Debt Rattle, August 1 2008: Bad Math Plugs Holes

George Grantham Bain Collection Haunted House circa 1908
House Chamber of the Capitol, with a quorum of ghosts in this time exposure.

Ilargi: In a CBNC interview, analyst Meredith Whitney gives her view of the credit and housing crisis, touching on a wide range of aspects. I think this is an important interview, because she makes a number of statements that contradict many claims and predictions published by the "respected" media on a daily basis. Even so, she very clearly looks to be holding back in what she says.

Still, while blogs may not always be taken seriously, an attitude that increasingly proves to be just plain wrong, Meredith Whitney cannot just as easily be shoved aside. It’s hard to name a high-level analyst on Wall Street with more credibilty than she has.

Here are some of the things she says:

• Merrill Lynch’s sale of $30.6 billion of its CDO’s will be a blueprint for all other financial institutions that own such instruments.
  
• 25 financial institutions will need to raise additional capital at some point this year.
  
• All the equity raised presently just serves to plug holes; it doesn’t improve banks’ financial positions.
  
• Stocks in financials will not rebound for at least 3 years.
  
• Fannie and Freddie are in the same quagmire as all the rest, they're just bigger.

While, as Whitney says, the Case/Shiller index predicts a 33% drop in residential real estate prices, and most other predictions claim an even - often much- smaller decline, she is sure it will be worse than 33%. She doesn’t say how much worse, but calls lesser claims "bad math".

Her reasoning is as follows:

• Since 2000, 85% of the liquidity in the US housing market has come from securitization. From 2005-2007, $2.5 trilllion worth of mortgages was securitized.
  
• Today, obviously, mortgage backed securities hardly find buyers. That is, except for Fannie and Freddie.
  
• A 33% drop in home prices would lead us back to the price level of 2002-2003. However, homeownership was higher then, and the securities trade was blooming.
  
• Today, banks have less capital, since their shares have lost 50% or more of their value. This will inevitable lead to less lending, which leads to less buyers, which results in lower housing prices.

Whitney therefore states that a drop in prices of 33% or less is not just unlikely, it is mathematically impossible.

Keep that in mind the next time you hear or read claims to the contrary: home prices will fall by more than 33%, and shares in financials won’t bounce back until 2012 at the earliest.

If you must, feel free to ignore my prediction for a drop in real estate prices by 80% or more; until it happens, that is. You will see.

Ignore Whitney at your own peril.



Future of Financials

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Paulson Says Stimulus to Ensure 2nd-Half U.S. Growth

Treasury Secretary Henry Paulson said he expects the government's fiscal stimulus plan will boost economic growth in the second half of the year, offsetting a housing downturn and high energy prices.

"While our economy faces substantial difficulties that will continue to be a drag on growth in the short term, it is important to remember our long-term fundamentals are strong," Paulson said in a speech at the Exchequer Club in Washington today. "I expect our economy to continue growing this year although at a moderate pace."

The Treasury secretary's comments followed a report earlier today that showed U.S. growth in the second quarter fell short of economists' forecasts. Paulson, who promoted a rescue plan of mortgage companies Fannie Mae and Freddie Mac signed into law yesterday, said housing "remains our most significant downside risk."

Paulson said he expected the $168 billion stimulus package enacted in February "to continue to support the economy in the second half of the year." Signals in the housing industry are mixed, Paulson said. Single-family housing starts "look to remain weak through this year" because of bloated inventories, new-home sales "appear to have stabilized" and house prices should begin to recover "in months rather than years," he said.

House prices in 20 U.S. metropolitan areas fell at a faster pace in May than a month earlier, a private report showed earlier this week. The S&P/Case-Shiller home-price index dropped 15.8 percent from a year earlier, the biggest decline since records began seven years ago.

"Until the housing market stabilizes further, we should expect some continued stresses in our financial markets," Paulson said. Today's Commerce Department report showed gross domestic product increased at a 1.9 percent annualized rate, compared with the median projection of 2.3 percent in a Bloomberg News survey.

A separate report showed that more Americans filed claims for unemployment insurance last week than at any time in more than five years. "The housing correction, credit-market turmoil and high energy prices remain a considerable drag on the economy," Paulson said.

He reiterated his stance that oil prices are a function of "supply and demand factors" that can only be alleviated with "a long-term, comprehensive effort." Paulson last week prevailed in persuading Congress to give the Treasury the power to buy equity in Fannie Mae and Freddie Mac for 18 months and expand their lines of credit with the government.

The measure, signed by President George W. Bush yesterday, also tightens regulation of the two so-called government- sponsored enterprises, which account for almost half of the $12 trillion U.S. mortgage market. The housing law "includes significant, temporary provisions that will boost market confidence in the two current, largest sources of U.S. mortgage finance," Paulson said.

Paulson reiterated that "there are no plans" to use the Treasury's temporary authority regarding the two mortgage finance companies, and said the firms' new regulator should work to correct their "structural concerns." "All parties must get to work immediately to begin to address the systemic risk issues posed by the GSEs," he said.

Responding to questions after the speech, Paulson said restoring confidence in Fannie Mae and Freddie Mac was essential to reducing financial-market turmoil. "The highest priority today is restoring our capital markets, not just these institutions but our capital markets broadly, and having these institutions continue to play the vital role they need to play in the housing market," he said.

The Treasury chief used the speech to reiterate his push for the Federal Reserve to take a greater role in financial- market oversight to prevent the reoccurrence of a credit crisis that has caused about $480 billion in writedowns and losses worldwide.

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Deutsche Bank Debt Rating Cut by S&P After Writedowns

Deutsche Bank AG, Germany's largest bank, had its long-term credit rating lowered by Standard & Poor's after announcing higher-than-estimated second-quarter writedowns of 2.3 billion euros ($3.6 billion).

S&P cut the long-term counterparty credit rating one step to AA- from AA, and affirmed the bank's A-1+ short-term rating. The outlook on all the ratings is negative, S&P said, adding that the investment banking industry is still under "heavy pressure."

"The downgrade reflects that we no longer consider Deutsche Bank's performance to be materially stronger than that of the leading peers in the currently difficult environment," said S&P analysts led by Bernd Ackermann in Frankfurt in a statement today.

