Thursday, August 21, 2008

Debt Rattle, August 21 2008: It Is Time

National Photo Company Flag Day 1915
Post Office, Washington

Ilargi: I’m not in the habit of calling moments, I prefer to focus on tendencies.

One of the reasons why is that mentioning specific timelines apparently allows and evokes in readers a license to misunderstand, intentional or not.

When I said in early March that the game was over, people took that to mean that the entire world would get a blue hat for Easter at the latest, with the skies coming down, and a deity of one’s choice pointing an accusing finger and announcing, in a thunderous voice, imminent disease and locust plagues.

I never said that. What I meant back then was that the changing tone in media reports, as well as a Goldman Sachs statement on coming writedowns, made it clear that a point of no return had been crossed.

Everything that’s happened since has confirmed what I said (just not necessarily what people wished to read into it).

The main development in financial markets in the past 6 months, bar none, has been the accelerated influx of taxpayers’ money into the US and EU economies, in an alleged but highly suspect attempt to "save" financial markets.

Today, August 21 2008, marks another such watershed moment that I simply have to call. A number of developments come together to mark the moment..

I think I first realized it fully when Fannie Mae and Freddie Mac share prices were rising this morning. There is no reason for that, and it won’t last. But it does shine a blindingly clear light on other things: Their shares went up because everything else is worse.

The main development may be that foreigners are no longer willing to buy US debt paper, at least not in the way they have until now.

Lehman, one of the oldest, best connected and largest US investment banks, until recently, tried to sell 50% of itself to foreign funds. They refused to buy.

6 months ago, it would have been unthinkable to offer 50% of such an institution to a Chinese fund. Congress would have forbidden it. Today, there’s no such protest. Just a "Thanks, but No, Thanks" from the Chinese.

Moreover, there’s a avalanche of reports on the desperate situation at the other investments giants, Goldman Sachs and Morgan Stanley. Waiting in the wings are the commercial banks, with Citigroup teetering toward oblivion.

Fannie and Freddie are long beyond salvation; the only reason they haven’t been liquidated to date is politics, the same kind that allows Ford and General Motors to pose as going concerns.

But neither Washington nor the Federal Reserve could possibly save the US financial system anymore, even if they wanted to, something I question. The number of institutions being hurled into the black abyss is increasing so fast, they wouldn’t know where to start anymore.

The game in town is saving the Hampton estates and the Learjets with tax revenue funds. It’s a game the market makers are good at.

The only consolation for the US is that the entire planet is incredibly shrinking into a credit crunch the likes of which nobody’s ever even dreamed of.

Mark Faber claims Asian current account surpluses (and I'd add: holdings of foreign debt) will lose 50% of their value in the next few months, and I think he’s dead on (though I doubt it'll boost the US dollar). Also, the European Central Bank can’t prop up EU banks any longer, and that will turn ugly, especially in Spain where Don Quixote is set to meet Franco in Guernica.

What has changed recently, and certainly today, is that the respected media now start saying the same things I’ve been warning about for a long time.

So the only consolation for me is that I’ve been right about it all, and all along.

It is time for a lot more people to realize what is going on. I'd find that a much more meaningful consolation.

Feeling lucky, punk?
Watching financial markets these days is akin to rubbernecking at a multi vehicle car crash; the initial rush of excitement and adrenaline gives way to sick sensations of horror and helplessness. Here are five more signs that the credit crisis is far from over.

Fannie Mae and Freddie Mac should be "credibly and demonstrably privatised," Federal Reserve Bank of Richmond president Jeffrey Lacker said this week. Such a move would signal a capitulation on the part of the US government.

"If you have a squirt gun in your pocket you may have to take it out," US Treasury Secretary Henry Paulson said in July, when requesting the power to grant unlimited credit to the companies. "If you have a bazooka in your pocket, and people know you have a bazooka, you may never have to take it out."

Fannie and Freddie's share prices suggest Paulson's attempt to bluff his way out of trouble has failed. The Bank of England, Long-Term Capital Management and Bear Stearns have all learned a variant of John Maynard Keynes's lesson - financial markets can keep pounding you in the head longer than you can stay solvent or irrational.

You know the credit crisis isn't over when the US government may have to turn its sponsorship of the mortgage companies into ownership.

"The worst is yet to come in the US," Kenneth Rogoff, former chief economist at the International Monetary Fund and Harvard University professor of economics, said this week. "I don't think simply having a couple of medium-sized banks and a couple of small banks going under is going to do the job."

Rightly or wrongly, Lehman Brothers tops many people's endangered lists. Goldman Sachs this week chopped its third-quarter earnings estimate for Lehman to a loss of $US2.75 a share from a prior 68-cent profit prediction. JPMorgan Chase sees Lehman writing down an additional $US4 billion ($4.6 billion) for the period, leading to a loss of $US3.30 a share.

Lehman is trying to find a buyer for investment-management unit Neuberger Berman, three people familiar with the matter told Bloomberg News.

You know the credit crisis isn't over when a bank that has seen its share price plummet 80% this year starts selling the family silver to stay afloat.

UBS is paying through the nose for its cash. The Swiss bank this week sold 2 billion euros ($3.4 billion) of two-year floating-rate notes, offering investors 95 basis points more than three-month money-market rates. At current rates, UBS is paying about 5.91% for the first three months of money.

Back in November, UBS borrowed $US1 billion for one year, paying just 6 basis points more than money-market rates. In April 2007, the bank sold 1.5 billion euros of five-year notes, paying a premium of just 4 basis points.

You know the credit crunch isn't over when UBS, which Moody's rates just two levels below its top credit grade, with an assessment of Aa2, regards two-year money at almost a full percentage point over money-market levels as worth grabbing.

When UK mortgage lender Northern Rock went bang, it said it was hobbled by not being able to borrow from the European Central Bank. This week, Nationwide Building Society said it will open an office in Ireland to "further diversify its geographical operations and funding opportunities." In other words, the building society will rent a room in Dublin to qualify for ECB funds.

Picture that new Dublin office. There's a single employee, let's call him Harry, persuaded to transfer across the Irish Sea by the promise of endless pints of Guinness. Harry's desk is bare, save for a red telephone with a single number programmed on speed dial that calls the ECB's repurchase agreement desk.

A steaming pile of British mortgages sits in the corner, composting down nicely in preparation for being repackaged as asset-backed bonds and shipped to the ECB in exchange for crisp, freshly minted euros. Harry knows that the ECB is currently lending banks with operations in a euro country about 476 billion euros a week.

You know the credit crisis isn't over when Harry joins the long, long line of funding officers dependent on central bank finance to keep their balls in the air.

General Motors is scrapping its sponsorship of the Academy Awards this year, said an unidentified GM spokeswoman cited in the Wall Street Journal. Lehman analysts said yesterday that the automaker may need $US7.3 billion of new capital to keep the factory lights on through 2009.

You know the credit crisis isn't over when GM can't afford a measly $US13.5 million to ferry Oscar to and from the red carpet.

Leading Economic Indicators Index in U.S. Falls 0.7%
The index of leading U.S. economic indicators fell in July by the most in almost a year, reinforcing the darkening outlook for growth.

The Conference Board's gauge dropped 0.7 percent, more than forecast and the biggest decline since August 2007, after an unchanged reading in June, the New York-based group said today. The index points to the direction of the economy over the next three to six months.

The worst housing recession in a quarter century, rising job cuts and shrinking access to credit raise the risk that consumer spending will falter by year-end, bringing the economic expansion to a halt. A separate report showed manufacturing in the Philadelphia region shrank in August for a ninth month.

The numbers are "consistent with the weak economy right now, probably an economy in recession," James O'Sullivan, a senior economist at UBS Securities LLC in Stamford, Connecticut, said in a Bloomberg Television interview. The index was forecast to decline 0.2 percent, according to the median of 63 economists in a Bloomberg News survey, after an originally reported drop of 0.1 percent in June. Estimates ranged from a decline of 0.9 percent to a gain of 0.1 percent.

Sagging orders and falling sales hurt factories in the Philadelphia region this month, a report from the Federal Reserve Bank of Philadelphia showed. Its general economic index rose to minus 12.7 from minus 16.3 in July. Negative readings signal a decline. The measure averaged 5.1 last year.

The leading index decreased at a 1.8 percent annual pace over the past six months. A decline of around 4 percent to 4.5 percent at an annual pace is one signal a recession is imminent, according to the Conference Board. The gauge met that requirement in January, when it dropped at a 4.7 percent pace. Five of the 10 indicators in today's report subtracted from the index, led by declines in building permits and stock prices.

Housing subtracted 0.53 percentage point. Building permits, a sign of future construction, fell 18 percent in July, while work began on the fewest houses in 17 years, the Commerce Department reported this week. A 0.25 percentage point drag came from the Standard & Poor's 500 index, which averaged 1257.3 last month, down from June's 1341.2.

First-time claims for jobless benefits took away 0.23 percentage point from the leading index. Claims rose to an average 420,800 in July, and jumped to a six-year high earlier this month. Earlier today, a Labor Department report showed initial jobless claims fell to 432,000, a level that still indicates the labor market is deteriorating.

A decline in orders for consumer goods and a drop in the money supply adjusted for inflation, which has the biggest weighting, also hurt the leading index. Seven of the 10 economic indicators that make up the index are known ahead of time: stock prices, jobless claims, building permits, consumer expectations, the yield curve, supplier delivery times and factory hours.

The Conference Board estimates the remaining three -- new orders for consumer goods, bookings for capital goods, and the money supply adjusted for inflation. The index of coincident indicators, a gauge of current economic activity, rose 0.1 percent to 106.8, after being unchanged the prior month. The gauge reached a high of 107.3 in October.

The index tracks payrolls, incomes, sales and production, which are the figures used by the National Bureau of Economic Research to determine whether a recession has begun. The gauge of lagging indicators rose 0.4 percent following no change the prior month. The index measures business lending, length of unemployment, service prices and ratios of labor costs, inventories and consumer credit.

Americans are spending less as firings mount. Target Corp., the second-largest U.S. discount retailer, said profit fell for the fourth straight quarter after consumers cut purchases of clothing and goods for the home. "We do not see any indication of meaningful near-term improvement," Target's Chief Executive Officer Gregg Steinhafel said on a conference call this week.

Let us just assume the financial system blows up…
Gold — and the division of assets - is on the mind of Marc (aka Dr Doom) Faber this week in a special interim note to his subscribers. It’s not a particularly attractive trade right now, he notes, although personally, he’s hooked. And anyway, people have been asking …..

For investors with all their assets in US dollar cash (and no other holdings), Faber suggests accumulating gold from here on down to possibly $600/oz. While not necessarily forecasting such a drop (from the current level of about $820/oz), he notes the metal could decline to that level.

Those with “99 per cent of their assets in gold and no cash flow” should hold for now, says Faber, as the gold chart looks “truly horrible” since prices fell below the key support levels of around $850. For traders, however, gold may have some short-term appeal right now because it is becoming oversold. But what, then, is the immediate upside potential? Heavy resistance would seem to exist at $850-$900 while the downside risk is at least as large as the upside potential.

From a personal perspective, says Faber, of his total assets, about 5 per cent is in equities, 8 per cent in gold, 8 per cent in real estate and related investments and the rest is split between US and euro fixed-interest securities. But Faber’s own cash flow (income) is to some extent dependent on the performance of equities, he acknowledges, since he receives some performance fees when stocks appreciate.
As a result, my indirect exposure to equities is higher than is suggested by the asset allocation figures listed above. From my fixed interest securities and from my business I have a relatively high cash flow and, therefore, I am a happy holder of gold and a buyer on the way down (in fact, irrespective of the price I buy every month some) for the following reasons:

I am not a great believer in insurance policies, but since I think that sooner or later the entire financial system will blow up I want to make sure that whereas my assets, which are on deposit and could become worthless through default, I shall still be left with some assets that are mine (physical gold in a safe deposit box — not in the US). I should like to emphasise that this is also a point which speaks for owning some stocks.

So in typically cheery mode, Faber says, “let us assume the financial system blows up”. Large deposits could become worthless overnight. But if you own shares of companies — even though they may decline in value — you will still own these shares since they are a certificate of ownership and not liabilities of someone else.

So, no matter how negative a stance one might have toward equities, at this point the ownership of some solid companies might be more desirable than being a creditor in a financial system that may not be able to pay at some point in the future. Also, I consider gold as a hedge against renewed US dollar weakness. Finally, I maintain the view that gold will over the next few years outperform US equities and bonds as it has done already since 2000.

