passed a housing-rescue bill, which authorizes the Federal Housing Administration to insure as much as $300 billion of refinanced mortgages in addition to establishing a new GSE regulator, "they think the problem is fixed," said Jim Bianco, president of Bianco Research in Chicago.
Bianco expects the other shoe to drop, perhaps in early August, when Freddie Mac reports quarterly earnings. "Freddie announced its intentions to raise $10 billion of equity on July 18, filed a shelf offering on the 22nd, and the clock is still ticking," Bianco said. "It took Merrill Lynch 12 hours to pull off an $8.55 billion stock sale."
In this era of big government, it's good to know there are a few things the market still does better.
Goldman sees bank buy unlikely, analyst Whitney says
Goldman Sachs Group Inc management was quoted by analyst Meredith Whitney as saying that the largest U.S. securities firm was "highly unlikely" to buy a retail bank given current regulation, and that current market environment posed strong headwinds to earnings growth.
"While much speculation has been made about Goldman's interest in acquiring a retail bank, we believe the chances are less than slim," the Oppenheimer & Co analyst wrote in a note to clients. On Tuesday, analyst Whitney met with Goldman's Chief Financial Officer David Viniar, Co-President Jon Winkelried, and Head of Investment Banking David Solomon.
"Management stated that the company would only be interested in purchasing a bank if it was able to use the acquired deposits as a funding source for any other part of the business and without additional regulatory scrutiny," Whitney said. "Obviously, current regulation makes that scenario impossible," she added.
The credit crunch has prompted analysts and investors to speculate that Goldman, eager to establish a new and more stable source of funds, would snap up a bank. The market talk has gained strength in recent weeks as rising loan losses and worries about the U.S. economy has made bank stocks cheap.
Earlier this week, Merrill Lynch analyst Guy Moszkowski, who had also met with CFO Viniar, said Goldman had considered buying a deposit-taking bank, but added that such a deal was not very likely now.
"CFO Viniar did caveat that clearly if the regulatory pendulum swung to an extreme so as to force broker dealers to convert into a bank holding structure... then GS would be interested in acquiring bank deposits," Whitney said.
Viniar expects additional regulation for broker-dealers, including greater U.S. Federal Reserve oversight, more disclosure requirements and higher capital requirements, Whitney said. Viniar, however, does not expect broker-dealers to be subject to full bank regulations, she added.
Goldman, which has largely avoided the credit losses hobbling its rivals, acknowledged that the current environment of low levels of activity and lack of confidence in the markets posed strong headwinds to earnings growth, Whitney said.
"Management believes these headwinds will continue to persist if not accentuate," she added. Goldman also expects material reduction in investment banking headcount by year-end, Whitney said.
The company, however, has positioned itself with healthy liquidity and "dry powder" to take advantage of attractive opportunities and potential share buybacks, she said. Whitney rates the stock "perform." Shares of Goldman were up 1 percent at $183.47 in morning trade on the New York Stock Exchange.
Merrill's fire sale sparks fears of more write-downs by the banks
Merrill Lynch's decision to sell mortgage derivatives with a face value of $30bn for less than $7bn has raised fears of more write-downs to come across the troubled banking sector.
And as investors debated whether the fire sale marks the bottom of the credit crisis, there was evidence yesterday that US house prices are continuing to fall, further reducing the value of the collateral that underlies hundreds of billions of dollars of these derivatives.
Wall Street has so far lost more than $400bn on investments in so-called collateralised debt obligations (CDOs) and the final tally will not become clear until the housing market stabilises. However, Merrill's sale does put a current market price on securities that have not been changing hands since the credit crisis began.
At 22 cents on the dollar, that is a lower price even than many had feared. Sceptics also pointed out that Merrill had lent the buyer, the private equity firm Lone Star, 75 per cent of the money to do the deal.
Meredith Whitney, the bearish banking analyst at Oppenheimer & Co, called Merrill's sale a "capitulation", while Prashant Bhatia, analyst at Citi, said it would have consequences across the sector. "This is a watershed transaction that provides price transparency. This is the first large-scale CDO transaction that is not a distressed sale."
Analysts said Citigroup, the US banking conglomerate, would now be forced to recalculate the value of its remaining holdings in mortgage derivatives known as collateralised debt obligations, which were valued at its last results at $22.5bn. Deutsche Bank estimated that this could lead to a write-down of another $7bn.
After Citigroup, UBS has the next largest exposure to CDOs, most recently valued at $15.6bn. In the UK, shares of Barclays and Royal Bank of Scotland were hit, since both have significant holdings of CDOs. Barclays shares fell as much as 9.5 per cent but closed down 4.1 per cent, while RBS stock closed down 2.7 per cent after dropping more than 7 per cent earlier.
Barclays has taken smaller write-downs than most other banks, insisting that its assets are of higher quality than those held by rivals. It wrote down £1.7bn on credit holdings in the first quarter and didn't take further significant charges in the second quarter. RBS has already flagged £5.9bn of write-downs on sub-prime related assets and leveraged loans this year.
Whether Wall Street has written down the value of CDOs by enough, or perhaps even by too much, will depend on the numbers of US homeowners who default on mortgages and the price fetched for repossessed homes.
The Case-Shiller index of house prices in the country's 20 biggest metropolitan areas, released yesterday, showed prices sharply down on a year ago, although the pace of decline has slowed in most areas. The year-on-year declines are still across the "sunbelt" – from Miami, Florida, to Los Angeles in California – which had been the hottest markets during the boom.
The average US home, according to Case-Shiller, is down 15.8 per cent in value on a year ago.
By cutting his losses rather than waiting to see if mortgage derivatives increase in value, CEO John Thain hopes to put Merrill Lynch on a more secure financial footing, ending months of rumours about its capital position which had buffeted the stock.
The financial restructuring also included an $8.5bn share issue, which was a significant U-turn for Mr Thain, who had previously said the company had enough cash.
Merrill sparks fears of soaring costs
Merrill Lynch's surprise write-down ratchets up pressure on rivals to cut the values of their own subprime assets as they grapple with mounting debts and economies weaken.
The global credit crisis, roughly a year under way, could cause total damage of around $1 trillion to balance sheets of financial services companies. That's far above the more than $400 billion of write-downs taken so far. Merrill's revelation of a $5.7 billion (2.8 billion pounds) write-down and plans to sell $8.5 billion of stock heightened worry of more pain to come from European lenders UBS AG and Barclays, and from Wall Street and U.S. commercial banks.
Citigroup , Bank of America Corp, Lehman Brothers Holdings and Wachovia, for example, each still have billions of dollars of exposure to complex debt, mortgages, or both. About $4.4 billion of the Merrill write-down came from a sale of $30.6 billion of collateralized debt obligations -- which are typically backed by mortgages -- to private equity firm Lone Star Funds for $6.7 billion, or 22 cents on the dollar. Merrill had valued the CDOs at $11.1 billion just four weeks ago.
"It was a very aggressive markdown," said Chris Henson, a portfolio manager at MFC Global Investment Management in Toronto. "The question is, is that now the clearing price for anyone who has CDOs?" Prospects of more write-offs and credit losses have already battered lenders' shares. The Standard & Poor's Financials Index , for example, had through Monday fallen 32 percent this year, twice the S&P 500's .SPX decline.
"The current environment is not one where people are prepared to give the benefit of the doubt," said Gerry Rawcliffe, group credit officer for financial institutions at Fitch Ratings. "There's a broad loss of confidence in banks." Merrill's sale may also offer insight into the value of rivals' so-called Level 2 and Level 3 assets. Banks value these based on prices of similar securities in the marketplace, or on their own models when there is no market for them.
"Other buyers out there are going to use this as a reference point," said Michael Hampden-Turner, a Citigroup credit strategist. "The question is, to what extent does 22 cents constitute fair value, or the price at which a bank could offload a huge volume of very distressed assets?" It remains difficult for outsiders to assess the quality of assets on balance sheets. Some banks, such as Barclays, claim their assets are better-quality and more well-hedged.
Citigroup said it ended June with $22.5 billion of subprime exposure. That included $18.1 billion of super-senior asset-backed securities CDOs (ABS CDOs), the kind of debt Merrill sold, including $14.4 billion of commercial paper. Deutsche Bank Securities analyst Mike Mayo said Citigroup might face an $8 billion write-down on CDOs, as the bank has valued them at 53 cents on the dollar. Fox-Pitt Kelton analyst David Trone estimated a $4 billion write-down.
Citigroup spokeswoman Shannon Bell declined to comment. On July 18, Chief Financial Officer Gary Crittenden said: "There has not been a single American dollar cash flow loss against the asset-backed commercial paper ... I rush to add that that is not a forecast for the future."
According to Oppenheimer & Co analyst Meredith Whitney, Lehman ended May with about $600 million of gross ABS CDO exposure, and $29.4 billion of commercial mortgage exposure. Lehman spokesman Randy Whitestone declined to comment. Bank of America said it ended June with $8.43 billion of net CDO exposure, including $5.17 billion of subprime debt it was carrying at 43 percent of its original net exposure.
"We price our CDOs frequently during the quarter," spokesman Bob Stickler said. "The values take into account everything, including underlying asset flows and external market events. We would certainly take the Merrill sale into account, but it wouldn't be a single driver of valuation."