Deutsche Bank reported yesterday that second-quarter profit declined 64 percent after markdowns on mortgage securities, loans and debt backed by bond insurers led to a loss at the securities unit. Chief Executive Officer Josef Ackermann said he "remains cautious" on the rest of the year.

Deutsche Bank stock has declined 34 percent this year, valuing the company at 31.3 billion euros. The bank, which generates the majority of its earnings from its securities unit, is unlikely to achieve the full-year pretax profit of 4 billion euros that S&P had estimated when setting its ratings, according to S&P.

Deutsche Bank's long-term credit rating was raised to AA from AA- by S&P in August 2007, citing improvements in the bank's profitability. Competitors including Goldman Sachs Group Inc., the largest U.S. securities firm, UBS AG and JPMorgan Chase & Co. also have AA- ratings from S&P, with a negative outlook.

The German bank's second-quarter markdowns brought its total to about 7.3 billion euros. The collapse of the U.S. subprime mortgage market has led to $480 billion of credit losses and writedowns at financial institutions globally, data compiled by Bloomberg show.

Merrill Lynch, the third-biggest U.S. securities firm, said on July 28 it will sell $8.55 billion of stock and liquidate $30.6 billion of bonds at a fifth of their face value to shore up credit ratings imperiled by $52 billion in mortgage losses. Zurich-based UBS, the largest Swiss bank, has recorded about $38 billion of markdowns.

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Manufacturing in U.S. Stagnated in July as Soaring Costs Hurt Producers

Manufacturing in the U.S. stagnated in July as orders slumped to the lowest level in almost seven years, signaling higher raw material costs and slower spending are hurting producers.

The Institute for Supply Management's factory index fell to 50, a higher reading than forecast, from 50.2 in June, the Tempe, Arizona-based group said today. A reading of 50 is the dividing line between expansion and contraction.

Manufacturers are scaling back to protect profits and prevent inventories from growing as demand weakens. The drop in the value of the dollar has made U.S. goods more affordable overseas, leading to gains in exports that are keeping factories from sinking.

"The economy is essentially stalled," David Resler, chief economist at Nomura Securities International Inc. in New York, said in a Bloomberg Television interview. "It will remain that way for the time being. We will see bigger job losses down the road."

Economists forecast the index would decrease to 49 from 50.2 in June, according to the median of 75 projections in a Bloomberg News survey. Estimates ranged from 47.8 to 52.5. A separate report from the Labor Department today showed U.S. employers cut jobs in July for a seventh consecutive month.

Payrolls fell by 51,000, less than forecast, and the jobless rate increased to 5.7 percent, the highest level in four years.
The purchasing managers' gauge of new orders for factories decreased to 45, the lowest level since October 2001, from 49.6. The production measure rose to 52.9 from 51.5.

A shrinking trade deficit has helped some companies withstand slower U.S. sales. Still, the ISM report showed exports, while still growing, are starting to cool. The group's export measure fell to 54 from 58.5 in June. The trade gap narrowed to a $395.2 billion annual pace in the second quarter, the smallest in seven years, the Commerce Department said yesterday. The reduction added 2.4 percentage points to growth, the most since 1980.

The employment index increased to 51.9 from 43.7 in June. BorgWarner Inc., the world's biggest maker of automatic- transmission parts, said yesterday it will cut 1,000 jobs in North America because of declining auto production in the region.
The Auburn Hills, Michigan-based company also said that second-quarter profits rose to $87.5 million, bolstered by overseas demand.

"In Europe and Asia, our businesses are expected to experience sustained growth," Chief Executive Officer Tim Manganello said in a statement. "In North America, our operations will remain focused on fuel efficiency and cost management."
Today's jobs report showed manufacturers cut 35,000 workers from payrolls.

Auto-industry figures, also due today, are forecast to show purchases of car and light trucks in the U.S. were unchanged at a 13.6 million annual rate in July, matching the lowest level since 1993, according to the median estimate. General Motors Corp., Ford Motor Co. and Chrysler LLC are each projected to post their sixth straight monthly decline in sales.

GM today reported a second-quarter loss of $15.5 billion, its fourth consecutive quarterly decline. The purchasing managers' index of prices paid fell to 88.5 last month from a three-decade high of 91.5 in June. Economists surveyed by Bloomberg News forecast the gauge would decrease to 88.

"In North America, our input costs are going up faster than our prices," John Faraci, chief executive officer of International Paper Co. in Memphis, Tennessee, said yesterday in a Bloomberg Television interview. "Inflation's a real issue." U.S. consumers also face inflation concerns. Prices surged 5 percent in the past year, the biggest jump since 1991, the Labor Department said July 16. The increase was led by surging expenses for food and fuel.

A gauge of supplier deliveries was unchanged at 55.1. The inventory index dropped to 45 from 51.2, and the group's measure of order backlogs decreased to 43, from 47.5.

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U.S. Jobless Rate Climbs to Highest in Four Years, Posing Economic Threat

The U.S. unemployment rate rose to the highest level in more than four years as employers cut jobs again in July, increasing the threat of a deeper economic slowdown.

Payrolls fell by 51,000, less than forecast, the Labor Department said today in Washington. The jobless rate rose to 5.7 percent, from 5.5 percent the prior month. As recently as April, it was 5 percent. A separate report showed that manufacturing stagnated in July as companies were hit by rising raw-materials costs and slower spending.

"This is further evidence the economy is in a recession, probably a shallow recession," said Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts, referring to rising joblessness. "It will be a major drag on consumer spending."

The last time the unemployment climbed so much in three months was at the end of the last U.S. recession in 2001. Payroll cuts combined with decreasing property values, stricter lending rules and near-record energy prices to send consumer confidence levels close to the weakest in 16 years in July.

Cutbacks at UAL Corp. and Starbucks Corp. signal firings are spreading beyond builders and manufacturers as raw-materials costs soar. General Motors Corp., which today announced a second- quarter loss of $15.5 billion, may eliminate about 5,000 U.S. jobs by year-end, people familiar with the plan said this week.

Payroll declines spanned transportation, retailing, manufacturing and temporary services industries, the Labor figures showed. The Institute for Supply Management's factory index fell to 50, a higher reading than forecast, from 50.2 in June, the Tempe, Arizona-based group said today.