Onto broader themes and Faber’s prognosis that we are amidst a significant liquidity contraction as a result of slower debt growth. Don’t forget, he says, that lending standards are now tightening in earnest for both individuals and for commercial property lending. In turn, tighter lending standards hurt personal consumption and lead to a contracting US trade deficit as a result of lower demand for imported goods and also oil.

Moreover, lower imports have negative implications for Asian economic growth rates. In turn, slower Asian economic growth amidst high inflation depresses the domestic demand in the Asian region, which then leads to reduced demand for commodities.

In addition, a declining trade deficit leads to a decline in the current account deficit and a relative tightening of global liquidity as Foreign Official Dollar Reserve growth slows down. Since FRODOR growth is inversely correlated with the USD and correlates over time with the movement of gold prices, any contraction in FRODOR growth would be USD supportive and negative for commodities and gold
I have a friend who is an outstanding economist who thinks that the Asian current account surpluses will shrink in 2009 by about 50% from their peak in 2007. In this scenario, global liquidity would become extremely tight and would have a devastating impact on asset markets including real estate, commodities, non-AAA bonds and equities. Such a decline in the Asian current account surpluses would cut the US current account deficit by half and lead to a very strong USD.

Equities, meanwhile, look shakey — although the US markets less so than the rest of the world. Over the last 18 months, households have been heavy sellers of equities. The support for equities in 2007 came only from LBOs and share repurchases.
Demand from these important sources has now collapsed and will not come back as long as lending standards are not eased considerably and as long as the outlook for the global economy deteriorates.

Outside the US, equity markets look even more vulnerable, he adds. The US economy is in deep trouble but this is now widely known whereas other economies such as Australia, the UK and the eurozone are just starting to deteriorate very badly, most from an even more inflated level. So while housing affordability has improved in the US as a result of the sharp price decline, affordability in Australia is at a record low.

So, predicts Faber, US stocks will continue to outperform foreign equity markets as they have since the start of the year — but that’s not because he thinks US equities will move higher but because they are likely to move down less than foreign markets and also because the USD should continue to strengthen.

Central banks around the world will shortly begin to cut interest rates, which supported foreign currencies so far. The NZ dollar, the Australian dollar and the British pound are particularly vulnerable, he adds. In the US, the most vulnerable sectors are now material and energy related companies and increasingly the last sector that has held up well: technology, including companies such as Apple, Research in Motion,, Google and IBM.

In recent commentaries we have also suggested that Japanese equities were relatively attractive. They have indeed begun to outperform the Hang Seng Index and also other Asian markets and I expect this outperformance to last for some time. Again, this does not mean the Japanese stocks will move up but that they will move down less than other Asian markets.

In sum, credit growth and global liquidity are contracting, a vicious economic downturn is about to unfold (China could surprise on the downside and put additional pressure on commodity prices) and asset markets are still very high by historical standards and, therefore, remain vulnerable.

In conclusion, advises Faber, use equity rallies as a selling opportunity and further weakness in gold as a buying opportunity for long term holders with significant cash and cash flows. But if his great strategist friend is right and the S&P500 trades down to the 500 level, “you should be careful not to be eaten by bears in all asset market”. Thanks for that, Marc.

Collapse of M3 Spells Deflation
There was good news yesterday for all those who mistakenly think inflation is worth worrying about: The U.S. money supply experienced its sharpest contraction in modern history. For the rest of us, this can only spell one thing: ruinous D-E-F-L-A-T-I-O-N.

The money supply story was reported yesterday by Ambrose Evans-Pritchard, the London Telegraph’s man-on-the-scene in America.  The news is likely to have been reported by the U.S. media as well, although we couldn’t find it anywhere else, even on Google’s business page.
Not surprisingly, Google led the section with the by-now smelly red herring about how wholesale prices jumped in July, putting still more “pressure” on the Fed to “decide” whether it should raise interest rates.

We’ve been predicting for quite some time that a rate hike was not in the cards, since, even though the Fed talks relentlessly about inflation in order to distract us, Bernanke & Co. recognize full well that deflation – the manifestly uncontrollable force that has been swallowing up the housing and banking sectors – poses a far greater threat to the economy and the financial system than any mere price inflation could.
Now, with the news that M3, the “broad” money supply, collapsed by $50 billion in July, we predict that the inflation story is about to go out of style. After all, how much inflation can we have if, instead of credit dollars flooding the system, they are now spiraling down the drain?

Money velocity has been falling as well, and although this goes hand in hand with a deflationary contraction of the money supply, don’t hold your breath waiting to hear more about it from Brokaw et al. Money velocity is one of those topics, along with campaign finance reform, that tends to make viewers’ eyes glaze over, and that’s why such data are likely to remain shrouded in mystery, other than among economists.

However, the cyclical ups and downs of money velocity are important nonetheless because they tell us how eager lenders and borrowers are to do business. When confidence is high, borrowers borrow like there is literally no tomorrow, and lenders find ways to put each newly deposited dollar aggressively to work, multiplying it across a daisy-chain of debt derivatives.

But let the action cool for too long, as it already has, and confidence in credit begins to spiral downward. This is reflected in falling money velocity, which obviously cannot coexist for long with inflation. Indeed, they cannot co-exist at all, since, in financial terms, one is the equivalent of an irresistible object; the other, of an immovable force.
Until deflation has come to dominate not just the housing and financial sectors, but the entire economy, we expect inflation-watchers to remain deaf, dumb and blind to reality, transfixed by whatever facts mislead. They will say, “Deflation?? Have you put a kid through college lately?” 

Funny they should ask, since we are quite certain that colleges, along with state and local government, are about to become drastic cost/price-cutters.  Given that student loans have become virtually unobtainable, what choice do the schools have? Most students must borrow, sometimes heavily, to make college “affordable,” so the schools will either have to reduce tuition or draw down their endowments to fill seats.

As for state and local government, their tax revenues are drying up faster than equatorial mud holes after a cloudburst. Public sector employment, a hitherto intractable engine of inflation, therefore cannot avoid a downsizing so drastic that even the Commerce Department’s patriotic statisticians won’t be able to conceal mushrooming unemployment ahead of the election. 

If the global economy is as safe as houses, then there's a crash on the way
I try to be very, very careful about calling a crash. Others are not. But most of the economic "yea-sayers" are, as usual, finding a bottom, like our friend from A Midsummer Night's Dream, who had no bottom.

For a few weeks I have been hearing of a big one coming, a very bad moon rising. I have, until now watched and wondered, but as the evidence mounts, the muttering of a major bank collapse that will bring the whole show down around our heads increases.

Ambrose Evans-Pritchard of London's The Daily Telegraph is reporting "the US money supply has experienced the sharpest contraction in modern history, heightening the risk of a Wall Street crunch and a severe economic slowdown. "Data compiled by Lombard Street Research shows that the M3 'broad money' aggregates fell by almost $US50 billion in July, the biggest one-month fall since modern records began in 1959."

This might, on its own, be dismissed as Ambrose doing what he does best, hunting down headlines. But this article does not exist in a vacuum. Unhappily, Professor Nouriel Roubini is in a glum mood even by his standards. "The UK economy is not my brief," he writes, "but I see that hedge funds are circulating a report from the US guru Jeremy Grantham predicting a very bad end to Gordon Brown's debt experiment.

"The UK housing event is probably second only to the Japanese 1990 land bubble in the Real Estate Bubble Hall of Fame. UK 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." That is one hell of a call. "If prices go all the way back to trend, and history says that is extremely likely, then the UK financial system will need some serious bail-outs and the global ripples will be substantial," says Grantham.

Roubini notes that for months the exchange markets ignored this impending train crash, just as they ignored the property bust in Europe's Latin Bloc, or the little detail that UBS alone had just lost the equivalent of 8% of Switzerland's GDP. All they cared about in the currency pits was the interest rate gap: US low, Europe high. "Now," Roubini writes, "the paradigm has flipped.

The Fed may have been right after all to slash rates to 2%. The European Central Bank may have panicked by tightening in July. Note that the elder Swiss National Bank did not do anything so rash. "Bulls now believe America is turning the corner. Financial stocks are up 20% since early July. Some 'monoline' bond insurers have risen 1200% in a month as fears of Gotterdammerung give way to sheer intoxicating relief, and a 'short-squeeze'. Such are bear-trap rallies.

"Regrettably, I remain beset by gloom. The US fiscal stimulus package that kept spending afloat in the second quarter is running out fast. There is nothing yet to replace it. The export boom cannot keep adding juice as the global crunch hits. My fear is that the US will tip into a second, deeper leg of the downturn, setting off a wave of savage job cuts. This will start to feel more like a real depression.

"The futures market is pricing a 33% fall in US house prices from peak to trough, based on the Case-Shiller index. Banks have not come close to writing off implied losses on this scale." Daniel Alpert from Westwood Capital predicts that a mere 28% fall would alone lead to a $US5.4 trillion haircut in US household wealth, and leave lenders nursing $US1.25 trillion in losses. So far they have confessed to less than $US500 billion.

Meredith Whitney, the Oppenheimer Bank's Cassandra, predicts a gruesome 40% fall in prices. "I do not think we are near the end of write-downs. I continue to see capital levels going lower, and stocks going lower," she said. "So no," says Roubini, "this painful ordeal is far from over. We are not witnessing a dollar rally so much as a collapse in European and commodity currencies. The race to the bottom has begun in earnest."

In an interview with CNBC, David Kotok of Cumberland Advisors argued that the financial crisis is only about halfway over and another leg down is in the offing. His main reason is that banks have continuing needs for capital and at current costs in the markets, the maths doesn't work. Some banks will be unable to raise funds privately.

Nobel Winners Expect Weak Growth; Goldman Sees Recession Risk
Nobel Prize-winning economists including Myron Scholes and Joseph Stiglitz predicted the credit squeeze will inflict more pain on global growth and Goldman Sachs Group Inc. projected half of the world economy faces recession.

"There will be a global recession," Scholes said in an interview today at a conference in Lindau, Germany, featuring 14 Nobel laureates in economics. Stiglitz forecast the world economy would continue to perform below its potential for some time, resulting in a "social loss" through weaker employment.

A year since the U.S. housing slump sparked about $500 billion in credit-market losses for banks globally, the world's largest economies are all stumbling as rising borrowing costs combine with record commodity prices to sap growth.

The U.S., Japan, the 15-nation euro area and the U.K. are "either in recession or face significant recession risks in the months ahead," Goldman's London-based international economist Binit Patel said in a report to clients today, noting such nations account for half of the world economy.

The "worst is yet to come," said Hong Kong billionaire Li Ka-shing in Hong Kong today. The credit squeeze is turning Li "very conservative about acquisitions," he said.

Lone Star Funds, the Dallas-based private equity firm, today agreed to buy IKB Deutsche Industriebank AG after the German bank was felled by the subprime mortgage crisis. Bear Stearns Cos., the fifth-largest U.S. securities firm, has already collapsed, while the bonds of regional banks such as National City Corp. and Keycorp are under pressure on expectations of more fallout.

"The financial sector needs to shrink," said Kenneth Rogoff, former chief economist at the International Monetary Fund, in an interview in Singapore yesterday. "I don't think simply having a couple of medium-sized banks and a couple of small banks going under is going to do the job." Rogoff also said "`the worst is yet to come in the U.S."

The U.S. index of leading economic indicators declined in July, suggesting the slowdown will deepen in the second half of the year, and Europe's manufacturing and service industries contracted for a third month in August, data released today showed.

The outlook for the U.S. economy will prove a hot topic when central bankers and economists gather tomorrow for the annual Federal Reserve conference in Jackson Hole, Wyoming. "The economy has really shown one sign after another of weakening," Harvard University Professor Martin Feldstein said in an interview in Jackson Hole today.

Citigroup Inc. economist Steven Wieting said in a report today that every U.S. downturn of the last six decades has been linked with a global slump. Economists at UBS AG led by Larry Hatheway this week cut their forecast for global growth next year to 2.9 percent from 3.1 percent, close to the 2.5 percent deemed a world recession.

Patel at Goldman Sachs sees the chances of a global recession at no more than 20 percent given his expectation that China's economy will continue to grow about 10 percent this year and next. "Continued robust, albeit slowing, growth in China and the rest of the emerging markets" will deliver world growth of 3.6 percent next year after 3.9 percent in 2008, said Patel.

Stiglitz, a professor at Columbia University, blamed U.S. and international regulators such as former Federal Reserve Chairman Alan Greenspan for failing to restrain an explosion in financial innovation and lending that led borrowers to rack up debt they couldn't repay.

"It was a massive failure of the brains of the economy," said Stiglitz. "There was a party going on and the regulator with the same mindset of those in the party didn't want to be a party pooper."