European lenders may also take hits. Stuart Graham, a Merrill analyst in London, said that under his revised "stress test," large banks on that continent may have $58 billion of future write-downs, up from his prior $22 billion assumption. Falling asset values could also make lenders less able to lend or more skittish about extending credit.
"They become much more cautious," Citigroup strategist Hampden-Turner said. "If you are a homeowner, it is harder to refinance. If you are a company, you can't borrow money as before." Pacific Investment Management, where Chief Investment Officer Bill Gross runs the world's biggest bond mutual fund, last week estimated that global banks could face $1 trillion in losses from the credit crisis and lowered asset prices.
Wachovia said it ended June with $5.86 billion of subprime exposure, including $4.38 billion of mostly hedged ABS CDOs. It also has a $122 billion portfolio of adjustable-rate mortgages where many borrowers owe more than their homes are worth. Spokeswoman Christy Phillips-Brown declined to discuss the exposures, but said the fourth-largest bank is reducing risk, after losing $8.86 billion in the second quarter.
Wachovia has hired Goldman Sachs Group, a Wall Street bank that largely sidestepped the credit crisis, for advice on what to do with its loan portfolio. Robert Steel, Wachovia's new chief executive, is also a Goldman alumnus.
Is IndyMac too much for the FDIC?
For all of the press that the failure of IndyMac Bank has generated in recent weeks — it was the largest thrift and the second largest financial institution to ever have failed, after all — it’s what hasn’t gotten press at all thus far that is much more likely to be the largest test of resources at the Federal Deposit Insurance Corp., as it seeks to sell off the bank’s assets.
Consider that IndyMac held the nation’s 8th largest residential mortgage servicing portfolio, at $200.7 billion by the end of the first quarter, according to statistics compiled by Inside Mortgage Finance. Now consider that the FDIC is tasked with managing the single largest servicing transfer tied to a failed bank in history — and by a long shot, too. It’s not even close.
The next closest comparison would be Superior Bank, which failed in July 2001 and serviced a $3.7 billion portfolio of securitized subprime mortgages, eventually sold to former Bear Stearns & Co. subsidiary EMC Mortgage Corp. in February 2002. But this isn’t a $3.7 billion servicing portfolio. This is more than 50 times larger.
Understandably, more than a few MBS investors have been on edge in recent weeks as the future of the servicing portfolio remains up in the air; $184 billion of the loans in the servicing portfolio were sold or securitized, with IndyMac retaining servicing rights. The future of the portfolio will likely remain in limbo for some time longer, as well, as FDIC officials sort through their options for selling off the portfolio.
Many industry participants had suggested to HW at the outset of IndyMac’s failure that trustees would look to move servicing elsewhere — a report by analysts at Credit Suisse Group, published last week, suggested that such movement is unlikely so long as the FDIC continues making servicing advances.
“Even if the trustee elects to initiate a servicing transfer, the FDIC may ignore the request in order to maximize the value of the assets it plans to sell,” wrote the team of analysts, led by Rod Dubitsky. “So the event of default directly resulting from receivership will not trigger an immediate transfer of IndyMac servicing.”
“[W]e believe that once the FDIC decides to assume the servicing contract it would be required to advance and comply with the servicing agreement. The bottom line is that we don’t believe the FDIC can selectively comply with the terms of the servicing agreement.”
HW’s sources have suggested that the FDIC has been blanketing much of the mortgage industry with requests for proposals regarding the servicing portfolio. Beyond large banks with their own servicing portfolio, who have been bidding on the active and parts of the special servicing business, independent REO shops have received requests to bid on pieces of the IndyMac portfolio as well.
“Nobody really knows which way the FDIC will go on this, or if they can sell the entire portfolio to one buyer,” said one source, a senior banking executive that asked his name not be used in this story. “There aren’t but four or five firms that could take on this big of a portfolio in one piece, and so far, it’s anyone’s guess if there’s interest there enough to make it the least-costly scenario the FDIC will look for.”
The team of Credit Suisse analysts postulated that the servicing book could be split along GSE and non-agency lines; $60 billion of loans in IndyMac’s servicing portfolio were sold to either Fannie Mae and Freddie Mac, according to the report.
In the short run, loan modification clearly looks to be on the rise within the IndyMac portfolio.
As HW reported earlier, the FDIC has initiated a foreclosure freeze on the serviced loans owned by IndyMac, equal to roughly 10 percent of the servicing portfolio; the government wants to attempt workouts with troubled borrowers, according to press remarks made by FDIC chairman Sheila Bair.
But our sources suggest that the FDIC is also actively looking into the Pooling & Servicing Agreements that govern the rest of the servicing portfolio, as well, in an effort to gauge the degree of flexibility in loan modification authority that exists.
The team of Credit Suisse analysts suggested that FDIC officials see IndyMac’s substantial portfolio as an “ideal test case with which to trigger a paradigm shift” towards the sort of modifications that Bair has pressed for in the past six months — in particular, the FDIC chairman has strongly advocated use of principal reductions in public speeches recently.
Of course, that all depends on how quickly the FDIC can sell off the servicing portfolio, in whole or in parts. And it depends on whether or what sort of messes the FDIC is called on to clean up next — some of the nation’s largest mortgage servicing portfolios are with institutions that have faced some pretty big challenges of their own as of late.
Among the nation’s top servicers: Citigroup Inc, which holds a $798.8 billion portfolio; Washington Mutual, which holds a $616 billion servicing book; and Wachovia Corp., which holds $197.3 billion.
Growth slump may force Italy out of eurozone
Italy is sliding into a deep structural crisis and risks being forced out of Europe's monetary union as the region's economic downturn gathers pace, according to a new report by Capital Economics.
Over the last decade, the country has failed to reform its labour product markets sufficiently to cope with the rigours of euro membership and is now caught in a spiral of decline as the working population starts to shrink. Productivity growth has slowed to 0.5pc a year.
"An ugly combination of weak GDP growth, poor international competitiveness, and rising government borrowing costs could lead to renewed calls for Italy to leave the euro," said the report, written by Julian Jessop and Roger Bootle. "As things stand, not only will Italy lose ground to the rest of the eurozone, it could soon start to do so at an even more rapid rate," they said.
Italy has lost roughly 40pc in labour competitiveness against Germany since 1995, according to Eurostat data. Capital Economics said Italy - now on the cusp of its fourth recession this decade - faces a "demographic time bomb" as the workforce starts to shrink at an accelerating rate over the next 30 years, making it ever harder to finance the biggest national debt in Europe (107pc of GDP).
There is a risk that the spreads between German Bunds and Italian 10-year bonds could widen quickly from 58 basis points today to over 100 if the question of euro membership creeps back onto the table. Italy set off a minor scare in mid-2005 when two cabinet ministers from the radical Northern League called for a return to the lira.
It was suggested that the political pain threshold in a major economic crisis may be lower than widely assumed. The country regained momentum during the final upswing of the global credit boom, helped by Fiat's remarkable comeback. This has entirely faded. "Italy's upswing has unravelled at an alarming pace," said the report.
Business confidence has fallen to the lowest since October 2001, following the 9/11 terrorist attacks. The country is disproportionately hit by the high euro because it relies heavily on "mid-tech" exports that compete toe-to-toe with Asian goods.
Italy can at least take some comfort that other euro members are feeling the strain too, reducing the risk of EMU break-up. France's Insee consumer confidence plunged to a 21-year low in July. The epicentre of the unfolding crisis is Spain, where the number of houses built this year is expected to collapse by half from the 760,000 constructed in 2007 at the peak of the bubble.
Spanish unemployment is rising by almost 70,000 a month, touching 10.6pc at the end of the fourth quarter. However, Spain has a much small public debt than Italy. Most studies on the risk of an EMU break-up conclude that it cannot occur because the costs would be too high. But this overlooks that markets could set in motion a chain of events that forces a country to leave.
Temasek Gets Sweet Deal As Merrill Raises Capital
Merrill Lynch & Co.'s plans to raise new capital are a great deal for one of its most important investors: Singapore's Temasek Holdings Pte. Ltd.
On Monday, the Wall Street firm announced plans to raise capital through an $8.5 billion share offering. By participating in the plan, Temasek, an investment firm owned by Singapore's government, will essentially wipe out much of its paper loss on a previous $5 billion investment in Merrill Lynch thanks to special downside protections it negotiated at the time.
The deal will also raise Temasek's approximate 9% ownership of Merrill -- potentially even pushing it above the 10% threshold for foreign ownership in U.S. companies that triggers a government review on national-security grounds.
When Temasek agreed to invest in Merrill this past December and March at $48 a share, it secured a price-reset clause. The agreement stated that if Merrill sold new shares within one year at a price less than $48, then Merrill would need to pay Temasek the difference in either cash or shares.
As part of the plans announced Monday, Merrill will issue $2.5 billion in new shares to Temasek. Temasek will kick in an additional $900 million. How much of a stake the company ends up holding in Merrill will depend on the price and number of new shares issued. On Monday, Merrill closed at $24.33, down $3.19 a share.