A reading of 50 is the dividing line between expansion and contraction. The Commerce Department reported construction spending dropped 0.4 percent in June. Today's unemployment figures reinforce the case for the Federal Reserve to hold off on any interest-rate increase until next year, economists said.

The Fed's "hands are tied, there is nothing they can do with regard to this," said Kathleen Stephansen, director of global economics at Credit Suisse Holdings USA Inc. in New York in an interview with Bloomberg Radio. Revisions added 26,000 to payroll figures previously reported for May and June.

Economists had projected payrolls would drop by 75,000 after a 62,000 decline the prior month, according to the median of 80 forecasts in a Bloomberg News survey. The jobless rate was forecast to rise to 5.6 percent. The July cuts bring the total drop in payrolls so far this year to 463,000.

The National Bureau of Economic Research, the official arbiter of U.S. contractions, tracks payrolls, sales, incomes, production and gross domestic product in making the recession call. The group defines downturns as a "significant" decrease in activity over a sustained period of time, and usually takes six to 18 months to make a determination.

The economy shrank at the end of 2007 and grew less than forecast in this year's second quarter, figures from the Commerce Department showed yesterday. Some economists said this indicated the U.S. slipped into a recession late last year. "The economy is limping along right around zero, slightly positive," said former St. Louis Fed President William Poole in a Bloomberg Television interview today.

Fed policy makers will probably keep their benchmark rate at 2 percent when they meet on Aug. 5, futures prices show.
More Americans filed initial claims for unemployment benefits last week than at any time in over five years, Labor reported yesterday. Consumer confidence surveys have indicated that Americans, growing more pessimistic about job prospects, may trim spending.

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China Manufacturing Shrinks for First Time on Record

Manufacturing in China contracted for the first time since a survey began in 2005 as export demand faltered and factories closed to clear the air before the Olympic Games.

The Purchasing Managers' Index fell to a seasonally adjusted 48.4 in July from 52 in June, the China Federation of Logistics and Purchasing said today in an e-mailed statement. The expansion of the world's fourth-biggest economy slowed for the fourth straight quarter in the three months through June on weaker U.S. demand.

China raised tax rebates for shipments of textiles and garments today and the commerce ministry is pressing for slower yuan gains to protect exporters after the currency's 6.8 percent advance against the dollar this year.

"Companies are less willing to invest as export growth slumps, credit gets tighter and the economic outlook worsens," said Sun Mingchun, an economist at Lehman Brothers Holdings Inc. in Hong Kong. "Factory closures ahead of the Olympic Games may also have played a role."

The government has closed construction sites and shuttered factories in and around Beijing to clear smog before the games start next week. Shougang Corp., a Beijing-based steelmaker, will keep only one of four blast furnaces open during the games.

China also faces power shortages. The government has asked coal producers to increase deliveries to power stations to help ease a sixth year of electricity shortages and ensure supplies for the games, according to a July 30 report by the state-run Xinhua News Agency.

Six of 11 sub-indexes in the PMI fell to record lows, including output, new orders and export orders. "The size of the slowdown is unexpected," said Xing Ziqiang, a Beijing-based economist at China International Capital Corp., the nation's biggest investment bank. "The government may use a more active fiscal policy, slow gains by the yuan, and encourage lending to small companies."

The Communist Party's Politburo said July 25 that maintaining growth and fighting inflation are the two biggest priorities for the rest of the year. Inflation this year is the fastest since 1996. Consumer prices rose 7.1 percent in June. China is raising tax rebates on exports of textiles and garments to 13 percent from 11 percent today, according to the State Administration of Taxation.

The Ministry of Commerce had urged China's cabinet to rein in currency gains and raise some rebates, a ministry official said July 14, speaking on condition of anonymity. The yuan's advance against the dollar in 2008 has been at more than double the pace of a year earlier.

The economy expanded 10.1 percent in the second quarter as the trade surplus narrowed 12 percent from a year earlier to $58.14 billion. Today's survey "may indicate the economy will continue to weaken," Zhang Liqun, a senior research fellow at the State Council's Development Research Center, said in the statement. Companies "are facing increasing difficulties and this could curb economic growth and reduce employment and incomes."

The PMI is based on a survey that started in January 2005 of more than 700 companies in 20 industries, including energy, metallurgy, textile, automobile and electronics. A reading above 50 reflects an expansion, below 50 a contraction. The output index fell to 47.4 in July from 54.2 in June, while the index of new orders dropped to 46.2 from 52.6. The index of export orders declined to 46.7 from 50.2.

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Merrill knowingly sold $30 BILLION of trash in eight months

This story is amazing. In 2007, during the time in which subprime lenders were collapsing and defaults soaring, Merrill was packaging up and selling $30 billion in rotten CDO’s and selling them as fast as they could.

Everyone already knows about the Merrill 5.47 cents on the dollar CDO deal that just went down. Now, of course, many are coming out saying ‘but but but that was for the worst of the worst CDO’s’ and ‘but but but, 2005 vintages were not as strong as recent vintages’.

That is not the truth. The truth is that Merrill’s marks are very similar to National Australia Banks write-down earlier this week and other banks with similar holdings will likely have to write down their holdings similarly.

Now, Janet Tavakoli, CEO of Tavakoli Structured Finance is coming out and telling the truth about Merrill’s deals in a report to her clients yesterday Elinor Comlay at Reuters reports.

She said that ‘of the 30 CDO’s Merrill sold in 2007, every one have performed poorly with either its best-rated portion cut to junk, is in technical default, is being liquidated, or is in danger of being liquidated. ‘The poor performance suggests that Merrill was underwriting deals it knew or should have known were bad’, Tavakoli said.

She also said “investment banks have a huge credibility problem when trying to explain that they didn’t know the gun was loaded” and “it is one thing to have documents that disclose risks…it is quite another to bring deals to market that you knew or should have known were overrated and deeply troubled the day the deal closed”.

I believe this entire Merrill ordeal is a watershed event and not of the same type Cramer was relentlessly pumping today. This is $30 BILLION of trash in eight months. The problem her e is subprime, Alt-A and even Prime whole loans and MBS (CDO parts) were under heavy pressure, subprime lenders were failing and defaults were surging during this period. I tend to agree with Janet…they knew exactly what they were doing.