Nobel laureate Daniel McFadden, who teaches at the University of California, said in Landau that a financial equivalent of the U.S. Food and Drug Administration should be established to monitor and certify new financial instruments. Scholes warned against a "rush to regulation," arguing "the cost of regulation may be far greater than its benefits."

The worst is yet to come in the US
"The worst is yet to come in the US," said Kenneth Rogoff, former chief economist at the International Monetary Fund at a speech in Singapore this week. Rogoff wasn't in the mood to mince his words.

"We're not just going to see mid-sized banks go under in the next few months, we're going to see a whopper, we're going to see a big one, one of the big investment banks or big banks." Apocalyptic stuff, but enough to hammer global stock markets all on their own? It seems so. Rogoff is taking the blame - and a fair amount of criticism in some quarters - after the slump in the Dow Jones and the FTSE 100 was pinned largely on his gloomy prognosis.

But markets have been waiting to sell-off again - they just needed an excuse. Rogoff just reminded the financial world of what it already knew - that this downturn is far from over and there is plenty of pain to come before we're anywhere near the light at the end of the tunnel. He just so happens to be one of the most high-profile figures so far to have nudged Wall Street and said: "Oh by the way, did you notice that the Emperor's got no clothes on?"

Old trends die hard. When you get to the end of a bull market, investors are still primed for an upturn. They just keep buying on the dips, not realising that said "dips" are just the latest pitstops on a gut-wrenching ride to the bottom. The same happens when bear markets end. Investors just can't believe that prices will keep rising, so they sell as soon as they've locked in even the tiniest profits.

Rogoff thinks "the financial crisis is at the halfway point, perhaps". That could be right, or it could be a touch optimistic. So far about $500 billion has been written off in losses globally. That's about half the $1 trillion that many respectable commentators now reckon will have to be written off in total. What this all hinges on is the US housing market.

A quick recap - as most people know by now, the problems kicked off in the subprime market. Lenders got too careless and greedy for fees, and gave out loans to people who almost immediately defaulted on them. As those loans, which had been parcelled up and sold to banks and investors around the world, went bad and the financial system froze up.

Back then, it was called a liquidity crisis. That was what brought Northern Rock down. Banks still clung to the hope that most of their assets were of perfectly high quality. The short-term problem was simply that no one was willing to lend money to each other as they couldn't be sure of where the toxic subprime loans were. This was hopelessly optimistic. It's important to understand that subprime wasn't the root cause of this crisis.

Subprime was merely the last straw. Subprime was the logical end-point of a system that had grown bloated and careless on cheap money and a complete disregard for risk. Think about it. By the end game, lenders were giving loans to people who couldn't even make their first mortgage payment, let alone 20 years' worth of payments. So what does that suggest about the quality of their other loans?

As Nouriel Roubini, the famously downbeat New York University economics professor, puts it: "We have a subprime financial system, not a subprime mortgage market." And as Rogoff says, it's only going to get worse. US house prices have already fallen by 15.8% in the year to May, according to the S&P Case Shiller index.

Banks repossessed three times as many homes in July as the year before, while the number of homes at risk of repossession (or foreclosure, as the Americans call it) jumped by more than half, reported foreclosure data group RealtyTrac last week. The extent of the carnage is mind-boggling. Already, about a third of homeowners who bought in the last five years owe more than their homes are worth, according to property valuation group

In four cities in California, more than 90% of homeowners are in negative equity. And it could get far worse. A report in April from Credit Suisse suggested that a full one in 12 US homeowners look set to lose their properties in the next five years. It predicts that 63% of subprime borrowers will be in negative equity by 2009.

This all has knock-on effects. People who are in negative equity, or who have lost their home, aren't going out there spending. If they're not spending, companies aren't making money. If companies aren't making money, they're laying people off and going to the wall. Meanwhile, car loans, credit card loans and personal loans are all threatening to go bad as well.

And there's no sign of the lending squeeze letting up - a quarterly Federal Reserve survey of banks found that banks intend to tighten their lending criteria even further in the three months ahead. And no wonder. They're going to need the money.

Meredith Whitney, the Oppenheimer analyst who was among the first to start talking about credit writedowns at banks, reckons that house prices in the US will fall 40% from peak to trough. Yet Daniel Alpert from Westwood Capital, quoted in The Telegraph, reckons that a fall of just 28% would see lenders forced to write down $1.25 trillion in total.

So Rogoff wasn't exaggerating. There have been fears about a major bank collapsing in the US since Bear Stearns was rescued by JP Morgan earlier this year. The demise of IndyMac, the Californian lender, was bad enough.

Another banking crash on the scale Rogoff suggests would certainly mean further falls in stock markets, and possible questions being raised about the ability of the Federal Deposit Insurance Corporation (the US equivalent of our own Financial Services Compensation Scheme) being able to cover all of the banks at risk. That could lead to runs on other banks as real panic spread through the system.

Let me turn to fund manager Jeremy Grantham of GMO to give the UK perspective. Grantham is another well-known pessimist, he reckons that US house prices could fall a further 17% at least. But there's one place that's far worse off than the US, he reckons.

"The UK housing event is probably second only to the Japanese 1990 land bubble in the real estate bubble hall of fame. UK house prices could easily decline 50% from the peak and at that level they would still be higher than they were in 1997 as a multiple of income."

Grantham continues. "If prices go all the way back to trend, and history says that is extremely likely, then the UK financial system will need some serious bail-outs and the global ripples will be substantial." So we should be keeping a close eye on the US. Because their problems could be appearing in a housing market near you, very very soon.

Bank borrowing from ECB is out of control
The European Central Bank has issued the clearest warning to date that it cannot serve as a perpetual crutch for lenders caught off-guard by the severity of the credit crunch.

Nout Wellink, the Dutch central bank chief and a major figure on the ECB council, said that banks were becoming addicted to the liquidity window in Frankfurt and were putting the authorities in an invidious position. "There is a limit how long you can do this. There is a point where you take over the market," he told Het Finacieele Dagblad, the Dutch financial daily.

"If we see banks becoming very dependent on central banks, then we must push them to tap other sources of funding," he said. While he did not name the chief culprits, there are growing concerns about the scale of ECB borrowing by small Spanish lenders and 'cajas' with heavy exposed to the country's property crash. Dutch banks have also been hungry clients at the ECB window.

One ECB source told The Daily Telegraph that over-reliance on the ECB funds has become an increasingly bitter issue at the bank because the policy amounts to a covert bail-out of lenders in southern Europe. "Nobody dares pinpoint the country involved because as soon as we do it will cause a market reaction and lead to a meltdown for the banks," said the source.

This "soft bail-out" is largely underwritten by German and North European taxpayers, though it is occurring in a surreptitious way. It has become a neuralgic issue for the increasingly tense politics of EMU. The latest data from the Bank of Spain shows that the country's banks have increased their ECB borrowing to a record €49.6bn (£39bn).

A number have been issuing mortgage securities for the sole purpose of drawing funds from Frankfurt. These banks are heavily reliant on short-term and medium funding from the capital markets. This spigot of credit is now almost entirely closed, making it very hard to roll over loans as they expire.

The ECB has accepted a very wide range of mortgage collateral from the start of the credit crunch. This is a key reason why the eurozone has so far avoided a major crisis along the lines of Bear Stearns or Northern Rock. While this policy buys time, it leaves the ECB holding large amounts of questionable debt and may be storing up problems for later.

The practice is also skirts legality and risks setting off a political storm. The Maastricht treaty prohibits long-term taxpayer support of this kind for the EMU banking system. Few officials thought this problem would arise. It was widely presumed that the capital markets would recover quickly, allowing distressed lenders to return to normal sources of funding. Instead, the credit crunch has worsened in Europe.

Not to miss out, Nationwide recently announced that it was setting up operations in Ireland, partly in order to be able to take advantage of ECB liquidity if necessary. Any bank can tap ECB funds if they have a registered branch in the eurozone, although collateral must be denominated in euros.

Jean-Pierre Roth, head of the Swiss National Bank, complained this week that lenders were getting into the habit of shopping for funds from those authorities that offer the best terms. The practice is playing havoc monetary policy.

"What we should avoid is some kind of arbitrage by banks, which say they are going to go to central bank X, instead of central bank Y, because conditions are more attractive," he said.

FDIC Faces Balancing Act in Replenishing Its Coffers
As financial institutions continue to fail, the Federal Deposit Insurance Corp. is under pressure to decide how to replenish the fund that insures consumer deposits.

The fund is stocked mostly by fees levied on U.S. banks. If the FDIC raises the fees, that would siphon more money from already cash-strapped financial institutions. It could also deplete funds that banks would otherwise use to make loans. But if the FDIC moves too cautiously, the fund could run dry at a crucial time. That could hurt public confidence in the banking system and force the government to use taxpayer dollars to restock the fund.

The agency could split the difference by raising premiums faster than most banks would like but slow enough so that the rebuilding of the fund takes years, not months. The FDIC is likely to unveil its intentions in October. The fund's $52.8 billion at the end of the first quarter was considered low by historical standards, covering 1.19% of all insured deposits.

Two bank failures in the second quarter are estimated to have cost the fund $216 million, and the four bank failures so far in the third quarter could have cost another $9 billion. The failure of IndyMac Bank in July may have wiped out more than 10% of the fund. Such losses could easily push the fund below a 1.15% level, triggering a requirement that the FDIC come up with an action plan within 90 days to bolster the fund.

"Congress gave the FDIC the mandate to replenish the fund through higher premiums on the industry," said Art Murton, the FDIC's director of insurance and research. "The FDIC has some flexibility in setting premiums, which will require striking a balance between building the fund quickly and ensuring that banks have sufficient funds to support the credit needs of the economy."

The premiums charged by the FDIC may seem small, but they can be significant for struggling banks. The government has the discretion to levy higher fees on higher-risk banks, but those are the institutions that often can least afford it. Most banks now pay the FDIC five cents for every $100 of insured deposits. Higher-risk banks are paying as much as 43 cents to insure $100 in deposits.

"To slam an eight-, 10- or 15-cent premium, that's going to cripple a lot of banks," said Camden Fine, chief executive officer of the Independent Community Bankers of America, a trade group. Some analysts expect the FDIC to move aggressively despite such complaints.

"They don't want headlines suggesting the deposit fund is shrinking and inadequate," said Jaret Seiberg, a Washington analyst for the Stanford Group, a diversified financial-services company. "They need a fortress deposit-insurance fund." Mr. Seiberg said the agency could raise premiums on healthy banks to 15 to 20 cents for every $100 of insured deposits.

Government officials have gambled wrong before. In response to the Great Depression, Congress created the FDIC in 1933 and a separate agency called the Federal Savings and Loan Insurance Corp. in 1934. The FDIC insured deposits at banks, while the FSLIC backed deposits at savings and loans.

The savings-and-loan crisis in the late 1980s, which led to the closing of thousands of banks and thrifts, bankrupted the FSLIC, costing roughly $150 billion in mostly taxpayer funds to clean up the mess. The FSLIC was subsequently abolished and its funds brought under the FDIC's control.

The FDIC was created to instill confidence in the banking system and to prevent customers from panicking and rushing to withdraw money. Depositors are covered for as much as $100,000 on most accounts. The FDIC is ramping up its public-awareness campaign to assuage fears about the safety of deposits, partly in response to the hysteria that came after the failure of IndyMac.

In the 75 years that deposit-insurance funds have existed in some form, their combined balances have ended the year with less than 1.15% of the nation's deposits only 10 times, from 1986 to 1995. Under a rule of thumb, raising premiums by one percentage point would bring in $700 million to the fund per year. Raising premiums 10 percentage points would generate $7 billion.

The FDIC has other options it has reviewed with Treasury Department officials, but these are seen as less desirable. For example, the FDIC could borrow as much as $30 billion from Treasury, an existing credit line that has never been tapped. It could also borrow short-term cash from Treasury to cover payouts if banks fail, which could become necessary if the FDIC is bogged down with billions of assets from failed banks that are hard to liquidate.

Bay Area median home prices down 29.3%
Cut-rate foreclosed homes being unloaded by banks wreaked havoc on the Bay Area's median price in July, sending it down nearly 30 percent to a level not seen in more than four years.

A third of all existing homes sold in the nine-county region in July were foreclosed properties, the real estate research firm MDA DataQuick of San Diego reported Tuesday. A year earlier, just 4.2 percent of existing-home sales were foreclosed properties. The brisk business in bank-owned homes buoyed sales volume, especially in counties with a glut of foreclosures.

"There is deep discounting in inland markets that have been slammed by foreclosures," said Andrew LePage, an MDA DataQuick analyst. Amped-up foreclosure sales actually could be a plus, hastening a return to normal once the deluge of bank repos ends, LePage said.