Temasek's deal highlights the importance of downside protection that sovereign funds and other investors negotiated when they agreed to plug the holes in Western banks' balance sheets left by the U.S. subprime crisis. Investments by sovereign wealth funds into Citigroup Inc. and Morgan Stanley, for example, have been structured to provide a steady, guaranteed return and to convert into shares later.
The terms of the Morgan Stanley deal guarantee China Investment Corp. a 9% annual return until it converts its investment to shares in 2010. The Government of Singapore Investment Corp. and other investors are getting a 7% dividend payment from Citigroup until a similar conversion.
Earlier investments, including ones made by several foreign investors in Barclays PLC, didn't contain such clauses. Temasek agreed to invest an additional £200 million ($398.8 million) and China Development Bank an additional £136 million in a £4.5 billion capital raising that Barclays announced in June. Those purchases, while not a huge increase in their holdings, helped prevent the investors' stakes from being significantly diluted.
Some investment agencies in Asia are coming under attack at home for bailing out foreign institutions when their local stock markets are suffering. And at least one, Korea Investment Corp., a sovereign wealth fund set up in 2005 that manages more than $20 billion, is having second thoughts about its experience, even with protections on its investments.
"We have learned a lot from investing in Merrill Lynch and will take a more cautious approach in the future," KIC Chief Executive Chin Youngwook said Tuesday.
In January, KIC agreed to buy $2 billion of preferred shares in Merrill at a price of $52.40 each alongside other investors. In a deal similar to Temasek's, the Korean investor agreed to convert its holding to ordinary shares earlier than planned in exchange for additional Merrill shares.
Merrill Deal May Cause Banks to Revalue Debt
Merrill Lynch & Co.'s fire sale of assets might burn some other fingers on Wall Street.
In the world of complex and infrequently traded securities, the investment bank's move to unload $30.6 billion in securities to private-equity firm Lone Star Funds produced a rare data point: a market price. And that market price was 22 cents on the dollar.
Securities such as collateralized debt obligations are highly varied and difficult to compare to one another. But analysts said banks, which generally carry securities at higher average values, will have trouble ignoring Merrill's price. It is also possible insurers such as American International Group Inc. could have a harder time viewing the impairment of similar assets as temporary. All of that means the write-downs plaguing Wall Street likely haven't come to an end.
"While these are Merrill-specific deals, they do have the potential to create marks and put pressure on some other companies to de-risk their balance sheets and take their lumps in an effort to move forward," UBS analyst Glenn Schorr said in a note to clients.
Merrill's sale, announced after the market closed Monday, appeared to be the biggest slug of troubled assets sold off in one shot and publicly disclosed by an investment bank during the credit crisis. It also commanded a low price.
Hedge fund Citadel Investment Group paid about $800 million, or 27 cents on the dollar, last year for assets with a face value of $3 billion sold by E*Trade Financial Corp. In May, UBS AG sold $22 billion in mortgage-backed assets to BlackRock Inc. for $15 billion, or 68 cents on the dollar. BlackRock is also liquidating about $30 billion in Bear Stearns assets for the Federal Reserve.
In addition to being large and public, Merrill's sale wasn't forced by a crisis. As such, it will be hard to ignore. "This is the first large-scale CDO transaction that is not a distressed sale," Citigroup Inc. analyst Prashant Bhatia said in a note. "Industry participants will likely mark super-senior CDO assets with 2006 and 2007 vintage collateral down to the 22-cent range."
Deutsche Bank analyst Mike Mayo said Citigroup may have to write down $8 billion on its portfolio of CDOs as a result and cut his earnings estimates for the bank. Citigroup values its portfolio of the securities at 53 cents on the dollar, he said. There are arguments for that position, he said, but he expects Merrill's sale will force Citigroup to revalue its own holdings sharply lower. Goldman Sachs analyst William Tanona agreed. Citigroup wouldn't comment.
Citigroup shares were up slightly in midday trading on the New York Stock Exchange. Merrill Lynch was down 1.3%. UBS shares fell in Zurich on concern the bank will copy Merrill's approach and sell off troubled assets at a loss that forces another round of capital raising, even as the bank repeated its position that more capital isn't needed. The stock closed down 3.2%.
"Although UBS has said it expects to break even in the second quarter, there is a risk that their results announcement will also include plans to accelerate the rate at which they sell off their subprime exposures and this could result in yet another large write-off and a capital-raising exercise to compensate," said Peter Thorne, a London-based analyst with independent brokerage Helvea.
UBS reports results for the quarter Aug. 12, but said earlier this month that it may eke out a break-even result thanks to tax credits related to the mortgage losses. Mr. Thorne said he sees additional UBS write-downs for the quarter of as much as five billion Swiss francs ($4.83 billion) and fund-raising of as much as 10 billion francs, as "entirely possible."
U.K. banks Royal Bank of Scotland Group PLC and Barclays PLC also slid, 2.7% and 4.1%, respectively. Analysts at BNP Paribas warned against automatically assuming every bank will have to take Merrill-like hits, but said Merrill's quick turnaround on the value of its securities will raise questions about the accuracy of banks' marks.
U.S. Profits May Drop Most Since at Least 1998, Led by Lehman
Profits at U.S. companies may have dropped the most in at least a decade last quarter after credit writedowns triggered a combined $7.43 billion loss at Merrill Lynch & Co. and Lehman Brothers Holdings Inc.
Earnings of Standard & Poor's 500 Index companies have tumbled 24 percent from a year earlier, according to data compiled by Bloomberg on the 291 companies that had reported quarterly results through yesterday. As recently as July 3, analysts expected a drop of 11 percent.
Financial industry profits, which analysts estimated would fall 60 percent, have plummeted 87 percent. Record oil prices drove earnings of ConocoPhillips and Occidental Petroleum Corp. to the highest in their histories. The energy group of the S&P 500 has posted a 15 percent gain in profits so far.
"It's a tale of two sectors that are really driving things," said Dirk van Dijk, director of research at Zacks Investment Research in Chicago. "On the bad side it's financials," he said in an interview. "On the upside, it's energy." The benchmark S&P index, representing companies with a combined market value of $11.3 trillion, slipped 3.2 percent in the quarter, the worst showing for the period since 2002. The index fell 14 percent this year before today.
A 24 percent earnings drop would be the deepest since at least the second quarter of 1998, according to the earliest comparable Bloomberg data. Profits fell 23 percent in the third and fourth quarters of 2001 and in the fourth quarter of 2007.
The decline marks the fourth straight quarter of reduced earnings for U.S. companies. The losing streak is the longest since the five quarters that ended in March 2002, when the U.S. was emerging from an eight-month recession. Excluding financial companies, profits have climbed 8.5 percent so far.
Lehman, the fourth-largest U.S. securities firm, posted a loss of $2.77 billion, or $5.14 a share. Merrill Lynch, the third-biggest U.S. securities firm, lost $4.65 billion, or $4.97 a share. Credit-market writedowns in the second quarter cost Merrill $9 billion and Lehman $4.9 billion.
Worldwide, banks and brokerages have reported more than $470 billion in writedowns and credit losses since the beginning of last year as mortgage-backed securities, collateralized debt obligations, leveraged loans and other fixed-income assets lost value. Information technology earnings advanced 21 percent for the quarter, as Apple Inc. jumped 31 percent and Google Inc. gained 35 percent. Analysts had estimated the category would increase 13 percent, as of July 3.
ConocoPhillips, the third-largest U.S. oil producer, posted the highest quarterly profit in its history, after crude prices climbed to a record and natural gas surged to a 2 1/2-year high. Net income of $5.44 billion, or $3.50 a share, topped analysts' average estimate by 2 cents.
U.S. oil futures climbed above $140 a barrel for the first time in June, and the average price during the period rose 90 percent from a year earlier. Oil prices have crippled earnings of consumer companies, including automaker Ford Motor Co., home furnishings retailer Bed Bath & Beyond Inc. and hotelier Marriott International Inc.
"Because of high oil prices, a weak housing market and a weak job market, the consumer is under unprecedented stress," Alec Young, a New York-based equity strategist at Standard & Poor's, said in an interview. Earnings for 41 companies that rely on consumers' discretionary spending that reported through yesterday have declined 22 percent, less than the 24 percent decrease projected by analysts.
"A lot of it does come down to the auto companies," Zacks' van Dijk said. "Pretty nasty earnings from Ford." Ford, the world's third-biggest automaker, posted a record quarterly loss of $8.7 billion, or $3.88 a share, as $4-a-gallon gasoline trimmed demand for the pickup trucks and sport-utility vehicles that generate a majority of its U.S. sales.
Ford's loss included a writedown of $8 billion for plant closings and the declining value of leased vehicles owned by its credit unit. Marriott, the world's largest hotel chain, reported a 24 percent drop in profit, and forecast declines for the rest of the year, as U.S. business and personal travel fell.
For the year, S&P 500 companies' earnings will rise 1.6 percent, helped by a fourth-quarter surge, S&P's Young said.
There will be "just a massive rebound in financial earnings," Young said. Comparisons with the fourth quarter of 2007 will be easier because of writedowns firms took in the period, he said.
Gold and long mattresses
If you saw dark clouds drifting from St. Charles last week, they were probably coming from the dreary mood at the CFA Institute's annual investment seminar for professional investment managers.