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GM Staggers Under Losses

General Motors lost a staggering $15.5 billion in the second quarter as the company struggled to come to grips with a weak economy and a head-spinning change in consumer tastes.

GM said on Aug. 1 that $9.1 billion of the losses came from one-time charges and writedowns. But the one-timers stemmed from restructuring moves taken because GM's business is out of step with the car market. Take those away, and GM still lost $6.3 billion.

The freefall in sales of SUVs and pickup trucks continues to hammer GM's revenue and profits. In North America, revenue fell $10 billion in the quarter, to $19.8 billion. Discounting one-time restructuring charges, GM lost $4.4 billion in its home market.

Even GM's overseas operations, while mostly profitable, didn't have such great news. GM's rebounding European business made just $20 million, a far cry from the $315 million the unit made in the second quarter last year. The automaker's Asia-Pacific business lost $163 million, though much of that was due to a one-time accounting charge. Latin America was GM's one bright spot: Profits grew 50%, to $445 million.

Since GM has long relied heavily on pickup trucks and SUVs for its profits, the consumer shift to smaller, thriftier vehicles has thrown the company into its second financial crisis in three years. And whereas investors and analysts usually discount one-time charges, in this case they are too big to ignore.

Of the $9.1 billion GM calls one-timers, $3.3 billion came from buying out hourly workers to cut payroll. Cutting production and closing plants ate up $1.1 billion. Then there's GM's former parts unit, the bankrupt Delphi. GM had to set aside $2.8 billion to help bail out the parts maker.

Even GM's lending operations have turned up snake eyes. GMAC, which is now 51% owned by Cerberus Capital Management, lost $2.5 billion in the quarter. GM's share of that loss comes to $1.2 billion. To make matter worse, GM had to write down about $2 billion in automotive leases.

Many carmakers are taking hits in their leasing portfolios, mostly because of a drop in value of SUV prices. Over the past decade, carmakers leased millions of SUVs. Now the gas guzzlers are coming back with resale values lower than executives anticipated when they leased the car. So the companies are selling them at a loss.

Add it all up, and GM continues to burn through a lot of cash. The company said it spent $3.9 billion in cash in the quarter, leaving it with a reserve of $21 billion. That may seem like a lot of money, but analysts say GM needs at least $10 billion on hand to keep parts coming in and plants rolling. Since the end of last October, GM has eaten up $10 billion.

That's why the company announced moves last month to save $10 billion in cash through various cost-cutting moves, and to raise $5 billion. GM Chief Financial Officer Ray Young said the company's primary focus is on conserving cash.

GM Vice-Chairman and Chief Operating Officer Frederick "Fritz" Henderson said GM knew how bad its second quarter results would be when the company drafted that plan. So he believes GM's cash should last through the current downturn.

J.P. Morgan analyst Himanshu Patel said in a research note that GM's overseas operations were weaker than expected. If its international businesses are weakening, the company will have a very tough time getting back in the black.

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GM Has $15.5 Billion Loss on U.S. Sales Drop, Leases

General Motors Corp. reported a second-quarter loss of $15.5 billion, the third biggest in its 100-year history, because of plunging U.S. sales and the declining value of truck leases. The shares fell as much as 9.8 percent.

The deficit of $27.33 a share compares with a profit of $891 million, or $1.56, a year earlier. Excluding costs GM considers one-time, the per-share loss was 4 times bigger than analysts projected. Labor strikes contributed to a $9.9 billion drop in North American revenue, and sales worldwide tumbled 18 percent to $38.2 billion.

The results step up pressure on Chief Executive Officer Rick Wagoner, 55, to show he can revive the largest U.S. automaker. Wagoner, in his 9th year as CEO, has posted $69.8 billion in losses since 2004 and is trying to raise as much as $17 billion in cash while speeding the development of fuel-saving cars to replace the trucks being abandoned by U.S. buyers.

"They really need those external fund-raising measures to get through to 2010," said Brian Johnson, a Chicago-based Lehman Brothers analyst, in a Bloomberg Television interview. "We cannot count on an economic rebound."

GM's fourth straight quarterly loss comes as a weakened U.S. economy and soaring gasoline prices drag U.S. auto sales to 15-year lows. GM's volume dropped 16 percent through June, and analysts expect the automaker to report a decline in that range when July results are released today.

"The second quarter has been one of the fastest-changing quarters I've ever seen" in terms of consumers switching from pickups and sport-utility vehicles to cars and small SUVs, Chief Financial Officer Ray Young told reporters in Detroit today.
GM burned through $3.6 billion in the quarter and said today its supply of cash, marketable securities and other funds available fell to $21 billion on June 30, from $23.9 billion at the end of the first quarter.

GM fell 85 cents, or 7.7 percent, to $10.22 at 9:54 a.m. in New York Stock Exchange composite trading, dropping to $9.99 earlier. The shares plunged 56 percent this year through yesterday, for the worst decline among the 30 companies in the Dow Jones Industrial Average. The Detroit-based automaker reported a $2 billion charge in the quarter because of the decline in residual values for leased vehicles.

Excluding costs such as a charge for an attrition program and an adjustment to its reserve for Delphi Corp. considered by GM to be one-time expenses, the loss was $6.3 billion, or $11.21 a share. On that basis, the company was forecast to lose $2.40 a share, the average of 12 analysts surveyed by Bloomberg.

GM was profitable in both its European and Latin America- Africa-Middle East region, posting profits of $20 million and $445 million, respectively. The automaker's loss grew to $9.3 billion in North America, from a deficit of $88 million. In its Asia-Pacific region, GM had a loss of $163 million after a profit of $280 million a year earlier.

About $1.2 billion of GM's loss was related to the automaker's partly owned GMAC finance unit. GMAC yesterday reported a $716 million pretax expense for residual-value losses as part of a $2.5 billion second-quarter net loss. GMAC said it was able to reduce that cost because of $1.55 billion that the finance and mortgage company expects to receive from GM through risk-sharing and other agreements and $350 million in payments already made.