"We're burning through them at a better rate than we were," he said. "It's not a bad sign that they're selling from a market-stability standpoint." Ken Rosen, chairman of the Fisher Center for Real Estate and Urban Economics at UC Berkeley, said he thinks the foreclosure flood makes the market appear much worse than it really is.

"The headline will read, 'House prices plunge,' " he said. "Actually, what it should read is, 'Foreclosed house prices plunge.' The data show a much smaller (price) decline, between 5 percent and 10 percent in the core Bay Area of Silicon Valley, Oakland, Berkeley, San Francisco and Marin (if foreclosure sales are omitted)."

According to MDA DataQuick, the median price for both new and resale homes and condos in the Bay Area stood at a 53-month low of $470,000, compared with $665,000 a year ago, a slide of 29.3 percent. For resale homes, the median was $485,000, a 34.3 percent drop from last July's $738,500.

Median prices are skewed by changes in the mix of properties sold: The more low-cost properties that change hands, the lower the median. The biggest percentage of foreclosure sales was in Solano County, where two-thirds of all resold homes were foreclosures. Sales volume there was up 56 percent.

The lowest foreclosure volume was in San Francisco at 4.6 percent of existing-home sales. Sales volume there was down for existing homes, but up for all homes, which LePage said was likely due to a throng of new condos being sold.

In the nine-county region, 7,586 new and resale houses and condos changed hands in July, up 2.2 percent from a year ago. For resale homes, a total of 5,585 sold, up 11.9 percent from a year ago. Discounted foreclosures are good news for two market segments: investors who see the chance to snap up bargains, and new home buyers who can meet today's stricter qualifications for getting a mortgage.

But they spell trouble for others. Many potential home buyers are still taking a wait-and-see attitude since prices are continuing to drop. And among sellers, many of those who are not under duress continue to stay on the sidelines.

"From an average person's perspective, until prices start to stabilize, (they think), Why buy today when tomorrow will probably be cheaper?" said Sam Khater, senior economist at First American CoreLogic. That mental psychology will not change until prices level out, he said.

Fannie and Freddie crisis deepens
The US Treasury on Wednesday backed away from assurances that it would not have to rescue Fannie Mae and Freddie Mac, as the crisis surrounding the mortgage groups deepened with their shares falling for a third day.

Although it was granted new powers to extend its credit lines to Fannie and Freddie and invest in their equity last month, the Treasury has been adamant it does not expect to have to make use of the new authority. But on Wednesday, a Treasury spokeswoman declined to repeat that assurance. Instead, she said Treasury was “vigilantly” monitoring market developments and was “focused on efforts that will encourage market stability, mortgage availability and protecting the taxpayer”.

The shift in emphasis towards a more open-ended statement may not mean that the Treasury is close to intervening to save Fannie and Freddie, since government funds would still only be used as a last resort. But it highlights the pressure facing Hank Paulson, US Treasury secretary, as he confronts the return of unease surrounding Fannie and Freddie.

A rise in the companies’ borrowing costs could translate into higher mortgage rates for prospective homebuyers, thereby prolonging the housing slump. Treasury officials had hoped the strengthening of the government guarantee implied in the rescue plan would be enough to restore investor confidence. 

“Hopes that making government support more explicit ... would add stability have backfired as holders further down the capital structure have turned up the heat, eradicating value ahead of a potentially damaging capital infusion,” Richard Hofmann, analyst at CreditSights, said

Daniel Mudd, Fannie chief executive, said in a radio interview yesterday that his company had not asked the Treasury for help, nor had it been offered any, reiterating that the housing agency has more capital than it has ever had in its history.

Fannie and Freddie shares have fallen 32.49 and 37.09 per cent respectively since Monday, as investors have grown concerned about a government intervention that would dilute shareholders and could affect holders of the groups’ preferred stock and subordinated debt issues. Freddie’s tumbling share price has also hamstrung the company’s efforts to raise $5.5bn of new capital it promised to issue in May.

Fannie bailout? Hold on a second
The frenzied trading in shares of Fannie Mae and Freddie Mac seems to assume the government will soon ride to the rescue of the mortgage giants.

But the cavalry is in no rush to get to the scene - because for the moment, federal intervention is unnecessary, not to mention tricky and politically unpalatable. "The government doesn't want to own these companies," FBR Capital Markets analyst Paul Miller said Wednesday on Bloomberg television.

Fannie and Freddie shares tumbled for the fourth straight day Wednesday, a day after Freddie paid its biggest premium in a decade to sell $3 billion of five-year reference notes. The companies' shares hit their lowest levels in nearly 20 years, dropping below the levels they bottomed out at last month in the panic that led Treasury Secretary Henry Paulson to propose a government-funded backstop that was later passed into law by Congress.

The selloff in the companies' shares and their rising borrowing costs have led to some talk that Paulson, just a month after proposing that the Treasury be authorized to invest in the companies, will have no choice but to recapitalize the companies.

Given the terms of the government's mid-March rescue of Bear Stearns - shareholders ended up getting $10 a share for a stock that just a year earlier traded for 17 times as much - the widespread assumption is that any bailout for Fannie and Freddie would effectively wipe out common shareholders, and perhaps preferred shareholders as well.

One suggestion batted about in the media would have the government buying preferred shares that are senior to all existing stock; others contemplate use of an explicit government guarantee, rather than a cash infusion. But despite the collapse of their stock prices and the ominous trends in the housing market that point to losses down the road, Fannie and Freddie aren't in dire need of cash right now.

Though FBR's Miller says he believes each company will need to raise $15 billion or so to survive the housing bust, for now both companies remain above the capital levels required by their regulator, the Office of Federal Housing Enterprise Oversight.

Fannie chief Dan Mudd said Wednesday that the company is churning out record profits on its new business, thanks to the collapse of the private mortgage industry competition. And though their borrowing costs have surged, Fannie and Freddie are still able to borrow in the debt markets - meaning a Bear Stearns-like cash crunch isn't imminent. Even so, investors suspect more bad news is ahead.

One event that could force the government to act on the companies' behalf would be a failure of Fannie or Freddie, each of which is facing more than $100 billion in maturing debt in coming months, to sell new debt into the markets. In its debt sale Tuesday, Freddie paid investors 113 basis points over the yield on comparable Treasury notes - up 60% from the spread Freddie paid in May, and double the average spread over the past decade, Bloomberg reported.

The rising yields on Fannie and Freddie debt come as Asian central banks slow their purchases of agency debt, and as bond investors elsewhere seek to limit their exposure to the financial services sector after a year of writedowns and other shocks. If Fannie or Freddie can't find new buyers for their debt, Treasury would face the difficult task of supporting the companies without either rewarding shareholders or exposing additional problems in the financial sector.

While some bailout scenarios being discussed would wipe out preferred shareholders as well as common shareholders, FBR's Miller notes that holders of Fannie and Freddie preferred stock include some regional banks, which are already under pressure from the collapse of residential real estate values and the slowdown in commercial lending markets.

Were a bailout plan to reduce or wipe out the value of those preferred shares, banks that hold Fannie or Freddie preferred shares could face big writedowns that would add to their capital problems.

Wilmington Trust, a small Delaware lender, took an $8 million hit in the second quarter on the decline of the value of its holdings of Fannie and Freddie preferred shares, though the firm said it planned to continue holding the shares, because "they pay dividends, they have investment-grade credit ratings, and their valuations are expected to normalize over the course of market cycles."

Another group that could take a hit in a preferred-stock haircut is big insurers. Among the top holders of Fannie and Freddie preferred issues are Hartford Insurance, Allstate, Genworth and Liberty Mutual Insurance, all of which have largely sidestepped the credit issues hitting the markets over the past year.

Paulson is no doubt eager to avoid intervening less than three months before the electorate chooses the next president. Paulson said last month that he hoped not to have to use his authority to invest taxpayer money in the companies, and has made clear that he would rather see the companies remain shareholder-owned, in hopes that Fannie and Freddie can raise new money on their own.

The swoon in the companies' shares seems to be making an intervention more likely - but far from certain. "We doubt that the Bush administration will embrace a nationalization of the mortgage market in front of the elections," Jeff Miller, CEO of investment adviser NewArc Investments in Naperville, Ill., wrote in a post on his Dash of Insight blog earlier this week. "This issue will be confronted incrementally and reluctantly."

Prescriptions for Fannie and Freddie
As policy makers work to ease the strain on the mortgage giants Fannie Mae and Freddie Mac, a consensus is emerging that the two companies will have to look substantially different in the long term.

Leading figures from across the ideological spectrum say that the companies, which were created by Congress to support the housing market, must be restructured so that they do not threaten the financial system. These voices include Republicans, many of whom have long been critical of the outsize roles of Fannie Mae and Freddie Mac in the mortgage market, and some Democrats, who have generally been more supportive of the companies.

Proposals for the companies include making them government-owned and breaking them up into smaller firms, phasing them out of existence entirely, or simply limiting their operations to certain core areas like affordable housing as well as limiting their ability to borrow money.

On Wednesday, speculation about a government intervention sent shares of the companies tumbling by more than 20 percent. The stocks have plunged more than 60 percent this month, with Fannie Mae ending the day at $4.40 and Freddie Mac at $3.25. The price of bonds issued by the companies surged, meanwhile, as some investors indicated that any effort by the Treasury Department to help the companies would benefit bondholders.

The moves in the stocks and bonds reflect investors’ growing belief that the government will have to come to the aid of the companies under the authority Congress gave to the Treasury in July. It remains unclear, however, exactly what form a rescue package would take.

The government created Fannie Mae during the 1930s to help bolster an ailing housing market, and Freddie Mac was chartered in 1970 to serve a similar function. The companies were privatized over the years but they remained quasi-governmental entities both in appearance and reality. Congress pressured them to make housing more affordable through explicitly stated goals, and they were able to borrow cheaply because investors believed the government would back the companies if they faltered.

The companies support the housing market by buying loans from banks and other lenders, allowing those firms to make more loans. Today, Fannie Mae and Freddie Mac own or guarantee nearly half of all loans outstanding, and the market has become increasingly dependent on them as the private mortgage market has come to a virtual standstill.

With the companies’ stock falling and their ability to raise capital dwindling, government officials met with executives of Freddie Mac on Wednesday. The Treasury Department has said only that it is monitoring the situation closely. Arthur Levitt Jr., chairman of the Securities and Exchange Commission in the Clinton administration, described the companies as “neither fish nor fowl.”

He said the country had long put off discussions about the implicit government backing of the companies, which Congress made explicit last month by empowering the Treasury to infuse billions of dollars into them. “The fabric of those companies was so intertwined with its political patrimony that ordinary considerations were put aside for what was or wasn’t politically acceptable,” Mr. Levitt said in a telephone interview. “As a result of that, the way one would operate a business according to business standards gave way to operating a business in a way that was palatable to a political system.”

Mr. Levitt and several other public figures say the immediate course of action for the government should be to stabilize the companies, given the vital role that they play in the financial and housing markets. Over the longer term, these people say, the companies’ dual public-private role should be reconsidered.

Alan Greenspan, the former Federal Reserve chairman, has said that the companies should be acquired by the government and then broken up into smaller firms and sold to investors. That would remove the federal backing from the firms and reduce the risk posed by the failure of any individual firm.

On Tuesday, Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, echoed that prescription on Bloomberg Television. And in a newspaper column a few weeks ago, Lawrence H. Summers, a Treasury secretary in the Clinton administration, wrote that the companies should be broken up, with some functions remaining public and others being privatized.

Another former Fed official, William Poole, the former president of the Federal Reserve Bank of St. Louis, has recommended having the government take over the companies and phasing them out over several years. That, he said, would allow the private market to take their place as the housing market recovers, while avoiding a financial crisis.

“It would be a mistake for the government to try and operate the whole mortgage finance business in the long run,” said Mr. Poole, who is now a fellow at the libertarian Cato Institute. But supporters of the firms, such as Representative Barney Frank, chairman of the House Financial Services Committee, said the critics failed to acknowledge that the companies had played a pivotal role in the housing market.

Never was that role more apparent than in the last year, when rising defaults in riskier loans bankrupted many mortgage companies and caused commercial and investment banks to take more than $300 billion in write-downs. In the first six months of the year, they securitized $692 billion in mortgages, up 25 percent from the comparable period last year, even as private deals dried up.

“I don’t jump to the conclusion that it is a bad thing,” Mr. Frank, Democrat of Massachusetts, said about the dual nature of the companies. “Fannie and Freddie have stood up better and functioned better than a lot of private institutions.”

Freddie Mac battles to remain independent
Executives at Fannie Mae and Freddie Mac, the American financial giants which sit at the core of the country's mortgage market, were desperately fighting yesterday to preserve their independence as a federal government takeover appeared closer than ever.