Every year, the respected chartered financial analyst investment education group brings money managers from around the world together in the Chicago area and exposes them to provocative thinkers on investment strategy and market conditions. And with most of the world's stock markets down 20 percent or more from their highs, economies slowing throughout the world, and a credit crisis toying with the flow of money, this year's speakers were gloomy.
"I am officially scared," GMO investment manager Jeremy Grantham told professionals from as far away as Abu Dhabi and Malaysia. "In 2000, we had a technology bubble. But this is massive, a massive credit crisis and a bubble in global housing, global equity and global land."
Grantham is sometimes referred to as a "perma-bear" because he's a stickler about avoiding overpriced stocks. Two years ago, he warned his audience that U.S. stocks were too expensive, even after recovering most of the ground lost from the 49 percent drop to correct the bubble in technology stock prices in 2000.
But back then, Grantham was cautious; not fearful. While he was avoiding U.S. stocks, he thought fast-growing emerging markets still held promise. Now, after a tremendous surge of investor money into Asia, Latin America, Africa and the Middle East, he is concerned about the prices of those stocks, as the world works its way through what he called the "first truly global bubble."
In the last few weeks, economies throughout the world have slowed sharply, and Grantham said corporate profit margins must decline as the trend continues. But he does not think investors have adjusted their expectations. For investors expecting 7 percent annual returns in the U.S. stock market, Grantham said the price-earnings ratio would either have to go to 35, or "profit margins would have to go off the chart."
The price of Standard & Poor's 500 stocks is currently about 22 times earnings. When asked by a money manager what he would buy now, Grantham said, "long mattresses"—jesting about the stereotypical nervous behavior of hoarding cash. He seriously suggested: "Put money into something incredibly safe, like a high-quality hedge fund."
Grantham said rather than buying stocks for the long run now, he would only "short" them, or bet that they will decline in price. He sees "nothing interesting in quality corporate bonds," and he has been shorting oil. "Commodities had a good run, but that's over," he said.
Although downtrodden mortgage-related bonds might be a good deal now because some are selling for 59 cents on the dollar, he said he wonders if the price will seem compelling if home prices fall another 20 percent or 25 percent. He confessed to the group that "I bought my first gold last week, and I hate gold. It doesn't pay a dividend. I would only do it if I was desperate."
Grantham said part of his angst comes from a lack of leadership. He criticized U.S. Treasury Secretary Henry Paulson for failing to force banks to raise capital when it was warranted two years ago. And he added: "Just imagine, we have chosen to borrow money from China so we can buy oil from the Middle East and use it to pollute the planet."
Marc Faber of Marc Faber Ltd. blamed former Federal Reserve Chairman Alan Greenspan for failing to acknowledge the Fed's role in repeatedly inflating dangerous bubbles. By keeping interest rates low, "the Fed has created a bubble in everything—stocks in emerging market, real estate everywhere in the world, commodities, art," he said. "The only asset class that is down is the U.S. dollar."
Generally, when bubbles burst, the asset prices stay down for lengthy periods. Grantham isn't expecting the stock market to hit its low until 2010.
Farouki Majeed, the senior investment officer for asset allocation and risk management for the giant California Public Employees' Retirement System, noted that with the tech bubble bursting in 2000 and the current bear market, investors in stocks have seen virtually no return for the last 10 years. That's unusual, but typical of "boom and bust" cycles, he said. Calpers reduced its exposure to stocks from 60 percent of the pension fund to just 54 percent this year.
Faber said, "It is quite likely that the current synchronized global economic boom and the universal, all-encompassing asset bubble will lead to a colossal bust." And with commodity prices so inflated, he expects an "increase in international tensions" over resources.
Waiting for Jamie Dimon's next move
With so many banks reeling because of the credit crisis, the rumor mill is cranking up again about what JPMorgan Chase might want to buy next. So what's chief executive officer Jamie Dimon waiting for?
A little more clarity, for starters. There is still plenty of uncertainty about whether the worst is ahead or behind for the financial services sector. Two more banks failed last Friday. In addition, Merrill Lynch announced Monday, that it was seeking to raise $8.5 billion in capital to clean up its balance sheet.
Analysts were also caught off-guard nearly two weeks ago when Dimon warned during JPMorgan Chase's second-quarter earnings conference call that he expected losses in his company's prime mortgage portfolio to triple in the coming quarters.
And there is no sign that housing prices, or the broader economy for that matter, have found a bottom, suggesting more writedowns and loan losses for the nation's banks. "He sees that we are in a muddy risk environment," said Jason Tyler, a senior vice-president at the Chicago-based Ariel Investments, which manages about $9 billion and owns shares of JPMorgan Chase. "He wants to makes sure the price is absolutely reflective of any downside scenarios."
Still, some analysts speculate that Dimon is eager to add another regional bank to JPMorgan Chase's franchise. As for potential targets, analysts say that many of the same names that Dimon was interested in since he first took over as CEO two and a half years ago are probably still intriguing.
There's Atlanta-based SunTrust for starters, which would give JPMorgan Chase a bigger presence in the Southeast. So far this year, SunTrust shares are down nearly 42%. And just last week, the company said it sold about $2 billion worth of its long-time investment in Coca-Cola Co. stock in order to raise capital.
The thrift giant Washington Mutual has been often mentioned as a takeover target as well. Acquiring the troubled WaMu would give Dimon the West Coast exposure he has long desired. In fact, WaMu reportedly snubbed a $8-per-share offer from JPMorgan in April, in favor of selling an equity stake to a group of investors led by the private equity giant TPG. For what it's worth, WaMu shares have fallen 67% since then and now trade at about $4..
And some experts believe the Charlotte-N.C.-based Wachovia, whose credibility was recently bolstered with the appointment of former Treasury undersecretary Robert Steel as its new CEO, may also be in play. Wachovia shares are down 64% so far this year.
But there are big hurdles to getting any deals done. The stock price of most targets may be so beaten down that management won't want to sell, noted Thane Bublitz, senior equity analyst at the Minneapolis-based Thrivent Financial. "There are a lot of regional banks that the management team is in it to eventually be acquired, but they are not talking about it because valuations are so depressed," said Bublitz.
Few doubt Dimon's ability to pull off another acquisition just two months after completing its purchase of investment bank Bear Stearns. For more than a decade, Dimon served as the right-hand-man of Sandy Weill, helping create the modern-day Citigroup through a dizzying number of mergers. But if Dimon waits too long, he might have to pay more for something than he would today.
"It's certainly a buyer's market - it would be to their advantage to do something relatively soon," said Christine Barry, research director at Aite Group. What's more, banks also face the threat of key accounting changes starting next year. One rule under consideration by the Financial Accounting Standards Board, an organization that establishes financial accounting and reporting standards in the United States, would require financial institutions to include all off-balance sheet assets onto their books.
While that might not be enough to prevent JPMorgan Chase from doing a deal in 2009, if Dimon waits until next year, that could mean more nasty writedowns for the bank. Dimon himself told Oppenheimer & Co. analyst Meredith Whitney in a meeting late last week that the new accounting changes for 2009 could "hamper M&A activity within the industry," Whitney wrote in a note published Sunday.
So if a deal is indeed looming for JPMorgan Chase, you can bet Dimon will want to act sooner, rather than later.
Moody's Profit Falls 48% as Rating Demand Dries Up
Moody's Corp., the world's second- largest credit-rating company, said second-quarter profit fell 48 percent as demand slumped for ratings on mortgage bonds and collateralized debt obligations.
Net income declined to $135.2 million, or 54 cents a share, from a record $261.9 million, or 95 cents, a year earlier, New York-based Moody's said today in a statement. Revenue dropped 25 percent to $487.6 million. Profit before a one-time tax benefit was 51 cents, beating the 47 cent average of seven analysts' estimates in a Bloomberg survey.
Moody's and larger rival Standard & Poor's are suffering from a plunge in bond sales that stifled demand for credit ratings. Revenue from mortgage-backed securities and CDOs dropped 56 percent in the quarter. Moody's Chief Executive Officer Raymond McDaniel, who sliced expenses 10 percent by firing workers and reducing compensation, said he remains "cautious" about the chances of a rebound in the credit markets this year.
"This will be the worst quarter in the cycle in terms of earnings performances," Peter Appert, an analyst at Goldman Sachs Group Inc. in San Francisco, said before the report. Appert, who rates Moody's "neutral," had predicted revenue would decline by 25 percent. The company reiterated its forecast for annual profit of $1.90 to $2. "First-half results reflect persistently difficult credit market conditions," McDaniel said in the statement.
McDaniel, 50, has failed to convince investors that the company can rebound from the seizure in the credit markets that began in August. Critics including Senate Banking Committee Chairman Christopher Dodd have said the slump was driven in part by ratings companies' willingness to assign AAA credit ratings to subprime mortgage securities. Merrill Lynch & Co. agreed July 28 to sell CDOs for an average of 22 cents on the dollar.
S&P, Moody's and Fitch Ratings, the three-biggest ratings companies, are being investigated by U.S. and European regulators for providing top grades to securities backed by U.S. subprime mortgages that sparked more than $468 billion of writedowns and credit losses at the world's financial institutions.