GMAC said it has $30 billion in North American leases. That includes $12 billion in SUVs and $6 billion in other trucks, vehicle types that are losing sales because of $4 gasoline. The residual value is what a vehicle is worth when a customer returns it at the end of a lease. The lender's residual losses average $11,000 a vehicle for GM models, GMAC Chief Financial Officer Robert Hull said yesterday.

The cost of protecting GM debt from default rose. The upfront cost of credit-default swaps on GM rose 3 percentage points to 43.5 percent, according to CMA Datavision prices at 7 a.m. in New York. That means it costs $4.35 million initially and $500,000 a year to protect $10 million of bonds from default for five years.

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Ilargi: Ambac will run out of cash very soon if this continues. But yes, Merrill’s CDO sale reverberates.

Ambac Financial Group reduces CDO exposure

Bond insurer Ambac Financial Group Inc. said Friday it settled one of its largest exposures to risky collateralized debt obligations.

Ambac agreed to pay $850 million to end an insurance agreement covering a $1.4 billion CDO transaction. So-called CDOs are complex financial instruments that combine various slices of debt. Shares of Ambac rose $1.02, or 40.5 percent, to $3.54 in midday trading.

As credit markets deteriorated over the past year, CDOs have been considered one of the riskiest types of debt, with investors and ratings agencies worried they would increasingly default, leading to a spike in claims payments for bond insurers. Many CDOs include portions of mortgage-backed securities, whose defaults are likely because of rising defaults among underlying mortgages.

Uncertainty surrounding ultimate losses on products like CDOs has led ratings agencies to slash bond insurers' critical financial strength ratings and sent their stock prices plummeting.

"The primary benefit of this agreement is that it eliminates uncertainty with respect to future losses related to this transaction," Michael Callen, Ambac's chairman and chief executive, said in a statement. "We view the final outcome as favorable in light of the numerous widely circulated models that assumed a 100 percent write-off for this transaction."

Ambac had already written down the value of the CDO by $1 billion - more than what turned out to be Ambac's actual loss on the transaction. Because it canceled the contract at an actual loss of $850 million, Ambac will record a positive pretax adjustment of $150 million to offset the previously recorded write-down.

Goldman Sachs Group Inc. analysts Monica Gabel and Daniel Zimmerman said the cost to end the transaction - about 61 cents on the dollar - is cheaper than losses than Ambac would have incurred had it continued with the insurance agreement. Gabel and Zimmerman said similar CDOs will likely lose 75 cents to 95 cents on the dollar if insurers hold them until maturity or they default.

The trend of making payments to cancel insurance agreements could be growing. "We believe that the financial guarantors will continue to make efforts to reduce their exposure to risky assets, with special focus on the larger and more volatile deals where ultimate losses are highly anticipated and principal payments can be accelerated," Gabel and Zimmerman wrote in a research note.

Earlier this week, another bond insurer, Security Capital Assurance Ltd., reached an agreement with Merrill Lynch & Co. to reduce its exposure to risky debt as well. Security Capital agreed to a deal to cancel eight derivatives agreements with Merrill Lynch.

Merrill Lynch will receive $500 million in exchange for canceling $3.74 billion in agreements. Security Capital shares have more than quintupled in value since the company announced the deal with Merrill Lynch. Security Capital shares rose 83 cents or 43.7 percent, to $2.73.

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UBS lawyer Aufhauser at center of New York probe

David Aufhauser, the general counsel for UBS AG's investment banking unit, is at the center of a civil probe by New York Attorney General Andrew Cuomo into the Swiss bank's sales of auction-rate securities, a person familiar with the situation said on Friday.

Last week, Cuomo sued UBS and accused it of committing fraud by steering clients into auction-rate securities that became impossible to sell once the credit market tightened. Cuomo contends UBS insiders dumped their own holdings even as the bank continued to sell the debt to clients.

Aufhauser is the executive who was described in the lawsuit only as "Executive A," said the source, who asked not to be named. According to the lawsuit, he was part of an executive group that looked into a series of problems related to auctions managed by UBS.

Shortly after exchanging messages with other UBS executives about the increasing difficulty with auctions, Aufhauser sent an e-mail to his broker asking to shed all of his $250,000 in personal auction-rate holdings, according to the lawsuit.

The New York AG's office did not respond to requests for comment. UBS declined to comment on Executive A's identity. "The New York attorney general did not identify the names of the executives in his complaint, and we decline to do so," the bank said in a statement. Aufhauser, who is still an employee of UBS, was not available for comment.

Aufhauser, who joined the bank in 2004 and was formerly a general counsel to the U.S. Treasury Department, later bought back some auction-rate securities, the lawsuit said. No charges have been filed against him or any other individual.

According to the state lawsuit, at least seven UBS executives dumped $21 million in auction-rate securities held in personal accounts as the credit market began showing signs of trouble. The state alleges the bank continued to sell those securities even as executives privately expressed worries that these markets were struggling.

UBS last week said it conducted an internal probe of alleged sales of personal holdings of auction-rate debt by its executives and found no wrongdoing.

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Report says French bank didn't know about alleged rogue trader

A report by French investigators contradicts former futures trader Jerome Kerviel's claim that his superiors at Société Générale knew he was betting with tens of billions of the bank's money, a judicial official said Friday.

Financial investigators concluded that Kerviel took advantage of his managers' negligence to hide his massive trades - which contradicts the trader's allegations that his higher-ups were aware of what he was doing and did not stop him as long as he made money for the bank, according to an article in Le Figaro newspaper.

A judicial official confirmed Le Figaro's account of the financial brigade's report. The official spoke on condition of anonymity because the investigation is ongoing. In one of history's biggest banking scandals, Société Générale accused Kerviel, 31, of betting tens of billions of euros of the bank's money without permission, which led to almost €5 billion, or more than $7 billion, in losses once the bank unwound his positions.

The affair rattled the already shaky banking sector earlier this year and prompted widespread calls for tighter internal controls at banks. Investigating judges have filed preliminary charges against Kerviel for forgery, breach of trust and unauthorized computer use.

The report by financial investigators, which joins various other documents in the probe, concluded, "We can legitimately believe that the size of the financial losses can be explained by the fraudulent maneuvers of a trader who abused his superiors by taking advantage of their failings and the breakdown of internal controls," according to Le Figaro.