Shares in the companies collapsed to lows not seen for two decades amid fears that any government-led refinancing would wipe out shareholders. Freddie Mac bosses met US Treasury officials to complain that the uncertainty was crippling their ability to find a private market solution to their problems.

The companies own or guarantee almost half of all outstanding US mortgages and have become even more important props to the mortgage market since the appetite for exotic mortgage derivatives waned last year.
Last month, the Treasury Secretary, Hank Paulson, promised to do whatever it took to shore up the companies.

Their failure could plunge the US housing market into a depression, and, because Fannie and Freddie debt is so widely held by foreign governments, it could also lead to a flight of capital from the US. Mr Paulson has insisted that the promise to backstop the companies with emergency lending or the injection of equity capital ought to shore up confidence enough to ensure that the money is never needed.

However, the companies' shares have been in freefall since reports on the weekend that the Treasury was drawing up a nationalisation plan, which it could put into effect within weeks. On Tuesday, Freddie Mac had to pay its highest-ever interest rate relative to Treasuries, to obtain $3bn (£1.6bn) of short-term debt.

Yesterday, Fannie Mae shares lost 27 per cent of their remaining value. Freddie Mac shares shed 22 per cent. Freddie Mac has promised to raise $5.5bn of new capital to strengthen its balance sheet, battered by billions of dollars of losses on US mortgage investments and by the falling value of its ultimate collateral, namely American houses.

In private, executives have expressed their fury that uncertainty over the Treasury's intentions has persisted, making it impossible to reassure potential investors they won't quickly be wiped out in a subsequent government takeover.

Fannie Mae's chief executive, Daniel Mudd, insisted yesterday that the company had more capital than ever before and did not foresee a government takeover. "They haven't offered anything and we haven't asked for anything.I don't anticipate that they will do that." The Treasury has consistently said it has no plans to take action and said the meeting with Freddie Mac executives was routine.

Long period of frugality needed for the U.S. economy
Looking for the foundations for the next bull market in U.S. stocks? Wait until you see consumers who save much more, have a lighter debt load and can actually sell their houses. In other words, bring a book: it may be a bit of a wait.

The S&P 500 is down about 12 percent this year and is at levels seen in both 2001 and 1999, leaving many investors sitting on paltry gains or losses for the past decade. On top of that, the United States is arguably in recession, a state of affairs that won't be helped by the rapid deterioration of economies in Europe and Japan. Fair enough, you say, but that information is a heck of a lot less useful than telling us when we might expect an improvement.

David Rosenberg, the U.S. economist at Merrill Lynch in New York, has three conditions he is looking for before he becomes more positive on U.S. stocks: a rise in the personal savings rate to about 8 percent; a decline in the number of houses on the market to about eight months of supply; and a big drop in the amount that debt payments sap from American household budgets.

The good news: All three of these conditions would only represent a return to historic norms. The bad news: The economy is a long way away from its historic norms. Interconnected market bubbles, first in stocks and then in housing, convinced Americans that they were richer then they were, and that they could borrow and spend freely without having to save much.

This belief was fundamental not just to the bubble in housing, but in underwriting huge swaths of the economy. The travel industry, the service industry, even the number and size of cars Americans bought, all benefited from the collapse in savings and the concurrent rise in debt.

According to the U.S. Commerce Department, personal savings comprised 2.5 percent of income in June, up from tiny levels of below 1 percent or even negative readings in recent years, but far beneath the 8 percent or 10 percent rates that had been common since World War II.

"What is the normalized pre-bubble savings rate? You don't have to dial back to the Jurassic period, just the late 80s or 90s," Rosenberg said. "Before we became addicted to asset bubbles, the savings rate was roughly 8 percent." A tripling in the savings rate from here implies a lot less consumption, and a huge hit to corporate profitability.

The housing market, too, needs to stabilize, a process that is being slowed by the credit crunch. Right now there is about a 10-month supply of existing homes for sale, down from 11 months recently but still very high on a historical basis. As long as home prices are falling, bank balance sheets will continue to suffer and the self-reinforcing credit crunch merry-go-round will continue.

Americans also have a huge amount of debt, which looked like a good thing when asset prices were rising and banks were falling over themselves to lend. But now it is a drag. Americans are spending 14.1 percent of their disposable income on debt servicing, near an all-time high.

Rosenberg said he would like to see that number fall to 10.5 percent, a level associated with recoveries from recessions in the 1980s and 1990s. "We've never been in a recession with the interest ratio where the household side is today," Rosenberg said. He pointed out that Japan went into its legendary recession in the 1990s with a personal savings rate of 14 percent, a fat balance that it ran down to 3 percent to cushion its fall.

To get the U.S. debt servicing figure down toward 10 percent, a huge amount of debt has to be either paid back or walked away from. "You are talking about the need to eliminate $350 billion of debt service. About $2 trillion of household debt has to be totally eradicated." This implies spending less, saving more and selling assets.

But the trouble is that banks and consumers alike are trying to lighten their debt burdens at the same time. It is looking a bit like a race to the bottom in asset prices before the solid groundwork can be laid for the next bull market. It is not impossible, and it does not even mean a terribly long recession, though we are probably in for a long period of weak growth.

What it does imply, unless the U.S. Federal Reserve can somehow pull a new bubble out of its hat, is the return of boring old parsimony. Stocks will struggle during the transition from excess to frugality, but once we are there, the rally could be huge. After all, by that point stocks will have more than a decade to make up for.

The standard-of-living bubble
We made it through the bursting of the Internet bubble and now the bursting of the real estate bubble. Next we may be approaching the end of the most worrisome bubble of all: the standard-of-living bubble.

That conclusion comes from the latest data on credit card debt. It's growing fast, but the problem is bigger than that - and to understand what it means, we have to take a few steps back.

For the past several years, the average inflation-adjusted total pay of American workers hasn't been increasing. That means we haven't been building a foundation for increases in our living standard. You might be tempted to say that by definition our living standard couldn't have increased, but that's not quite right.

Even with stagnant real incomes, we can always live a little better every year through borrowing and pretending that our living standard is still rising, just as it was for decades. So the Great Bull Market made us feel rich, and we felt justified in saving less and borrowing - and spending - more. After stocks collapsed, home prices took off, making us feel rich all over again.

So we continued saving less and spending more, creating the illusion that our living standard was still rising. In 2005 our personal savings rate went negative, but even that didn't slow us down, because our homes were still appreciating - and rising home values meant that household net worths weren't declining. (Don't be fooled by that saving-rate spike in this year's second quarter; it was probably a one-time event resulting from the federal stimulus payments.)

Of course, we don't hear those assurances anymore. Stocks are back where they were eight years ago, and home prices are where they were five years ago. But personal debt is much higher than ever before, and average pay is still going nowhere in real terms. So now how do we live as if our living standard is still rising?

That's where the credit card reports come in. Last year, just as the subprime crisis happened, credit card debt took off. The home-equity ATM had been shut down, so people turned to the last source of easy money they had left, the most expensive debt on the menu, credit card borrowing.

Since credit card debt has been growing much faster than the economy - more than 8% in last year's third and fourth quarters and over 7% in May (the most recent month reported)- people are apparently using it as a substitute for income. Thus, for the past year or so we have still maintained the standard-of-living illusion.

But a big crunch is coming - and here's why. Credit card debt, like mortgage debt, gets bundled, securitized, and sold off by banks. Citigroup, one of America's largest credit card lenders, just reported that it lost $176 million in the second quarter through securitizing such debt.

That happens when the buyers of those securities observe rising delinquency rates and rising interest rates, and decide the debt is worth less than Citi thought. More generally, the amount of credit card debt that is securitized nationwide has plunged by more than half in the past five months because it's getting riskier.

That means credit card issuers will be charging customers higher interest rates, and since the banks can't offload as much of the debt as before, they'll have less money to lend to cardholders. The squeeze has already started, which is why Congress is in the process of passing the Credit Cardholders' Bill of Rights, which would prevent issuers from changing rates and terms without warning, among many other provisions.

But bottom line, the credit card money window is going to start closing - and soon. So now what? It's hard to see where consumers can turn next. Home prices seem highly unlikely to start rising again soon. Stocks? You never know, but the Great Bull Market looks like a once-in-a-lifetime event. Homes and stocks are households' biggest asset classes by far. There isn't much else to borrow against.

It may be that the standard-of-living bubble finally has to deflate. Sustainable increases in living standards have to be earned, not borrowed, and that means performing ever higher value work that can't be outsourced. We haven't been meeting that challenge very well; doing so will probably require much more and better education for millions of Americans, which takes time and money.

The result may feel like deprivation, but I don't see it that way. Who knows - we might even find that living within our means and saving a little money actually isn't so bad.  

Citi cuts outlook on Lehman, Morgan Stanley, Goldman
Wall Street research analysts are projecting yet another tough quarter for U.S. investment banks marked by additional writedowns across a series of fixed-income assets amid an already weak operating environment.

Citigroup analyst Prashant Bhatia widened his third-quarter loss estimate for Lehman Brothers Holdings Inc. Bhatia and Lehman Brothers Inc analyst Roger Freeman also cut their third-quarter earnings estimates for Goldman Sachs Group Inc and Morgan Stanley.

"We are lowering our third-quarter estimates to reflect the difficult operating environment, characterized by lower client-related trading volumes and losses on hard-to-sell assets," Citigroup's Bhatia said. Bhatia expects Lehman to take fresh asset-related writedowns of $2.9 billion. He expects $1.8 billion in writedowns at Goldman and $1.7 billion at Morgan Stanley.

"Based on further deterioration in several indices, we expect further writedowns, primarily related to mortgage assets," Bhatia wrote in an August 20 note to clients.

Lehman analyst Roger Freeman said writedowns for this quarter would come from exposures to prime residential mortgages, subprime mortgages and securities, Alt-A residential mortgages and securities, collateralized debt obligations, and leveraged loans.

Commercial mortgages have also experienced price depreciation this quarter, as measured by widening commercial mortgage-backed securities spreads and a decline in the CMBX index, which tracks commercial-mortgage-backed securities, Freeman said. These declines have accelerated in the past couple of weeks, he said.

Banc of America Securities analyst Michael Hecht said he expects large U.S. investment banks to face a "lackluster, low-visibility" environment through 2008, on account of their "still-large" balance-sheet exposure to residential and commercial mortgages.

Troubled-asset disclosures for U.S. brokers and asset managers totals $443 billion, down from $599 billion a quarter ago, Hecht said. He, however, added that there was still quite a "hangover" to work through for the industry.

Among the companies under his coverage, Lehman has the largest exposure to troubled assets at about $72 billion, while Morgan Stanley has the least at about $25 billion, Hecht said. Financial services firms have recorded more than $400 billion in writedowns on investments, largely as a result of the subprime mortgage crisis which has roiled global markets since last year.

Lehman's Roger Freeman and Citigroup's Prashant Bhatia were the latest among Wall Street research analysts to cut their outlook for U.S. investment banks. nSince the start of this month, analysts at Merrill Lynch, Fox-Pitt and Bernstein have cut their estimates for Goldman and Morgan Stanley, while forecasting a third-quarter loss for Lehman.

Freeman on Thursday cut his third-quarter earnings estimates for Goldman to $1.70 a share from $3.77, and for Morgan Stanley to 75 cents a share from $1.13. A second round of estimate cuts is most likely with Goldman's earnings and this will cause shares of the largest U.S. securities firm to be at the "greatest risk" through the end of the quarter, Freeman said.

Freeman rates Goldman and Morgan Stanley "equal-weight." Citigroup's Bhatia cut his earnings estimates for Goldman to $2.50 a share from $4.50, and for Morgan Stanley to 75 cents a share from 76 cents.
He widened his third-quarter loss view for Lehman to $3.25 a share from 41 cents a share.

Bhatia, however, said he saw a "lower probability" that Lehman would sell its Neuberger Berman business or raise capital in the near term. Several Wall Street analysts have been speculating a possible sale of all or a portion of Lehman's asset-management business -- a move mentioned in media reports as a possibility for weeks. Experts estimate the business, whose core is Neuberger Berman, could be worth about $8 billion.

"Even under the potentially more stringent rating agency guidelines related to the amount of preferred securities in the capital mix, we anticipate that Lehman can absorb over $3 billion of after-tax losses without adding more common equity," Bhatia said.

Bhatia rates Lehman and Morgan Stanley "buy," and Goldman "hold." He cut his price target on the shares of Lehman to $35 from $50. Shares of Lehman closed at $13.73 Wednesday on the New York Stock Exchange, while those of Goldman closed at $158.25 and Morgan Stanley at $37.40.