Moody's, whose largest shareholder is Warren Buffett's Berkshire Hathaway Inc., is down 37 percent in the past 12 months, making Buffett's 19.6 percent stake worth $1.5 billion less than it was a year ago. The stock rose $2.60 to $36.15 in New York Stock Exchange composite trading yesterday after New York-based McGraw-Hill Cos., parent of S&P, said profit fell less than analysts' estimates on revenue gains in education and investment services.
McGraw-Hill reported a 44 percent slump in new bond sales yesterday, driven by a 95 percent decline in mortgage-backed securities and an 88 percent slide in CDOs. "The reason I'm not recommending Moody's is it's a pure play rating agency" as opposed to McGraw-Hill, Appert said. "They are getting the full negative of the near-term trend. The positive is a five-year story, not a one-year story."
Moody's exceeded analysts' estimates in the previous two quarters and its shares outperformed the Standard & Poor's 500 Index so far this year. Still, speculators anticipate more declines. Short interest in New York-based Moody's jumped to a record 47 million shares in mid-July, an increase of 10 percent from the end of June and double a year ago, according to data compiled by Bloomberg.
McDaniel cut more than 7 percent of the workforce, reduced compensation and closed some offices. He ousted President Brian Clarkson in May and removed Noel Kirnon as head of structured finance this month. He said employees violated internal rules in assigning ratings to constant proportion debt obligations. Moody's awarded AAA ratings to at least $4 billion of CPDOs, or bonds backed by derivatives, before the securities lost as much as 90 percent of their value.
Sales of residential- and commercial-mortgage bonds, asset- backed debt and CDOs created by banks fell 66 percent to $510.3 billion in the first half from the same period in 2007, according to newsletter Asset-Backed Alert.
"The revenue from securitization ratings was a substantial component of their profitability," said Tom Priore, chief executive of Institutional Credit Partners LLC, a New York investment bank, before the Moody's announcement. "The level of securitization and their financial performance is highly correlated."
Moody's profit rose more than 30 percent in 2005 and 2006 as sales of CDOs soared. CDOs package pools of debt and slice them into pieces of varying risk, requiring ratings for each part. Moody's profit fell 7 percent in 2007 as CDO issuance dropped. McDaniel's compensation declined 10 percent to $7.4 million in 2007, according to company filings.
Eventually, securitization will return and credit-rating companies will benefit, Priore said. "Is that to say we're not going to see growth from these levels, because securitization is forever impaired and gone?" Priore said. "I don't believe that's the case."
Economic Growth or the Environment?
As economic conditions worsen, people who are asked to make a decision between protecting the environment or economic growth and development have moved even more strongly into the economic growth column. Specifically, a Harris Poll conducted online among 2,454 adults aged 18 and over between June 9 and 16, 2008 by Harris Interactive(R) found:
• U.S. adults are divided on how they perceive things in their own community as 38 percent say it is going in the right direction while 37 percent believe things have "pretty seriously gotten off on the wrong track". This perception has gotten better in the past few months. In November, almost half (47%) of adults felt things were going off on the wrong track in their community and one-third (32%) felt they were going in the right direction;
• More than three in five Americans (63%) say economic growth and development is more important to their region while one-quarter (27%) believe protecting the environment is more important. Just over three in ten Easterners (31%) believe protecting the environment is more important while seven in ten Midwesterners (69%) believe economic growth is more important;
• The focus on economic growth has grown over the last year. In June of 2007, Americans were more divided as 48 percent thought economic growth was more important and 43 percent believed protecting the environment was more important. In November, a small 51 percent to 37 percent majority believed economic growth was more important; and,
• Looking ahead to the future, just over half of U.S. adults (56%) believe that the quality of life in the area they live in will decrease for their children and grandchildren while 44 percent believe it will increase. Younger generations are more optimistic on this - over half (56%) of Echo Boomers (those aged 18-31) believe the quality of life will increase compared to 38 percent of Baby Boomers (those aged 44-62) and one-third (32%) of Matures (those aged 63 and older).
In Canada, there are different opinions on some of these topics:
• Canadians are much more positive about the direction of their community as over three in five (63%) believe things in their community are going in the right direction and 37 percent say they are going off on the wrong track;
• Canadians are more evenly split on which is more important, economics or environment as 45 percent say it is economic growth and development and 44 percent believe it is protecting the environment; and,
• One area Canadians agree with Americans on is the quality of life in their region for children and grandchildren as 56 percent of Canadians say it will decrease and 44 percent believe it will increase.
So What? As the economic woes continue, anything that places the economy versus something else will see economy most likely winning the battle. But, many polls, including earlier Harris Polls, show very strong support for strengthening environmental protections and regulations.
Also, most people do not see the hard trade off between economic development and protecting the environment. In fact, many people believe that we not only can do both of these, but that we should be doing both.
NY governor recalls legislature to solve budget crisis
New York Gov. David Paterson on Tuesday said he will recall the legislature next month to solve a budget crisis that he said reflects Wall Street's sliding fortunes, saying public-private partnerships and spending cuts will be needed.
Paterson said the state's budget shortfall for the multiyear period starting next April has soared 22 percent in just 90 days, to an estimated $26.2 billion from $21.5 billion. "The damage on Wall Street is infecting all of our communities and its effects on New York state finances are devastating," the Democratic governor said in a televised address. He said he also will be "addressing the size of the state work force."
Paterson is recalling the legislature on Aug. 19 to solve what some pundits have called the state's worst fiscal crisis since the 1970s. About one out of every five tax dollars that the state collects comes from Wall Street banks and brokerages, which have written down hundreds of billions of dollars of losses from their ill-fated subprime mortgage investments.
In June, New York's tax take from its top 16 financial companies plunged by 97 percent to $5 million, down from $173 million in June 2007. "It is time for us and other governments to cut up our credit cards," Paterson said, urging elected officials from Albany to Washington and business and labor leaders to "join us in this great effort."
Paterson, who took office in mid-March after Eliot Spitzer resigned, trimmed the budget he inherited to $122 billion, pruning spending by $500 million to $800 million. But Paterson said that for the next fiscal year starting on April 1, 2009, the deficit has ballooned to $6.4 billion from the $5 billion estimate made when he was sworn in.
Additional details about the state's finances will be released on Wednesday by the state budget division.
Though the Republican-led Senate said it will return in early August to enact the governor's property tax bill, the Democratic-controlled Assembly has yet to reveal its plans.
Edmund McMahon, who directs the Empire Center, a conservative Albany-based research group, and Democratic State Comptroller Thomas DiNapoli agreed that New York had gone on a multiyear spending binge fueled by booms on Wall Street and the housing market that legislators now would have to tackle.
After Paterson spoke, DiNapoli said it will take years to fix long-standing problems. "New York State has spent money it didn't have and borrowed to make up the difference," he said in a statement. The size of the budget has leaped 75 percent over the past 10 years, McMahon told Albany radio station WCBI.
He blamed the increases on Spitzer, a Democrat who enacted only one budget, and his predecessor, Republican Gov. George Pataki, who oversaw eight budgets. The November elections could prove pivotal because the Senate Republicans, who have run that house for decades, have just a one-seat majority and political analysts said this puts extra pressure on Paterson to devise a sound fiscal plan that does not cost his party votes.
SEC Extends Limit on Short Sales of Brokers, Fannie, Freddie
The U.S. Securities and Exchange Commission extended an emergency limit on short sales in shares of Freddie Mac, Fannie Mae and 17 brokerages as it prepares broader rules to thwart stock manipulation.
The SEC pushed back expiration of its ban on so-called naked short sales of the firms' stocks to Aug. 12, the Washington-based agency said in a statement yesterday. The order aims to keep traders from driving down financial stocks to boost profits after Bear Stearns Cos. and IndyMac Bancorp Inc. collapsed amid rumors they were faltering.
The emergency order, focused on companies whose collapse might expose the U.S. government to losses, gives regulators time to weigh wider restrictions. SEC Chairman Christopher Cox last week told lawmakers the agency is examining additional proposals.
"The commission will continue exploring other remedies for the broader marketplace to further protect investors from 'distort and short' artists," Cox said in the statement. The agency doesn't plan to extend the temporary order again. In traditional short selling, traders borrow shares and sell them. If the price drops, they profit by re-buying the stock, repaying the loan and pocketing the difference.
Naked short sellers don't borrow shares before settling sales. The SEC is concerned manipulative investors may use the sales, legal under some conditions, to drive down prices by flooding the market with orders to sell shares they don't have.
The temporary order took effect July 21 and would have expired yesterday. It requires traders to at least arrange to borrow shares before selling short Freddie Mac and Fannie Mae, the government-sponsored mortgage buyers. The order covers brokerages with access to the Federal Reserve's discount window, which was opened to investment banks after the March collapse of Bear Stearns.
Market makers have an exception under the SEC order that permits them to sell short to maintain liquidity. Investors, such as hedge funds, previously could start trades without an agreement to acquire shares.
Short sales, particularly among retail investors, plummeted after the SEC announced the ban, according to data from S3 Matching Technologies, which processes trades for three of the top five retail brokerages. The sales fell 78 percent on average among the companies named in the order, compared with trades on July 14, the day before the SEC announced the measure, S3 data shows. The company handles about 15 billion transactions daily.