Société Générale, or SocGen, declined to comment about the investigators' report, while Kerviel's spokeswoman and legal team did not immediately respond to phone calls seeking comment. The report by financial investigators echoed many of SocGen's own findings.

SocGen has said Kerviel began trading illicitly in 2005 for modest amounts. He was involved in what is known as "plain vanilla," or the more basic forms of hedging, with limited authority. The bank says in 2007 he went far beyond his role - taking massive directional positions in various futures contracts, apparently escaping detection by the bank's control systems by forging documents and e-mails to suggest he had hedged his positions.

An internal report by the bank in May said Société Générale managers failed to follow up on 74 different alarms about Kerviel's activities and queries from derivatives exchange Eurex. The bank says it had no knowledge of Kerviel's actions.

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Citigroup faces formal SEC probe, state subpoenas

Citigroup Inc on Friday said the U.S. Securities and Exchange Commission has opened a formal probe into possible violations of federal securities laws in connection with the sale of auction-rate securities.

The largest U.S. bank by assets also said it is responding to subpoenas from state agencies, including those in Massachusetts, New York and Texas, concerning the securities. Regulators are examining whether banks and brokerages nationwide misrepresented the safety of auction-rate securities to investors.

The $330 billion market normally lets municipal issuers borrow money long-term but at lower, short-term rates. Some of the market remains frozen after a February meltdown in which brokerages quit their role as buyers of last resort.

Separately, Citigroup said it is cooperating with information requests from governmental and self-regulatory agencies regarding several bank-managed hedge funds, including Falcon Two, ASTA and MAT Five LLC. Citigroup disclosed the various regulatory actions in its quarterly report filed with the SEC.

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Ambac reaches $850 mln derivatives settlement

Bond insurer Ambac Financial Group Inc said Friday it reached an $850 million counterparty settlement over derivatives that it had insured, which will help boost a unit's capital position.

Ambac said it had already recorded about $1 billion in mark-to-market losses on the securities, which were once highly rated but have since been downgraded to junk status.

As a result of the transaction, the company will be able to record a $150 million mark-to-market adjustment and boost the capital position of Ambac Assurance Corp, its main business unit

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Hedge funds are buying up delinquent mortgages

Guess who holds your mortgage now? It's your friendly neighborhood hedge fund.

Dozens of hedge funds, private equity groups and other investors have plunged into the beaten-down mortgage market in recent months, buying tens of thousands of distressed loans and foreclosed properties around the country. They hope to profit from the woes of banks and other investors holding mortgages that have plummeted in value as home values sink and defaults soar.

They are buying them from Wall Street investment banks eager to rid themselves of bad assets. Merrill Lynch & Co., for example, said this week it would sell mortgage-linked investments once valued at $30.6 billion for just $6.7 billion to Lone Star Funds, a distressed-debt investor in Dallas.

Many of the hedge funds, run by former Wall Street and lending industry executives, claim they can do a better job than banks or other investors of modifying mortgages at terms that consumers can afford.

"We're much easier to deal with than a bank," said Jacob Benaroya, managing partner of New Jersey-based Biltmore Capital Group, a hedge fund that's buying up to $100 million in mortgage debt per year. "We've bought (the loan) at enough of a discount that we can make special arrangements with the borrower."

However, the hedge funds acknowledge that the loans they purchase are often in such trouble that as many as two-thirds to one-half can't be salvaged. In that case, the fund obtains the property through foreclosure and tries to sell it off, or allows the borrower turn over the house keys in return for forgiving the outstanding mortgage balance.

Edelmira Sayo, a real estate agent in Northern California, wound up turning over a rental property to investment firm G8 Capital this month after falling into financial trouble as her business slowed down and her income dropped. The investor had offered to cut the value of the $410,000 loan by $50,000, but she still couldn't qualify for a new loan because the value of her property had plummeted by nearly $100,000.

"If I could have just had it modified, I could have kept it," she said. "I didn't want to tarnish my credit report...It's just so sad."
Evan Gentry, chief executive of G8 Capital, said the company worked with Sayo for months to help her find a way to refinance the mortgage, but he said it couldn't be done because of falling property values, tighter credit standards and Sayo's lower income.

For many such borrowers, he said, "the best move for them is to simply do a deed in lieu of foreclosure and simply start over," adding that many borrowers "feel a great relief when we tell them it's OK" to do so.

So far, housing advocates say they haven't yet seen the impact of such hedge funds among the borrowers they counsel. But they hope these new investors will be more amenable to borrowers interests' than the current mortgage holders, which have been widely criticized for being sluggish to modify loans amid an unprecedented volume of defaulting loans.

"I have been waiting for this to happen," said Gabe del Rio, vice president of lending at Community HousingWorks, a nonprofit housing agency in San Diego. "It will equate to a deeper ability to modify mortgages." Still, there are some worries that desperate borrowers unwittingly may be giving up protections - such as the right to sue the original lender - when they agree to a modification.

"Borrowers are not represented by an attorney or anybody who can advise them about the legal effects of what they're signing," said Kurt Eggert, a professor at Chapman University's law school. Distressed debt investors, however, emphasize that they are less bureaucratic and more willing to make changes than most loan servicers, which collect and distribute mortgage payments.

"They've got too many loans and not enough people," said Matt Stadler, a principal with investment group National Asset Direct, which currently owns about 750 loans and is looking to double that amount. Restructuring the loan, when possible, is often faster and less expensive than going through the foreclosure process.

"We're fully aligned with the interest of the borrower to find a way to make the loan more valuable by keeping them in their home," said Stanford Kurland, a former Countrywide Financial Corp. executive who founded Private National Mortgage Acceptance Co. Kurland's company, nicknamed PennyMac, aims to raise $2 billion for mortgage acquisitions.

To negotiate new loan terms with borrowers, some companies are setting up their own loan servicing operations. For example, Marathon Asset Management, a New York-based hedge fund that specializes in debt investments, has its own loan servicer, Phoenix, Ariz.-based Marix Servicing, to handle the loans it purchases and those for other companies.