Lehman’s secret talks to sell 50% stake stall
Lehman Brothers, the beleaguered US investment bank, held secret talks to sell up to 50 per cent of its shares to South Korean or Chinese parties in the first week of August but failed to reach agreement with either. The South Koreans and Chinese walked away after concluding that Lehman was asking too high a price, said New York-based people familiar with the potential buyers. Lehman declined to comment.

The talks reflect the growing pressure on Dick Fuld, Lehman’s chief executive, to raise capital ahead of the mid-September earnings report, which, analysts said, could include more writedowns of $4bn (£2bn), bringing the total so far to $12bn. Lehman shares have fallen nearly 85 per cent since early 2007 and its market value is now about $9.5bn.

In addition to selling a stake in itself, Lehman is considering selling all or part of its holdings, including its troubled $40bn commercial real estate portfolio and its asset management arm, which includes Neuberger Berman. Analysts said the asset management arm was the crown jewel that could be worth up to $10bn.

In the first week of August, Lehman held parallel talks with the government-owned Korea Development Bank and China’s Citic Securities at its headquarters in New York’s Times Square area. The South Koreans discussed a two-step process under which KDB would buy a 25 per cent stake directly from Lehman and another 25 per cent of the shares though a market tender.

The price under discussion was 50 per cent above Lehman’s book value. The two sides were said to have been close to a deal but last-minute disagreements torpedoed the talks. Simultaneously, Lehman met top executives of Citic Securities but these talks never reached the level of detail of those with the South Koreans.

“They [Lehman] wanted ... a few irons in the fire,” said one person familiar with the matter. The talks to sell a substantial stake in Lehman are likely to lead to questions about the future of Mr Fuld, 62, who has spent his career at the bank and is the longest-serving chief executive of a top Wall Street firm.

Lehman had been one of the grandest names in high finance before a series of mis-steps forced its sale to Shearson American Express in 1984. For members of the old guard at Lehman, like Mr Fuld, the years inside Amex were a humiliation. It took a decade for Lehman to break free and Mr Fuld has jealously guarded the independence of his firm ever since.

“What is Lehman’s strength also became Lehman’s weakness,” said one former executive at the bank. “The plus was that there was continuity. The negative side was that, as the game changed, the senior people became too removed.” In June, Mr Fuld had to accept the resignation of Joe Gregory, his long-time deputy, who was replaced as president and chief operating officer by Bart McDade.

Erin Callan, the high-profile chief financial officer, was replaced after only six months in the job by Ian Lowitt. Mr McDade has been playing an increasingly prominent role at the investment bank, according to people who have dealt with Lehman.

However, in spite of Lehman’s share price fall, those who have negotiated with the firm in recent weeks describe Mr Fuld, who wields additional influence as a director of the Federal Reserve Bank of New York, as being as pugnacious as ever. “He thinks he is playing with a full deck,” said one person on the other side of the table.

Fed Acted on Lehman Rumor
In an apparent attempt to prevent a repeat of the cascading rumors that helped sink Bear Stearns Cos., the Federal Reserve last month quietly called one major bank to see if it had pulled a credit line from Lehman Brothers Holdings Inc., people familiar with the matter said.

Responding to a July rumor that Credit Suisse Group planned to pull a line of credit to Lehman, Federal Reserve officials called to see if it was in fact true, according to these people. Credit Suisse told Fed officials there was no truth to the rumor and it had no intention of pulling the line of credit, the people said.

The Fed's unusual move underscores the tough position that federal officials are in as the Wall Street investment bank tries to overcome mortgage-related losses. As financial institutions suffer through write-downs and loan woes, the Fed has a strong incentive and the moral authority to dispel groundless speculation that could threaten the viability of an important cog in the U.S. financial system.

"You don't want to upset the Fed," said one senior Wall Street banker. But urging lenders and trading partners to stick by an embattled firm also carries the risk that it will inflame the same anxieties that the Fed is trying to soothe. That is one reason why such calls occur rarely.

In addition to pounding its bottom line, Lehman has complained that its problems have been fodder for vicious, unfounded rumormongering by traders who profit when the firm's share price declines. Lehman has repeatedly denounced negative speculation, even calling individuals believed to be spreading rumors and trading desks said to be skittish about doing business with the investment bank. Yet Lehman shares are down 79% so far this year.

Fed officials contacted Credit Suisse last month, but it isn't clear if the move occurred before or after the Securities and Exchange Commission subpoenaed dozens of hedge funds and financial firms about four Lehman-related rumors. One person familiar with the rumor said it was circulating in early July.

Last month, the SEC also put limits on short-selling of 19 financial stocks, including Lehman, aiming to crack down on abuses. The temporary rules expired last week. Lehman declined to comment on the Fed's call to Credit Suisse. When the Bear Stearns crisis erupted in March, Lehman and other Wall Street firms criticized the SEC for not responding more aggressively to rumors that essentially caused a run on the bank, forcing Bear's emergency sale to J.P. Morgan Chase & Co.

At the time, Fed officials called at least two major banks rumored to have stopped trading with Bear and were told that wasn't true. The Fed has more standing to intervene as a result of its move after Bear's collapse to allow securities dealers such as Lehman to borrow from the central bank on much the same terms as commercial banks. That was one of the broadest expansions of Fed lending authority since the 1930s, but few Wall Street firms have used the lending facility.

The flurry of rumors about Lehman has died down since the SEC's actions. But the New York firm's results for the fiscal third quarter ending Aug. 29 are expected to be bleak, with some analysts forecasting a net loss of more than $2 billion. Lehman, led by Chairman and Chief Executive Richard S. Fuld Jr., is exploring various options in case it decides to raise capital. One possibility is a sale of a piece of the investment-management unit that includes Neuberger Berman, according to people familiar with the matter.

Auction-Rate Brokers Likely Knew of Flaws, Cuomo Says
Fidelity Investments, Charles Schwab Corp. and Oppenheimer Inc. may be punished for their sales of auction-rate securities, New York State Attorney General Andrew Cuomo said, as he laid out his argument for pursuing brokerages that he says deceived investors.

"It seems highly unlikely that the firms had no understanding of what was happening in the ARS market," Cuomo's deputy counselor, Benjamin Lawsky, wrote in a letter today to the Regional Bond Dealers Association. If the brokerages "continued to actively market these products to unknowing investors, that will certainly be relevant to our calculus of the firms' culpability."

The attorney general and federal and state regulators have already wrung agreements from five Wall Street banks, including Citigroup Inc. and UBS AG, to repurchase about $35 billion of auction-rate securities. The regional bond dealers group last week told regulators that the banks -- not brokers -- should be required to buy back the securities they created.

Cuomo said he has subpoenaed Fidelity, Schwab, Oppenheimer, TD Ameritrade Holding Corp. and E*Trade Financial Corp. The regulators are examining how the securities were marketed before February, when firms overseeing periodic auctions for the debt abandoned their routine role as buyers of last resort, saddling investors with holdings they couldn't sell.

Greg Gable, a Schwab spokesman, didn't return calls seeking comment today. Oppenheimer Secretary Dennis McNamara also didn't return a call. E*Trade spokeswoman Pam Erickson didn't return a call, and nor did TD Ameritrade's Kim Hillyer.

Cuomo's office has also stepped up its probe into Goldman Sachs Group Inc., Bank of America Corp. and Deutsche Bank AG, a person briefed on the matter said. Cuomo is asking the banks for more documents than those already produced in the investigation, the person said, speaking on condition of anonymity. The Wall Street Journal earlier today reported the requests.

Ted Meyer, a spokesman for Deutsche Bank in New York, declined to comment. Goldman spokesman Michael DuVally said the firm is "cooperating fully" with regulators and declined further comment. Bank of America's Shirley Norton said the bank doesn't discuss talks with regulators.

Cuomo shares the regional brokerage group's concern in "providing relief to investors who were defrauded," Lawsky wrote. "With that in mind, your member firms should consider liquidating the ARS investments of their clients, especially those clients who were marketed and sold these instruments by your firms."

The bond dealers group's co-chief executive officers, Michael Decker and Mike Nicolas, said in response to Cuomo's letter that they expect regulators to take "full appropriate measure" against any firms that broke securities laws. "Our focus has been and remains on investors and ensuring they can liquidate their ARS positions as soon as possible."

Fidelity, the world's largest mutual-fund manager, has also been targeted in the auction-rate probe. Massachusetts Secretary of State William Galvin yesterday urged Fidelity Investments to buy back frozen auction-rate securities from individual investors who bought them through the company's brokerage unit.

Brokerages Face Inspections Tied to Sales of Auction-Rate Debt
U.S. regulators will start on-site inspections next week of about 40 brokerages involved in sales of auction-rate securities, stepping up a nationwide inquiry into whether the firms failed to warn clients the market was collapsing, a person familiar with the matter said.

The Financial Industry Regulator Authority, which regulates almost 5,100 brokerages, wrote to the firms this month seeking detailed records, said the person, who reviewed the letters. New York Attorney General Andrew Cuomo said yesterday he had subpoenaed firms including Fidelity Investments, Charles Schwab Corp. and Oppenheimer Holdings Inc. in a parallel probe.

Financial regulators are shifting the focus to brokerages that sold the securities from banks that created them after wringing pledges from five Wall Street firms, including Citigroup Inc. and UBS AG, to repurchase about $35 billion of auction-rate debt. Like Cuomo, Finra has uncovered evidence that firms improperly sold the instruments, the person said.

"If downstream brokerages deliberately stuck their heads in the sand but continued to actively market these products to unknowing investors, that will certainly be relevant to our calculus of our firms' culpability," Cuomo's office said in a letter to the Regional Bond Dealers Association yesterday.

State and federal regulators, including the Securities and Exchange Commission, are looking at how brokerages sold auction- rate securities before the $330 billion market collapsed in February. That's when firms running the periodic auctions for the debt abandoned their routine role as buyers of last resort, leaving investors stuck with securities they couldn't sell.

Finra's sweep focuses on firms that haven't yet settled regulatory probes and have the largest client holdings of auction- rate debt, the person said. That includes national, regional and boutique firms, as well as brokerages affiliated with banks or insurers.

The Washington-based watchdog is examining whether the companies conducted due diligence on the products, ensured that brokers understood them and explained risks to customers. Investigators are scrutinizing the firms' communications with banks that ran the auctions, following up on signs that brokerages placed bids to help support the sales. The regulator is demanding spreadsheets on bids submitted for the products and clients' holdings, the person said.

It wants copies of training and marketing materials and is seeking the firms' risk analyses and the results of internal investigations. Firms may be punished if evidence shows they sold the debt while ignoring signs the market was weakening, Cuomo's office said in its letter yesterday. The attorney general has subpoenaed companies including TD Ameritrade Holding Corp. and E*Trade Financial Corp.

The bond dealers group's co-chief executive officers, Michael Decker and Mike Nicolas, said in response to Cuomo's letter that they expect regulators to take "full appropriate measure" against any firms that broke securities laws. "Our focus has been and remains on investors and ensuring they can liquidate their ARS positions as soon as possible."

Schwab said in an Aug. 15 statement it was cooperating with regulators' requests for information, noting it didn't underwrite the securities or market them to clients. The firm said it acted as an agent "as an accommodation when clients asked for them." Oppenheimer's Dennis McNamara, E*Trade spokeswoman Pam Erickson and TD Ameritrade's Kim Hillyer didn't return calls for comment.

Fidelity, the world's largest mutual-fund manager, has been targeted in the auction-rate probe. Massachusetts Secretary of State William Galvin urged Fidelity on Aug. 19 to buy back frozen auction-rate securities from individual investors who bought them through the company's brokerage unit. "Fidelity is neither the issuer, underwriter or the sponsor" of auction-rate securities, spokesman Vincent Loporchio said that day. "We believe the underwriters should stand behind their securities."

Brokerages won't get pass in auction rate probe
New York Attorney General Andrew Cuomo said Wednesday that smaller brokerage firms that acted as middlemen in sales of auction-rate securities will be held accountable for any losses suffered by investors.

Brokerages like Fidelity Investments, Charles Schwab Corp., TD Ameritrade Holding Corp., E-Trade Financial Corp. and Oppenheimer & Co. are being investigated over how they pitched the investments to clients, according to a letter obtained by The Associated Press. These firms, known as downstream brokerages, acted as secondary dealers by purchasing auction-rate securities from the major banks that packaged them.

"If downstream brokerages deliberately stuck their heads in the sand but continued to actively market these products to unknowing investors, that will certainly be relevant to our calculus of the firms' culpability," Benjamin Lawsky, deputy counselor and special assistant in the attorney general's office, said in the letter.

"These firms are licenses broker-dealers and were obviously well paid by their clients for their specialized knowledge and diligence regarding the appropriateness of various products as investments."