"I see no reason that will turn around," said John Standerfer, the Austin, Texas-based firm's vice president for financial services. "It seems like a pretty restrictive rule to put in place for the entire market."
Penson Worldwide Inc., the Dallas-based company that clears trades for more than 250 firms, is introducing a system this week to automate much of the process after employees were forced to manually review short sales and work weekends, said Mike Johnson, head of global securities lending.
"I hope they don't go market-wide, because that would take six months to a year to implement," he said. "Capital has to be extended, systems have to be rebuilt and we're talking about months of infrastructure building." Cox last week told Congress the agency may also force investors to disclose "substantial" bets on falling stocks and reinstate a version of the so-called uptick rule, which barred short sales of stocks when prices are falling.
The uptick rule, implemented after the Great Depression and scrapped last year, allowed short sales only if a preceding trade boosted the stock price. The SEC is studying whether increasing the uptick increment, such as to a nickel or dime, might be more effective, he said.
England’s retailers suffer worst month in 25 years
Britain's retailers have suffered their grimmest month in a quarter of a century as deep price cuts in the summer sales failed to entice wary consumers into the shops, the CBI said today.
The monthly snapshot of the high street from the employers' organisation found that 61% of businesses said activity was lower in July than a year earlier while only 25% said it was higher. The CBI said the resulting balance of -36 points was the weakest since it began its distributive trades survey in 1983 and that retailers expected another dismal month in August.
Andy Clarke, chairman of the CBI distributive trades panel, and retail director of Asda, said: "It is turning out to be a very grim summer for many retailers. Pressure from higher fuel and food prices is prompting many people to rein in their spending, proving that value retailing has never been more important.
"The faltering housing market has really depressed sales of home furnishings and white goods this month and the high street is still struggling, but supermarkets are faring better. "The retail sector will have to focus more than ever on providing good value to customers if they want to keep the sun shining this summer."
Faced with consumer belt-tightening, the shops and stores surveyed by the CBI had been expecting July to be a poor month for business, but the negative expectations balance of -32 was far worse than the -7 points anticipated. In a potential blow to the rest of the economy, retailers said that they were slashing orders with their suppliers.
The reluctance to spend displayed in today's report confirms poor recent trading reports from individual retailers such as Marks & Spencer and John Lewis. Only supermarkets and sellers of footwear and leather goods bucked the downward trend.
The CBI said sales of big-ticket items were especially weak, with every respondent selling durable household goods and furniture and carpets reporting that sales were down on a year ago. Clothing retailers also suffered.
Howard Archer, economist with Global Insight, said: "The CBI's July distributive trades survey is a real shocker, pointing to consumer spending starting off the third quarter very much on the back foot. Indeed, evidence is mounting that consumers are now reining in their spending appreciably in the face of seriously squeezed purchasing power and other significant pressures."
Euro-Zone Economic Sentiment Drops Following ECB Rate Increase
Business and consumer confidence in the 15 countries that use the euro weakened significantly in July after the European Central Bank raised its key interest rate. According to a European Commission survey published Wednesday, the overall measure of economic sentiment in the euro zone fell to 89.5, from 94.8 in June.
It was the largest monthly fall since October 2001, the immediate aftermath of the Sept. 11 attacks on New York and Washington, D.C., and much larger than the drop to 93 that was forecast by economists. The Economic Sentiment Indicator now stands at its lowest level since March 2003, indicating that the economy will slow further in the months ahead.
"It was only the latest number in a string of very weak data that confirm that the economy is experiencing a severe downturn," said Aurelio Maccario, an economist at Unicredit in Milan. "It will be very hard to see the return to relatively healthy growth numbers the ECB currently envisages from Q4 onwards."
Consumer confidence was particularly hard hit, with the headline measure falling to -20 from -17. Economists had forecast a drop to -18. Consumers became much more pessimistic about the outlook for the economy over the next 12 months, and about the jobs market.
The consequences for their spending plans are clear from a quarterly survey also released by the commission Thursday. It found that consumers are more reluctant to buy a new car or a new home over the next 12 months than at any time since records began in 1990.
However, the ECB will gain some comfort from the fact that inflation expectations fell slightly, which may be a direct consequence of its decision to raise rates in order to show its determination to bring inflation under control, come what may. The ECB raised its key rate to 4.25% from 4% at its July meeting, its first move since June 2007, which was also an increase.
With interest rates rising, the credit crunch sapping world growth, and oil prices still near record highs, industrial confidence weakened sharply. The headline measure fell to -8 from -5 as new orders slowed, with export orders dropping sharply. Economists had forecast a decline to -7.
"Business and consumer confidence is being pummeled by a myriad of factors," said Howard Archer, an economist at Global Insight. "These notably include elevated energy and food prices, the ongoing credit crunch and financial market turmoil, the very strong euro, the ECB's raising of interest rates in July and fears that it could tighten monetary policy further, and serious concerns about the global economic outlook."
In a quarterly survey, manufacturers reported that they were running at only 82.9% of capacity, down from 83.8% at the start of the second quarter. But in a development that will worry the ECB, manufacturers said they expect to raise their prices at a much faster rate than previously.
So despite the sharp drop in confidence that signals a further slowing of economic growth in the months ahead, the ECB may yet decide another rate increase is needed to counter inflationary pressures. No part of the economy was left untouched by the gathering gloom.
The services sector recorded the largest decline in confidence, with the headline measure plunging to 1 from 9, while the headline measure for the retail sector fell to -9 from -4, and for construction fell to -14 from -11.
Confidence also weakened again in the financial services sector, which had seen a rebound in May and June after sharp declines early in the year. The headline measure fell to 13 from 20 in June, still above the record low of 8 reached in April.
Financial services firms said they intend to cut back on hiring in the next three months, a goal shared by manufacturers, other service providers and construction companies. Retailers were the exception, reporting that they intend to keep payrolls at June levels.
"Hiring intentions in industry and services fell away sharply, continuing the recent trend and offering further evidence to suggest that a vicious circle of weaker spending, output and employment is now in train -- just the kind of vicious circle which leads to a recession," said Ken Wattret, an economist at BNP Paribas.
A separate measure of the climate for doing business in the euro zone -- the Business Climate Index -- fell sharply in July. The BCI declined to -0.21 from +0.13, the first time it has been in negative territory since September 2005. "The low level of the indicator suggests that economic activity in industry ... remains subdued," the commission said.
Lone Star Unafraid Of Investing Where Others Won't
Lone Star Funds isn't afraid of going it alone. On Monday, New York-based investment bank Merrill Lynch & Co. said it was selling a portfolio of collateralized debt obligations with an original face value of $30.6 billion to the Dallas-based private equity firm for $6.7 billion.
The CDO's, essentially bonds collateralized with other forms of debt, are so risky the struggling broker had already written their value down to $11.1 billion as of the end of the second quarter. Merrill's CDO portfolio isn't the only risky bet Lone Star has made on assets affected by the on-going housing slump and credit crunch.
It recently acquired CIT Group Inc.'s (CIT) mortgage business for $1.5 billion. It also bought Bear Stearns' residential mortgage business and paid $295 million for Accredited Home Lenders Holding Co. Why Lone Star would pony up so much money for assets seen as being shaky is no secret.
Unconstrained by capital requirements and freed from quarterly reporting obligations, a private equity firm like Lone Star can take time to let the assets mature. That means it can turn a tidy profit if even only a portion of the businesses functions the way they were originally expected to perform.
"If there's anyone who's to have the risk appetite in this kind of environment, it's going to be the alternative investment community," said Philippa Allen, a director at ComplianceAsia, which provides consulting services to the financial industry.
Representatives of Lone Star could not be reached for comment.
Lone Star was founded in 1995 and is led by John Grayken, a former associate of Texas billionaire Robert Bass. Grayken developed his investment strategy while resolving bad debt during the savings-and-loan crisis in the 1980s. The fund has made a name for itself by buying chunks of companies facing financial stress, rehabilitating them and then selling them to other investors or listing them on stock exchanges.
One of its first big deals was the purchase of Shoney's Inc., the restaurant chain that once operated the Big Boy franchise. After owning the restaurant for about five years, it sold it off to another investor. Lone Star has also dabbled overseas. In 2001, Lone Star bought a small nationalized lender from the Japanese government for around $400 million.
It sold about a third of the bank, which it had renamed Tokyo Star Bank, to the public in 2005, raising almost twice what it paid for it. It then sold another portion to a hedge fund as part of a deal that was valued at more than $2 billion. It also bought hotels and golf courses in Japan as the country's prolonged real estate recession created opportunities in property-related businesses. It rolled those purchases into operating companies so that it could maximize economies of scale.
In South Korea, Lone Star made a splash by buying most of Korea Exchange Bank, Korea's seventh-largest bank, for about $1.3 billion in 2003. Three years later, Lone Star tried to sell its stake to Kookmin Bank, the biggest Korean lender by assets, but the deal fell through.
Later, South Korean authorities questioned whether Lone Star executives had manipulated the stock prices of a credit card company KEB bought after it was owned by the fund. The investigation of the alleged impropriety grew so heated that Grayken was detained in Seoul for 10 days earlier this year after he flew to South Korea to testify to authorities. Lone Star was found not guilty of wrong-doing by a South Korean court last week.