The company's 85 employees handle no more than 200 cases each, compared with 500 or more for more typical loan servicing companies, said Rick Smith, the company's president. His employees are also more aggressive. "It's not just calling somebody once a week," Smith said. "We might call them on a daily basis, morning noon and night to find the best contact."

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New Hampshire accuses mortgage company of fraud

The New Hampshire Banking Department is taking aim at The Mortgage Specialists Inc. with allegations of fraudulent loans and altered documents at the mortgage company.

An examination of the Plaistow-based company -- which has offices from Massachusetts, to Manchester, to the New Hampshire Seacoast -- uncovered altered and missing documents, poor record-keeping and at least one fraudulently issued mortgage loan, state bankers allege in a cease-and-desist order issued July 24.

The department is proposing administrative fines of up to $200,000 against The Mortgage Specialists Inc., its president, Michael Gill, compliance officer Lisa Tracy, operations manager Jean Duerr, and Salem branch manager David Caillouette. The Mortgage Specialists Inc. also could have its state mortgage banker-broker license suspended or revoked. The order instructs the company not to break state banking regulations and laws.

State regulators and investigators claim an inspection showed that The Mortgage Specialists:

• Represented photocopied customer signatures as originals;
  
• Removed a signature from a loan file;
  
• Altered broker fee agreements after the consumer signed the documents;
  
• -Failed to keep customer application files under lock as required by the Gramm-Leach-Bliley Act;
  
• -Fraudulently issued a 40-year adjustable rate mortgage with a balloon payment at the end of 30 years to a customer who had applied for a fixed-rate, 30-year mortgage.

The department alleges The Mortgage Specialists committed a total of 50 violations of state banking laws, each subject to an administrative fine of up to $2,500. If the violations were upheld after hearing and applied to both the corporation and the four named defendants, administrative fines could total $1 million.

"We are working with the banking department and having continuing discussions with them and are prepared to take whatever steps are necessary to make sure the banking department is completely satisfied with the company's practices and procedures," said attorney Alex J. Walker, partner in the Devine Millimet law firm, which represents the mortgage firm.

The cease-and-desist order gives The Mortgage Specialists and individual defendants 30 days to request a hearing or reach formal settlement with the Banking Department. Attorney Walker said he received notice of the Banking Department staff's petition and order to show cause over the weekend. It was posted on the department Web site yesterday.

"The company obviously takes the allegations very seriously and is working very diligently to address each and every one of the concerns raised by the banking department," he said. The Mortgage Specialists Inc., which has been in business since 1991, has New Hampshire-licensed branches in Manchester, Nashua, Plaistow, Salem, Somersworth and Windham. It also has Massachusetts branches in Peabody and Worcester.

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Chavez intends to nationalize foreign-owned Banco de Venezuela

Banco Santander bank said Friday it was in talks with Venezuela over the future of its subsidiary, Banco de Venezuela, which President Hugo Chavez says he intends to nationalize.

The Spanish bank said it had planned to sell the Venezuelan financial entity to a group of investors in the South American country, but had not reached a final deal. Banco Santander said in a statement it had since learned of the Venezuelan government's interest in the bank and was "in conversations to this end at the moment."

Spain's government said it had no plans to intervene in the announced nationalization. "There has been a dialogue and a negotiation and we hope that in a short space of time an agreement will come about between the government of Venezuela and Santander," Deputy Prime Minister Maria Teresa Fernandez de la Vega said.

De la Vega said she has spoken with Banco Santander President Emilio Botin, who had confirmed negotiations for the sale of Banco de Venezuela were under way.

In a televised address Thursday, Chavez said he decided to nationalize after learning that Banco Santander had contacted a local bank to sell the institution. He said the local bank asked for authorization from the government, but that he, "as the head of state," said no. "We are going to take back the Bank of Venezuela to put it at the service of Venezuelans," Chavez said.

Banco Santander purchased the Banco de Venezuela in 1996. The financial institution is the country's No. 3 bank with nearly 3 million customers and some US$11 billion in assets. Chavez had threatened to nationalize Venezuelan subsidiaries of Spanish banks after King Juan Carlos told him to "shut up" at a summit last November.

But just last week he wrapped up a European tour with a hug-and-kiss makeup visit to Spain, where he was greeted warmly by the king at his summer residence on the island of Mallorca. Chavez later flew to Madrid for talks with Prime Minister Jose Luis Rodriguez Zapatero. The two leaders said their relationship was renewed and any past tension was behind them.

But the Venezuelan leader Thursday claimed the Spanish news media would use the opportunity to damage relations once again. The announcement was a lead news item on Spanish media all day Friday. Chavez has already nationalized its largest telephone, electricity, steel and cement companies and has assumed majority control over four major oil projects

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UK faces negative equity crisis

Britain is on course for a re-run of the negative equity crisis of the early 1990s, with one in seven UK homeowners facing the prospect of having a property worth less than their mortgage, the ratings agency Standard & Poor's said today.

The company predicted that house prices would tumble by a further 17% over the next year, prompting a rise from 70,000 to 1.7m households in negative equity - the same as at the depth of the housing-market meltdown of the early 1990s.

Andrew South, a credit analyst at S&P, said: "The downward trend in UK house prices now seems well established, and we expect prices to continue falling in the near term".

House prices have been falling at their fastest rate on record in recent months, but the previous boom in property values means that only a fraction of Britain's home-owners - 0.6% - are currently in negative equity. The average UK mortgage is for 54% of the value of the home.

S&P warned, however, that for every further percentage point fall in house prices, a further 0.5%-1.5% of borrowers (between 60,000 and 180,000) could enter negative equity. Noting that the trough in the cycle would not be reached until 2009, S&P said: "At this point, we expect 1.7 million borrowers - around 14% - would be in negative equity."

The company said borrowers in the buy-to-let and sub-prime sectors were most at risk from negative equity. "A further 17% decline in house prices could put around 24% of noncomforming borrowers into negative equity, compared with only 13% of prime borrowers."

A return to the negative equity levels of the early 1990s would put additonal pressure on the government to help homeowners. Alistair Darling received an interim report yesterday on the mortgage market from the former HBOS chief, James Crosby, and is expected to come up with proposals in the autumn pre-budget report.