The Regional Bond Dealers Association earlier this week asked regulators to focus their attention on the primary dealers that first sold the securities. They believe that smaller brokerages should not be expected to buy back the investments from their customers, arguing that the major Wall Street banks that underwrote the securities should be held responsible.

Five major Wall Street firms including Citigroup Inc. and Switzerland's UBS AG have agreed to $42 billion in settlements with state and federal regulators over auction rate securities. The investigations are examining how brokerages sold auction-rate securities before the $330 billion market collapsed in February.

The Washington-based bond market trade group said that about $60 billion of the auction rate securities were sold through brokerages that didn't know the market was in danger of collapse. The auction-rate securities market involved investors buying and selling instruments that resembled corporate debt, except the interest rates were reset at regular auctions, some as frequently as once a week.

A number of companies and retail clients invested in the securities because they could treat their holdings almost like cash. But the market for them collapsed in February amid the downturn in the broader credit markets. Regulators have been investigating the collapse in the market to determine who was responsible for its demise and whether banks knowingly misrepresented the safety of the securities when selling them to investors.

Merrill Brokers Press Pimco, BlackRock to Buy Auction-Rate Debt
Merrill Lynch & Co. brokers are pressing fund managers Pacific Investment Management Co. and BlackRock Inc. to buy back auction-rate securities, aiming to speed up client bailouts in the frozen market.

More than 300 brokers have e-mailed Pimco saying its executives may "no longer be welcome in our offices" unless they redeem the securities, according to Erick Ellsweig, a Merrill financial adviser in North Carolina who spearheaded the e-mail campaign. Will Fuller, head of distribution for Merrill's U.S. brokerage arm, wrote to BlackRock on Aug. 15 saying its failure to offer redemptions in the past two months has created "dissatisfaction in our financial advisers and clients."

Merrill's brokers, who make up the biggest U.S. financial advisory network, say they're trying to help clients stuck with more than $10 billion of securities in the $200 billion auction- rate market. Pimco, which manages the world's biggest bond fund, and BlackRock, the largest publicly traded U.S. fund manger, used the market to finance their closed-end mutual funds, and Merrill brokers sold the investments to its customers.

"The brokers at Merrill are very upset about the lack of access to capital for their clients, and they have been rattling the cage," said Geoffrey Bobroff, a mutual-fund consultant in East Greenwich, Rhode Island. The auction-rate market seized up in February with $330 billion in securities when the credit crisis prompted Wall Street firms to stop supporting the periodic auctions in which the securities were bought and sold.

New York Attorney General Andrew Cuomo has accused Merrill and other brokers of improperly peddling them as investments that were as liquid as cash. Merrill has said it's cooperating with government probes.

Five banks, including Citigroup Inc. and UBS AG, have reached settlements with Cuomo and other regulators, agreeing to pay $360 million in fines and repurchase about $35 billion of auction-rate securities. Merrill, the third-biggest U.S. securities firm, has offered to buy back $10 billion starting in January, a proposal Cuomo said was inadequate.

Purchases of auction-rate securities by BlackRock and Pimco would benefit Merrill by reducing the amount of the investments it may have to repurchase. "The only thing we care about is getting our clients redeemed as quickly as possible," Ellsweig, who has worked at Merrill since 2001, said in an Aug. 16 e-mail. Bloomberg obtained copies of the correspondence between Merrill, BlackRock and Pimco, which was confirmed by officials of the companies.

"This was a grassroots effort reflecting the opinion of a group of financial advisers," Merrill spokesman Mark Herr said in an e-mailed statement. "The firm continues to work with all interested parties at resolving the liquidity challenge caused by the unprecedented freezing of the auction-rate securities market." Merrill, based in New York, has a "long track record of working with Pimco and BlackRock," he said.

The flare-up with New York-based BlackRock is notable because Merrill owns 49 percent of the firm and is the largest distributor of its funds. BlackRock has a "leadership position within our company," Fuller wrote in the e-mail to BlackRock President Robert Kapito, so it faces higher expectations from Merrill's brokers.

"We continue to work constructively with all major market participants to address the unprecedented issues in the auction- rate market," said BlackRock spokesman Brian Beades in an e- mailed statement. Closed-end funds, which trade on exchanges, sold auction- rate securities to finance asset purchases and increase returns for common shareholders.

The funds had $64 billion outstanding when the market froze, according to research firm Thomas J. Herzfeld Advisors Inc. in Miami. Fund managers including Nuveen Investments Inc., Eaton Vance Corp. and BlackRock have redeemed or scheduled the redemption of $24.1 billion of auction-rate preferred shares, according to Herzfeld, which specializes in closed-end funds.

Following the Cuomo announcements, some funds dropped plans to assist in the buybacks. On Aug. 14, three funds managed by Hartford, Connecticut-based Phoenix Cos. announced they were suspending efforts to obtain bank credit lines to finance auction-rate redemptions.

Daniel Sontag, who oversees Merrill's U.S. retail division, wrote in a memo last week that the firm's buyback offer doesn't let closed-end funds off the hook. "We fully expect" fund managers to "work with us even more actively," he wrote.

Nuveen, which had $15.4 billion of the securities outstanding as of February, has announced redemptions of $5.53 billion, or 36 percent, according to Herzfeld. Eaton Vance's buybacks total $3.8 billion, or 76 percent. BlackRock's repurchases stand at $2.5 billion, or 25 percent. BlackRock hasn't announced any redemptions since June 2, Merrill's Fuller wrote in the memo to Kapito. "We fear that our financial advisers view BlackRock as conspicuous by its absence," Fuller wrote.

Munich-based Allianz SE, which owns Pimco, hasn't redeemed any of its $5.3 billion of outstanding auction-rate securities, according to Herzfeld. Pimco, based in Newport Beach, California, is the home of manager Bill Gross's $130 billion Total Return Fund, the world's biggest bond fund. On Pimco's Web site in February, Gross called the unraveling auction-rate market Wall Street's latest twist on "Old Maid" -- a card game in which players try to avoid getting stuck with a lone queen.

Cuomo Snubs Treasurers in Rescue of Auction-Rate Debt Holders
New York Attorney General Andrew Cuomo's auction-rate securities settlements with Wall Street banks show that the man who bills himself as the "people's lawyer" favors savers over shareholders.

The almost $35 billion of frozen debt that Citigroup Inc., UBS AG, JPMorgan Chase & Co., Morgan Stanley and Wachovia Corp. agreed to repurchase covers less than 18 percent of the $200 billion Cuomo last week estimated was outstanding, and is targeted at individuals, charities and small businesses.

Corporate finance officers, who also say they bought the securities after banks marketed them as safe alternatives to money-market investments, aren't being offered the same commitment. The best they got was a promise by Wachovia to buy securities, though maybe not until June 10, 2009.

"It's safe to say we're not pleased that what was marketed as highly rated investment grade securities in our portfolio are illiquid and have lost value," said Michael Smith, a spokesman for ADC Telecommunications Inc. The Minneapolis-based maker of telephone-networking equipment, which owned $170 million of auction-rate securities in May, has written down the value of the debt by almost $100 million since Oct. 31, 2007.

Companies from Mountain View, California-based Google Inc. and United Parcel Service Inc. in Atlanta to Texas Instruments Inc. in Dallas have taken markdowns totaling $2.1 billion on more than $32 billion of auction-rate holdings, according to a July 31 survey from New York-based Pluris Valuation Advisors LLC.

The auction-rate market collapse may also lead corporate treasurers to abandon Wall Street, jeopardizing fees for bankers who arrange bond sales, mergers and public offerings. Some finance managers are moving their cash to the trading desks of commercial banks as others shift to money-market funds or bank accounts, said Anthony Carfang, a partner at Treasury Strategies Inc., a Chicago-based treasury consulting firm. "They're coming home to the trusted provider," he said.

Memphis, Tennessee-based Pinnacle Airlines Corp., whose subsidiaries operate a fleet of regional jets, including Delta Connection and United Express, reported a second quarter loss of 64 cents per share on Aug. 11 in part because of an $8.7 million charge on $136 million of auction-rate securities backed by student loans.

In a conference call to discuss the results, Pinnacle Chief Financial Officer Peter Hunt said the settlements seem "to focus more on taking care of the small guys." "It does seem like there are also some promises of assistance to larger companies over time," he said. "That doesn't change the fact the asset is impaired."

Auction-rate securities allowed municipalities, student loan agencies, and closed-end mutual funds to sell long-term debt with lower short-term interest rates set at periodic auctions, typically held every seven, 28 or 35 days. Investors have been stuck in the securities since the one- time $330 billion market collapsed in February. That's when dealers, who for two decades bought debt that went unsold at auctions, suddenly pulled back because of widening credit-market losses.

Investors who were told the debt was as safe and liquid as money-market funds were left with depreciating securities they couldn't sell as auctions failed. "A lot of institutions were lied to by their brokers, and brokerage firms put their own interests ahead of their institutional customers," said Jacob Zamansky, a securities lawyer at Zamansky & Associates in New York who represents institutional investors in auction-rate cases. "Cuomo was run over in his haste to get a settlement by these major firms."

Cuomo, at an Aug. 14 New York press conference announcing settlements with JPMorgan and Morgan Stanley to buy back $7.5 billion of the securities, said returning money to retail investors was his priority because they needed more protection. Both firms are based in New York.

"They're less sophisticated," Cuomo said. "They have fewer resources to begin with. The institutional investors we also believe need fairness and need equity, and to the extent they were victimized, they need to be compensated." The settlements reached with the banks by Cuomo and state securities regulators call for the firms to use their "best efforts" to help institutional investors turn the securities to cash. The settlements didn't provide specifics.

"If we believe those best efforts are not achieving the fair and just goal, then we can take action," he said.

Sallie Mae Rises on Funding for $20 Billion in Student Loans
SLM Corp., the largest U.S. education lender, gained the most in more than a month in New York trading after saying it will provide at least $20 billion in new government-backed student loans in the coming academic year.

SLM also said its wholly owned subsidiary, Sallie Mae Bank, has agreed with federal regulators not to engage in certain "co-branded marketing practices." The practices stopped in August 2007, the Reston, Virginia-based company said in a filing today with the Securities and Exchange Commission.

SLM, known as Sallie Mae, rose $1.33, or 10 percent, to $14.33 at 4:15 p.m. in New York Stock Exchange composite trading. It was the biggest increase since July 16. The company has declined 70 percent in the past 12 months. SLM said in a statement today that it was the first lender to receive money from a new government program to ensure loans are available for all eligible students.

President George W. Bush signed the legislation in May, allowing the Education Department to buy federally guaranteed student loans that lenders haven't been able to sell to investors. Sallie Mae, which makes federally guaranteed and private loans, has been hurt by the global tightening of credit and a reduction in government subsidies. Lower demand for loan-backed bonds caused profit to fall 72 percent in the second quarter.

The company issued more than $7 billion in asset-backed securities in the quarter and originated $3.3 billion in student loans. The $20 billion in loans that Sallie Mae estimates that it will originate in the 2008-2009 school year will be part of the federal Stafford and PLUS programs, according to the company's statement. Neither spokesman Tom Joyce nor spokeswoman Martha Holler immediately returned calls for comment.

The company said its bank's agreement with the Federal Deposit Insurance Corp. is for "specific compliance-related matters" and didn't affect the bank's safety and soundness. The bank, which was established in 2005 and makes education loans, is expected "to play a growing role in the financing of Sallie Mae's private credit loans," SLM said in its filing.

A Tax Revolt Is Quietly Brewing in Some States
And to think they used to call it "Taxachusetts." On Election Day, Massachusetts will vote on whether to eliminate its state income tax. Advocates hope victory in a place long thought of as a free-spending liberal bastion will pave the way for similar initiatives in other states over the next few years. Critics insist a yes vote would lead to fiscal disaster.

While Americans are focusing on the presidential and congressional races, voters in Massachusetts and other states will decide the fate of dozens of state and local tax and spending issues. It's still unclear precisely how many of these issues will be on ballots on Nov. 4. Some still haven't received final approval from state officials or may face challenges in court.

But Kristina Rasmussen, director of government affairs at the National Taxpayers Union, a nonprofit group based in Alexandria, Va., estimates there are more than 60 ballot measures that would have "some significant impact" on taxpayers. Oregon voters, for example, will decide whether to allow taxpayers to deduct an unlimited amount of their federal income taxes on their state returns.

Nevada is expected to vote on a constitutional amendment that would restrict property-tax increases. North Dakota voters may vote on whether to chop the state's personal income tax in half. And Minnesota will vote on a proposed amendment to its state constitution to raise the state sales tax by three-eighths of a percentage point, with the money going to protect the environment and to benefit the arts.