The fund is now negotiating a sale of the KEB stake to London-based HSBC Holdings PLC that could bring it a profit of as much as $5 billion. The two sides have a self-imposed deadline of July 31 to reach a deal. Lone Star's deal with Merrill Lynch will likely be less controversial but still very profitable.
As part of the deal, Merrill is funding three quarters of the purchase price. If Lone Star defaults on that loan, the only recourse Merrill has is to the CDOs it sold Lone Star. That means the fund is only putting up about 5.5 cents of its own money for every dollar of face value.
America's Long Overdue Extreme Makeover: Extreme Failure
Symbolic to our era like a sledgehammer to drywall, the biggest house that ABC's "Extreme Makeover: Home Edition" ever made over -- a sprawling, four-bedroom starter castle, a three-car garage mahal with a turret and all -- has gone into foreclosure, in the 'burbs south of Atlanta.
In that particular episode of the hyper-benevolent reality show, which first aired in February 2005, it took 1,800 volunteers a week to demolish the house with the overflowing septic tank that belonged to Milton and Patricia Harper of Lake City, Ga., and then entirely rebuild a new, larger house, while the Harpers and their three children went away to Disneyland.
When they returned, they had the biggest house on Ahyoka Drive, with all the appliances and furnishings, plus enough money to pay taxes on it for decades, plus a fund to send their children to college.
The house will be auctioned off, according to the Atlanta Journal-Constitution, next Tuesday on the steps of the Clayton County Courthouse. The Harpers had used their home as collateral on a $450,000 loan from JPMorgan Chase and fell in arrears, the newspaper reported.
He ran a home security business; she mommed at home. Happy to be on television back then, they declined to be interviewed last week, when a news crew showed up from local station WSB, wanting to know wha'ppen.
The mayor of Lake City, Willie Oswalt, who said he'd helped lift a beam into place in the Harpers living room, told the press that "it's aggravating. It just makes you mad. You do that much work, and they just squander it."
You could (and will) say the Harpers had it coming, but really, we all had this coming. One thing we'll always remember about this decade was the constant home do-over fetish, in real life and in the reality of reality TV -- the constant warping of the consumer's sense of entitlement, the fairy-dust economics, the MasterCard reminder that the experience is priceless.
We'll look back and think of all the time we spent watching shows where people flipped houses for easy profit, or traded spaces, or designed it to sell, or were led into rooms blindfolded to experience the paroxysms that came with new paint, new furniture, new life.
All the crying people did for the camera: They cried when television's magic wand touched them, and the hosts always cried, too, while telling the camera how good they felt making the dreams of the sick and wretched owners of substandard tract houses come true. Think of the many tears that were shed on American television over organized closets and new kitchen countertops.
Now comes a long period of tsk-tsk, and tut-tut. The schadenfreude potential is everywhere now in these newly sobered times, and it would be something if the Harpers would make themselves available for an entirely other kind of documented extreme makeover, penny by penny.
Every day, we are greeted with fresh evidence of the great American fire sale. If it was wrong to think the economy could go on forever subsisting on money that no one actually had, then it was wrong to think there was something wonderful about watching shows where people got houses for nothing, and then expect them to live happily ever after.
Last week, the new numbers came out: Foreclosures were filed against some 740,000 U.S. homes between March and June alone. There should be shows on every cable channel about that, hosted by people who don't cry, and who don't have megaphones and plastered-on smiles.
These shows should air only on analog television, after Feb. 17, 2009. A certain kind of television viewer wouldn't mind watching some more of this, please, if certain kinds of television producers are listening. It's hard to explain, comeuppance. But surely it's as fascinating as installing laminate-wood floors.
Bring on Extreme Failure.
Massachusetts Finance Authority Ending Private Student Loans
The Massachusetts student lending authority announced this week that it will stop issuing private student loans, a move that could affect Connecticut students who attend school in the Bay State and rely on the agency for loans. But Connecticut officials say those students should be able to obtain other loans, in part because Connecticut's student lending agency remains in good shape.
The Connecticut Higher Education Supplemental Loan Authority, or CHESLA, offers state-backed loans to students from or attending school in Connecticut. It now has nearly $20 million to lend, and officials will begin working on a $45 million bond issue next month to replenish the lending pool, executive director Gloria Ragosta said Tuesday.
CHESLA has avoided the problems similar state student loan agencies have faced because it raises money by selling fixed-rate bonds, rather than the auction-rate securities that have caused trouble, Ragosta said. Officials at the Massachusetts Educational Financing Authority, or MEFA, announced Monday that the agency was unable to secure funding to loan money for the coming school year. During the past academic year, MEFA loaned $510 million to students from or attending school in Massachusetts.
MEFA previously announced that it would stop providing federal student loans. Monday's announcement marked a withdrawal from the private student loan market. MEFA officials are advising students to consider federal PLUS loans, which allow parents to borrow up to their students' cost of attendance.
Mark French, associate director of student financial aid for the Connecticut Department of Higher Education, advised students who still need to secure financing for college to speak with their school's financial aid office. Higher education officials and families have been closely watching the student loan market as the nation's credit market has slumped.
Officials now say students who qualify should not have trouble obtaining federal loans. Some lenders have stopped offering federal loans, but many more remain. Private loans may be more difficult to obtain. Some lenders have limited their programs because of difficulty raising money, and many others have raised the credit requirements for private loans.
Students Scramble to Secure New Loans as Dozens of Lenders Drop Out
Forget back-to-school shopping: With just a few weeks to go before the start of the fall semester, many college students are doing some last-minute student-loan shopping as more and more cash-strapped lenders drop out of the student loan business.
Texas A&M University financial aid director Delisa Falks said that in the last few days, the university has heard from seven different lenders saying they could no longer provide federally guaranteed loans. It's a problem that has been ongoing nationwide for months, leaving many students with dwindling options for financing their college educations.
Falks said that while there are many other lenders to take the place of the recently discontinued lenders, "it's very disappointing that it's gone this way in the student loan industry." Student loan companies traditionally raise capital by selling bonds, but as a fallout from the subprime housing meltdown continues to shake the country's financial sector, investors have become wary about putting their money into student loans.
As a result, "lenders have been having a hard time raising enough capital to continue making loans," said Justin Draeger, a spokesman with the National Association of Student Financial Aid Administrators.
"The whole problem in the capital markets started with mortgages and has drifted down," said Thomas Graf, the executive director of the Massachusetts Educational Financing Authority (MEFA), which this week announced that it would not provide funding to 40,000 students and families.
"Difficulty in the capital markets in the last few months has made it extremely difficult for us to secure funding for the fall season," Graf told ABC News. Since March, roughly 100 U.S. lenders have suspended their government-backed student loan programs while nearly 30 have also stopped their private student loan programs, according to the NASFAA statistics.
MEFA, a state non-profit agency, had already announced in April that it would not be providing government-backed student loans. This week's announcement pertained to low-cost private loans. The suspension of MEFA loans and others have led students and families to scramble for alternatives.
Lynne Meyers, the director of financial aid at College of the Holy Cross, said that on Tuesday alone, her office received 120 applications for PLUS loans, government-backed loans that parents take out on behalf of their children. Kaitlin Sullivan, 19, was among those filing an application. Though applying for a new loan meant more paperwork for Sullivan, the sophomore took it in stride.
"The financial aid office sent me all the information that I needed to know, and they assured me that if I followed the steps, I'd be all set," she said. "That's what I've done." But PLUS loans don't work for everyone. Dyneche Duffield, 18, of Nacogdoches, Texas, comes from a single-parent household. She and her mother, she said, don't receive financial support from her father, and while Duffield has obtained federal student loans, her mom's poor credit history has kept her from qualifying for a PLUS loan.
Instead, Duffield, an incoming freshman at Houston Baptist University, is now applying for private loans, which generally have higher interest rates than federally-backed loans like PLUS. (PLUS loan interest rates are currently 8.5 percent; interest rates on federal Stafford loans are 6 percent this year.)
Duffield has noticed the decline in student lenders. Her local bank, she said, used to offer student loans but recently stopped.
"I would have much rather taken out a loan there than somewhere where I didn't know anyone," she said. NASFAA's Draeger said the federal government has taken steps to shore up the student loan market through the Ensuring Continued Access To Student Loans Act, which was signed into law in May.
Among other measures, it allows the U.S. Department of Education to buy government-backed loans from student lenders, thereby providing lenders with more capital that they can then use to make new loans. The bill passed Congress and hit the president's desk "very fast," Draeger said. "Everyone's on the same page -- no one wants to see a student denied any access to a federal student loan."
Draeger conceded, however, that the credit crunch means that private loans will be harder to obtain. Charlene Haykel, the CEO of Simply College Aid, a company that advises families on financial aid, advised that when it comes to private loans, students and families should start their research and planning early -- ideally by January of a student's junior year of high school.
"They have to be much more vigilant," Haykel said. Students and parents should treat their search for college funding, she said, "like a job." "Too often, kids wait until the last minute," she said, "and get into very high-debt situations."