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UK Housing Bubble Nears Apocalypse

Who will save the great British House-Price Bubble? I'd been calling the top for so long – as long-time Daily Reckoning UK readers will recall with a groan – that the crisis now upon us almost missed me by.

But "in the market for established homes, more transactions [are] falling through," reports the latest Summary of Business Conditions from the Bank of England, "with some estate agents reporting a cancellation rate of up to 40%."

Put another way, some parts of the UK – where national transaction volumes have already dropped 43% from their average of the last three-and-a-half decades – are seeing four-in-ten sales grind to halt after the deal is agreed.


"That was partly due to the unwillingness of many sellers to accept a lower offer," says the Bank's July report. Meaning that would-be buyers are under-cutting their initial bid, leaving vendors to either take it or leave it. But vendors remain in denial, meantime, about the true market-price of their homes in this fast-sinking market.

Central London has already seen prices lose 10% from last autumn. Nationwide, average sale prices have fallen 8%. But compare the average "asking price" tracked by Rightmove – the No.1 estate-agency website – with the actual "completion prices" recorded by the official Land Registry, and the gap between hope and reality continues to widen, rather than shrink.

It reached almost £59,000 in June, a 24% discount off vendor intentions. How come? Contrary to popular belief – egged on by central government, the media (not least Channel Four), and claims that the UK "needs" an extra three or maybe Five Million Homes by 2020 to meet demand – house prices don't always go up. Not with the average home costing a record 6.5 times average income by mid-2007.

And then, of course, came the credit crunch. Now, on the other side of the trade from would-be vendors, many potential buyers simply cannot raise a mortgage loan, let alone match the seller's over-inflated dreams of yesteryear's gains.

Anecdote here in London has that what US realtors would call "jumbo" mortgages now require the buyer to settle a minimum 25% of the sale price with a cash deposit. Lenders will then advance a maximum half-million pounds. That effectively caps home prices in the capital at the apocalyptic level of £666,000...some $1.3 million.

Yes, that's more than twice the price of London's average semi-detached home (a quaint English expression meaning "a house with only one shared wall". American readers enjoying the average 2,250 square feet of US living space should consider that British homes are barely one-third that size.

The most common alternative to "semi-detached" is a sardine-tin "terrace" with neighbors squashed right up against you on both sides.) But the greatest lie of them all during this decade's historic bubble in prices was that the "trickle down" from high-end home buyers – numbering the Russian mafia, Euro-trash bankers and City traders fat on year-end bonuses – would keep the whole game running at any price for ever.

Fact is, in contrast, that the excesses higher up the housing ladder merely encouraged more modest subjects to beggar themselves trying to keep up. All told – adding personal loans and credit-card debt to outstanding mortgages – UK citizens now owe the banks some £1.44 trillion...roughly $2.8 trillion and well over 12 months of gross domestic product (GDP).

That's more than twice the outstanding debt owed in July 2001. The economy has grown a mere 24% since then. So at the top of the curve, with new debt growing by 14% year-on-year, every extra Pound borrowed resulted in just 10 pence growth in the economy.

Never before in history has any other nation even come close. At least the Tokyo real estate bubble ending in 1989 came against strong personal savings rates and a massive surplus in Japan's balance-of-payments.
Whereas now, and here...?

"The UK housing event is probably second only to the Japanese 1990 land bubble in the Real Estate Bubble Hall of Fame," writes Jeremy Grantham, co-founder of the GMO investment group in the late '70s. It now runs $126 billion in assets from Boston.


"While the US is a newcomer to housing bubbles," he goes on in his latest client letter, "the Brits are old pros. It's practically their national past time. "1973 and 1989 were the peaks of two handsome, fairly symmetrical housing bubbles in the UK.

[Now] house prices could easily decline 50% from the peak, and at that lower level they would still be higher than they were in 1997 as a multiple of income. It will make our troubles look like a toothache to their hip replacement.

What's more, "unfortunately for global financial well being," notes Grantham, "the UK is not Iceland, but a major player in the global banking business, so the scale of the write-downs will produce yet another wave of destabilization."

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British Airways chief warns 'airlines will go bust'

More airlines will go bankrupt this year as rising fuel costs and weak consumer confidence ravage the industry, the chief executive of British Airways warned today.

Willie Walsh said carriers that struggled to make a profit during the recent sales boom will not survive the "worst ever" trading environment the industry has seen. The downturn has put 25 airlines out of business this year, including Luton-based business carrier Silverjet.

"You are going to see more airlines go bust. If you look around there are a lot of airlines out there that have not been profitable in the past few years. Those guys will not survive," he said.

Walsh added that fares will rise by an average of around 3% for the rest of the financial year, as BA passes on higher fuel costs to ever fewer passengers. Fares are expected to increase towards the end of the year as airlines' fuel hedges, where carriers buy their fuel in advance at a fixed cost that is often cheaper than the current market price, come to a close.

"As hedging unwinds within the industry, airlines are going to have to reflect the higher oil price. We will have to do something and it's not just BA that will have to adjust prices. The whole industry will have to. We are not reflecting the spot price [of oil] today. What is reflected in our fares is the oil price net of hedging." Higher fuel surcharges are also an option, but BA has already increased those significantly this year.

Walsh said BA is now planning for an oil price of up to $150 (£76) per barrel - a level at which no carrier in the world can make a profit currently. The BA chief executive, who announced an 88% dive in first quarter profits today due to high oil prices, said the re-fashioned BA will have more fuel-efficient aircraft, better customer service and be focused on long-haul business class customers.

"We are honest and realistic about this in a way that a lot of airlines are not. We have asked ourselves the question of what does the industry look like at $150 per barrel and what do we do to be one of the airlines that succeeds in that environment. We don't just want to hang in there."

Walsh did not rule out further capacity cuts next summer, adding that BA will fly its older long-haul planes less often next year in order to cut fuel bill that now stands at £8m per day. "We are not talking about grounding aircraft but the average utilisation will come down slightly."

He said he was "comfortable" with axing around 160 flights per week from BA's winter schedule because sales are always slower between October and March. He denied that the case for a third runway at Heathrow had been hit by recent capacity cuts at BA and other airlines, because long-term demand for commercial flights remains strong, he said.

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