Treasury stimulates money grab
When the government of the United States offers to give the financially ailing public an "Economic Stimulus" check (funny thing), I thought that that was what is was to be used for. I was wrong! Apparently, it was a way for the Student Loan people to get additional funds from those who are already hurting economically. This is wrong!
SallieMae is already taking 15 percent of my Social Security check every month, leaving me and hundreds of thousands of Americans who are already hurting without even this small bit of relief.
This was not a tax rebate check. This was not a tax refund check. This check was given for a specific purpose, and that was to simulate the economy and encourage spending to help move some merchandise and get the country moving forward.
It was not suppose to be a grab bag opportunity for SallieMae or any other student loan organization. Where are our representatives? Where are our rights? By what right does SallieMae or anyone else get to confiscate this money?
SallieMae was supposedly under investigation for overcharging students on their student loans and then giving kickbacks to the universities that allowed them to do that. What happened to that investigation? Did our supposed representatives in Washington get an additional kickback to drop the investigation?
I hired a lawyer to settle the account with SallieMae. I have been disabled for years; I can no longer either drive or work. SallieMae disregarded letters sent to them by my attorney three times, effectively denying me my right to have legal counsel. I always thought that the right to legal counsel was a constitutional right, even in a case such as this. Apparently I was wrong there also!
I grow weary of this kind ripoff tactic by SallieMae and others like them. We are already being inundated by outrageous prices at the pump and at the grocery store.
We are being overrun by people who routinely violate our boarders, costing the taxpaying American public billions of dollars a year, and now this new and unconscionable usurpation of our measly little "Economic Stimulus."
This is bordering on the ridiculous. Is there a lawyer anywhere in these United States willing to take on the student loan organizations and stop them from running roughshod over the disabled and poor?
Ilargi: Peter Schiff’s take from a few days ago.
US National Debt Limit Raised Ahead of Budget Busting Bailout Legislation
With President Bush no longer threatening a veto, the subprime mortgage and Fannie and Freddie “bailout” bill is now sailing through Congress. In anticipation of its enactment, Congress had the foresight to raise the national debt limit to $10.6 trillion. Who says that politicians don't plan ahead?
Once signed into law, the budget busting legislation will hand the Administration a blank check to prop up the ailing home lenders. The ultimate cost is anybody's guess. I believe that the price tag will be higher than just about anyone imagines. Paulson's Bazooka will be locked and loaded with enough fire power to blow what's left of our economy into the dustbin of history.
Though the government and Wall Street assure us that these bold moves will save the housing market, and the economy as a whole, from collapse, the reality is that the solution is far worse than the problem. As painful as the failure of Freddie and Fannie would have been, bailing them out will hurt even more. In other words, it's not the disease that will kill us but the cure.
Ironically, while government is rightly criticizing mortgage lenders for ditching lending standards during the boom (well after the horses had left the barn) the new law will actually encourage lenders to be even more reckless then before. By taking all of the risks out of mortgage lending (provided of course that the loans are conforming), the government is telling lenders not to worry about the loans they make, because if borrowers do not repay, the government will.
Since this bailout eliminates all market based deterrents to reckless lending for conforming loans, the only checks remaining will be those imposed by Freddie and Fannie themselves through the criteria they set for those loans. And although they have taken some steps over the past few months to tighten their minimal “standards”, the political agenda behind the bailout will cause this nascent effort to lose steam. In essence, the government's main goal is to prop up home prices. Since American homes are still overvalued given the fundamentals, their prices can only be pushed up with reckless lending and inflation.
As a result of this bailout bill, the share of mortgages owned or insured by Freddie and Fannie will likely swell from near 50% today to over 80% within a year or two, turning a $5 trillion problem into a $10 trillion fiasco. If the government succeeds in keeping real estate prices propped up, it will only do so at the cost of sending all other prices through the roof. More likely, real estate prices will continue to decline despite government efforts to levitate them, compounding the problems and the losses.
The grim reality is that trillions of dollars were borrowed and spent that will never be repaid. No government program can alter that fact. Someone is going to have to pay the piper for all those granite counter tops and plasma TVs. The price tag is staggering and for all the bailouts and stimulus packages, all the government can do is exacerbate the losses and shift the burden through inflation. Nor can the government resurrect bubble home prices and the fantasy of real estate riches that went along with them. One way or another, rational home prices will be restored and the myths of our asset-based, consumption-dependent economy will be finally discredited.
CNBC once nicknamed me “Dr. Doom”, but compared to what I see coming now, they should have then called me “Dr. Sun Shine”. Take a look at a presentation I made back in November 2006, at the Western Regional Mortgage Bankers Conference. There are eight clips in total, and though the entire presentation is worth watching, most of the real estate comments begin with the 4 th clip. Click here to watch the video on YouTube. Every real estate prediction I made at that conference, which was considered outrageous at the time by those in attendance, has already come true. As confident as I was then about this impending crises, I am even more confident now that the government has just thrown gasoline onto the fire.
Ilargi: Good news is hard to find these days, but this I like.
Doha world trade talks collapse in blow to globalisation
The Doha round of world trade talks has collapsed in what one former trade chief called the biggest blow to globalisation since the end of the Cold War.
An emergency World Trade Organisation summit aimed at resuscitating the seven-year long talks broke down in acrimony last night. Negotiators warned that there was now little or no chance of salvaging the talks, which promised to bring down trade tariffs, pull millions out of poverty and keep food and goods prices under control.
It is the first time a major set of world trade talks has collapsed entirely, and insiders warned that the consequences would be comparatively weaker economic growth and a less globalised world in the coming years.
Although the talks broke down at a summit in Cancun five years ago and were later revived, officials warned that there was now “little or no appetite” to return to the round. Insiders said the talks had stumbled after the United States, China and India failed to compromise on the size of their agricultural tariffs.
After nine days of emergency talks in Geneva, WTO chief Pascal Lamy broke the news to ministers from the seven biggest trading blocs that the talks had failed. At the centre of the dispute were so-called “safeguard clauses” which allowed developing nations to slap emergency tariffs on imports if they suddenly jumped to unmanageable levels.
US negotiators apparently balked at Indian and Chinese proposals to trigger these safeguards on their cotton exports. European Trade Commissioner Peter Mandelson said: “We have missed the chance to seal the first global pact of a reshaped world order. We would all have been winners from a Doha deal. Without one, we all lose.”
Peter Sutherland, the chairman of BP, who as director general of the WTO’s predecessor, GATT, helped bring the previous trade talks - the Uruguay round - back from the brink, said the collapse was “a disaster.” “This is deeply disturbing,” he said. “Years of negotiation which were and are important for globalisation have been sacrificed by this failure. And there would appear to be no short-term fix.”
“This is undoubtedly the biggest blow to globalisation since [it gathered pace after] the fall of the Berlin Wall. It is a deliberate and serious blow to multilateralism, and has raised further the spectre of protectionism, which is always evident at a time of weak economic growth and recession.”
Negotiators will now discuss whether any of the progress made in the seven years of discussions can be salvaged. However, with the Presidential election in the US next year and a change of European commissioners later this year, the consensus is that there will be no meaningful opportunity to discuss trade until at least after 2009.
The Demise of Doha
What global trade talks lack in cat-like agility they often make up for by having nine lives. But the Doha Round may not land on its feet after yesterday's collapse, which is dreadful news for the struggling world economy.
There's plenty of blame to go around. The proximate cause of yesterday's schism was a "special safeguard mechanism" for agricultural imports. American officials accused China and particularly India of wanting to renegotiate the level of import growth at which developing nations could invoke this safeguard and jack up their tariff rates.
Officials from other nations reply that India never signed off on that import level in the first place. Indian Commerce Minister Kamal Nath said yesterday that the higher threshold on which Washington insisted would risk "the livelihood of millions of farmers" in his country. We would point out that developing nations ought to welcome cheaper farm products at a time when many of them are raising export tariffs to ensure that enough food stays inside their borders.
In any case, the blame can hardly be laid solely at India's and China's feet. To hear non-American officials tell it, the U.S. was as much at fault as anyone else. The Bush Administration made waves last week when it offered to cut its allowance of trade-distorting ag subsidies by 70% to $14.5 billion per year. But that level, while lower than outlays in seven of the past 10 years, was still twice what Washington paid farmers last year.
U.S. subsidy payments fell in 2007 as commodity prices rose. Congressional mandates for ethanol, which uses corn, have also contributed to the higher prices. Boondoggle that those requirements are, U.S. negotiators could have at least taken advantage of them to make their lower subsidy offer last year. America's trading partners might have been impressed back then; now, not so much.
The U.S. also seems to have erred in insisting on farm-market access (i.e., lower tariffs on food products) to match its cuts in trade-distorting ag subsidies, rather than asking for lower tariffs for manufactured goods and better access for services. The U.S. farm lobby may be strong -- strong enough to muscle Congress in May into passing the new $300 billion farm bill over President Bush's veto. But Americans were always going to benefit far more from a Doha deal that gave their industrial goods and services better access to emerging markets.
The Bush Administration was calling the shots on this negotiation, but Democrats in Congress have also spooked the rest of the world with their protectionist talk -- from their farm-bill veto override to their refusal to ratify a bilateral trade deal with U.S. ally Colombia. For all their talk about listening to America's partners, Democrats have their fingers in both ears on trade.