These and othe battles come at a time when many states are struggling to cope with tough economic times. As the national economy's growth rate has slowed to a crawl, growth in state tax collections generally has withered, intensifying budget strains. "Many states have reduced their revenue forecasts, some many times," said a recent report by the National Conference of State Legislatures, a Denver-based group. "In a number of states, collections are even below the lowered expectations."

Since that report was issued last month, "the news has gotten even worse" in several states, says Arturo Pérez, fiscal analyst at the National Conference of State Legislatures. A recent report by the Nelson A. Rockefeller Institute of Government, the public-policy research arm of the State University of New York, paints a similarly gloomy picture.

The report said state tax revenue rose only 1.7% in this year's first quarter from the same quarter in 2007. That was the third quarterly growth-rate decline in a row -- and the slowest pace in five years. Besides tax and spending issues, voters will pull the lever this fall on a wide range of questions involving social issues, including abortion, affirmative action and same-sex marriage, says Jennie Drage Bowser of the National Conference of State Legislatures.

She says more than 123 questions already have qualified for ballots around the nation, with many others awaiting final approval. Most have come from state legislatures or from citizen initiatives. Here is a look at a few of the most high-profile tax battles:

Massachusetts. The issue is whether to erase the state's income tax in two phases. The 5.3% tax would be sliced in half next year and then disappear entirely the following year. Advocates of repeal are hoping for support from voters worried about tough economic times and angered by bloated government spending.

Six years ago, a similar proposal attracted 45% of the vote. Eliminating this tax "will mean less money in the hands of politicians and will give back an average of $3,700 to each of 3.4 million workers and taxpayers in Massachusetts -- not just once but every year," says Carla Howell of the Committee for Small Government, a nonprofit citizen group battling to repeal the tax. "There are tax-cut activists around the country who are very interested in what we're doing here," she says. "If it does well, we may see copycat initiatives in 2010 and 2012 across the country."

Grover Norquist, president of Americans for Tax Reform, a Washington-based coalition of taxpayers and taxpayer groups opposed to tax increases, agrees. The Massachusetts vote, officially dubbed "Question One," "could be a model for the future" in many other states, he says. Critics of the proposal say passage would be a major blow. "It would be an absolute disaster for the state," says Michael J. Widmer, president of the Massachusetts Taxpayers Foundation, a Boston public-policy research group funded primarily by employers.

If adopted, "this extreme measure would throw the finances of state and local governments into chaos and inevitably lead to major increases in property and sales taxes," Mr. Widmer says. The state income tax in Massachusetts generated about $12.5 billion in the latest fiscal year, out of a state budget of around $28 billion, says Bob Bliss, a spokesman for the state revenue department. State officials haven't said what they'll do if the repeal proposal wins approval and becomes law.

Massachusetts Gov. Deval Patrick, a Democrat, has been "very clear" in his opposition to repeal of the state income tax, says Rebecca Deusser, a spokeswoman. "A cut of this magnitude would severely reduce the ability of the Commonwealth to provide the services that citizens and taxpayers have come to expect from their state government," she says.

"Best guess: It will go down" to defeat because of voter fears that approval would lead to "evisceration of key programs," says Douglas Schoen, a political consultant and author based in New York. Most states have a state income tax. Seven, including Florida, Texas, Washington and Nevada, have none. Two other states -- Tennessee and New Hampshire -- don't tax wages and salaries but do tax investment income, such as interest and dividends

Britons fall into fuel poverty: energy prices up 30%
Two of Britain's energy providers have dramatically raised gas and electricity prices today, adding to the misery facing hard-pressed UK consumers and putting more people into fuel poverty.

Scottish & Southern Energy is putting an extra 29.2 per cent on gas customers' bills and 19.2 per cent on electricity bills, while more than four million customers of E.ON have been hit with energy price prices of up to 26 per cent. Scottish & Southern, which will increase prices from next Monday, said the spike in the wholesale gas market yesterday demonstrated "the dramatic increase in wholesale energy prices we have experienced in the UK."

The group said customers on its duel-fuel contracts would on average pay £100 less at £1,259 this year than British Gas customers. E.ON, the German-owned energy giant, said it had been forced to lift its prices for electricity by 16 per cent and gas by 26 per cent because of soaring wholesale energy prices, which it claimed had risen 51 per cent since February 1.

Graham Bartlett, managing director of E.ON’s retail business, said: “I’m very aware of the effect that today’s announcement will have on our customers and I recognise that this is a very tough time for everyone. This was not an easy decision to make and we’ve tried to keep these increases as low as possible while protecting as many of our customers as we can."

The price move, which takes effect tomorrow, amounts to a 22 per cent rise for an average dual-fuel customer from £1,063 in July up to £1,297. In total, customers have been hit with an increase of 42 per cent, or £384, since the beginning of the year when the average E.ON dual-fuel bill stood at £913.

The company has 5.5 million UK customers but one in four will be unaffected by the changes because they are on fixed tariffs or price-protection plans. The latest increase is expected to raise an extra £930 million a year for E.ON whose price rise follows similar recent increases from EDF and British Gas.

E.ON said it was investing billions of pounds in new energy projects as well as £200 million in a gas storage scheme in Cheshire. The company said this would allow it to store gas when prices are low in the summer for use when wholesale prices increase, thereby reducing price volatility. The remaining two big UK energy suppliers, Scottish Power and N-Power, are expected to follow suit in the weeks ahead.

Gordon Lishman, director general of Age Concern, said: “These enormous price hikes will be a huge blow to millions of people already wondering just how they’re going to pay their bills this winter. We are extremely concerned that the one-in-three pensioner households likely to be living in fuel poverty by the end of the year will feel forced to cut back on essential food or fuel.”

He called on the Government to offer fuel vouchers to the poorest pensioners. Maria Wardrobe of National Energy Action said the increase had pushed the number of households living in fuel poverty in the UK above 5 million for the first time since the late 1990s - representing around 19 per cent of households.

Fuel poverty is defined as having to spend 10 per cent or more of monthly income on energy. “This is going to make the problem even worse,” she said, calling for the Government to boost its funding on energy efficiency programmes.

Alert over asset seizure in emerging markets
Private equity groups are taking big legal and financial risks as they invest more in emerging markets to escape the US and European credit crunch, buy-out executives and lawyers warn. Peter O’Driscoll, a lawyer at Orrick in London, said: “Expropriation of foreign-owned assets is on the rise. Not surprisingly, when an investment has done well, local partners have a greater incentive to try to steal it.”

Private equity investment in the Bric countries – Brazil, Russia, India and China – reached almost $17bn in the year to June, up about 80 per cent on the previous year, according to Dealogic. Paul Fletcher, senior managing partner at Actis, an emerging market private equity investor, said. “We all have scars from falling out with sponsor. You need protection should it break down.”

Mr O’Driscoll said that examples of such risks included the dispute over the investment by Kohlberg Kravis Roberts in Kamaz, a Russian truckmaker, in the late 1990s and a clash over property investments by AIG Capital Partners in Kazakhstan. Some groups, such as TPG Capital of the US and Lion Capital of the UK, have invested billions of dollars in Russian groups in the past 12 months, drawn by growth in consumer spending.

Others are more cautious. Johannes Huth, head of KKR in Europe, said: “We don’t see an emerging market like Russia as our core focus. Oligarchs are inevitably going to be better connected than us.” The risks for foreign investors in countries such as Russia have been illustrated by BP’s tussle over its TNK-BP joint venture. The war in South Ossetia has also damped appetite for Russian assets.

Ajay Khaitan, founder of Emerisque, which buys western brands such as Lee Cooper jeans to expand in emerging markets, said: “You cannot count on the efficiency of legal systems in some countries to resolve differences.” Mr O’Driscoll at Orrick said: “There are emerging market private equity funds that have seen their investments stolen, which is obviously not the exit you would hope for. The favoured technique at present is a collusive lawsuit in which a plaintiff secretly controlled by the local partner sues the foreign investor in a local court.”

While western investors usually provide for contracts to be governed by US, UK or Swiss law and turn to arbitration to resolve disputes, Mr O’Driscoll said it could be hard to enforce rulings in places such as Russia and Ukraine

Yen Rises as Credit-Market Losses Damp Demand for Higher Yields
The yen rose to the highest level in three months against the euro as European and Asian stocks slid on concern that credit-market losses are widening, reducing demand for higher-yielding assets funded by loans in Japan.

The yen advanced versus all 16 of the most-active currencies after the Financial Times reported Lehman Brothers Holdings Inc. failed to sell a 50 percent stake to investors. The dollar traded near to its lowest level in a week against the euro before industry and government reports that may show the U.S. economic outlook worsened in July for a third consecutive month and manufacturing in the Philadelphia region contracted.

"The yen has risen as concerns tick up about the health of financial companies worldwide and the outlook for the global economy" said Paul Robinson, a currency strategist in London at Barclays Capital and a former Bank of England economist. "These concerns are likely to remain simmering which is going to keep the yen somewhat supported."

The yen advanced 0.9 percent to 160.71 per euro at 7 a.m. in New York, the highest level since May 13, from 162.03 yesterday. The Japanese currency slid 1 percent to 108.72 per dollar, from 109.86. The dollar fell to $1.4775 per euro, from $1.4747. The U.S currency fell as much 0.6 percent to $1.4833 earlier, the lowest level since Aug. 14.

Gains in the yen accelerated when it went through a so- called key level at 160.87 per euro. Earlier, the Japanese currency advanced after breaking above 109.50 and 109.20 against the dollar and 161.50 per euro, where traders had orders to buy the currency, said Lee Wai Tuck, a currency strategist at Forecast Pte Ltd. in Singapore. Traders sometimes place automatic instructions to limit losses in case their bets go the wrong way.

Lone Star to Buy IKB, First German Subprime Casualty
Lone Star Funds, the Dallas-based private equity firm, agreed to buy IKB Deutsche Industriebank AG, Germany's first casualty of the subprime mortgage crisis, for less than one-third of the bank's market value a year ago.

The U.S. firm said it will acquire a 91 percent stake in Dusseldorf-based IKB from state-owned development bank KfW Group after beating a rival bid from RHJ International SA, Timothy Collins's investment firm. KfW declined to give the precise purchase price today, saying only it didn't get the 800 million euros ($1.2 billion) the government had originally sought.

The agreement ends an 11-month search for a buyer. The government led a 10 billion-euro bailout after part of IKB that bought subprime mortgages ran out of funding last July. KfW has since ousted Chief Executive Officer Stefan Ortseifen and three other top IKB executives after auditors blamed "flawed" risk management for the lender's collapse.

"This will finally bring clarity and calm," Green party lawmaker and KfW administrative board member Christine Scheel said in a telephone interview today. "It was the right decision to sell the bank as quickly as possible." IKB and its funding units have posted about $15.1 billion in writedowns, more than any other German bank, according to data compiled by Bloomberg. In all, the world's biggest banks and brokerages have announced more than $504 billion in markdowns.

KfW received a "low three-digit million-euro sum" for its stake, KfW Chief Executive Officer Wolfgang Kroh told reporters in Frankfurt today. He described the price as "reasonable" and declined to be more specific.

IKB rose 9 percent to 2.91 euros at 2:05 p.m. in Frankfurt, valuing the bank at about 282 million euros. Lone Star will inject 225 million euros in fresh capital into IKB and another 200 million euros into a special purpose vehicle that will contain 3.3 billion euros in securities currently owned by IKB. KfW will assume 1.3 billion euros of the bank's remaining securities, for which the German government will provide a 600 million-euro guarantee to cover possible losses.

The U.S. firm plans to boost profit its investment in IKB by charging more for loans, selling other products such as derivatives and possibly wealth-management services to corporate clients, Bruno Scherrer, senior managing director and head of European investments at Lone Star, said in an interview in Frankfurt today.

The firm expects to own the stake for at least two years, Scherrer said. Lone Star could sell its stake after returning IKB's core business to profit, which it expects to achieve within the next three years, he added. "IKB could eventually play a role in German banking consolidation or be of interest for a foreign bank," he said.

Job cuts aren't a "primary goal," though assessments are still being made, and IKB will remain publicly traded for the time being, Lone Star Germany Chairman Karsten von Koeller told reporters at a press conference today. Lone Star, which manages more than $13 billion, is targeting distressed financial assets around the world as credit market turmoil deters other investors.

The firm agreed last month to buy $30.6 billion of collateralized debt obligations from U.S. securities firm Merrill Lynch & Co. for about a fifth of their face value. It also acquired mortgage bank Allgemeine Hypothekenbank Rheinboden AG in 2005, renamed it Corealcredit Bank, and returned it to a profit last year after selling its international loans and targeting commercial property financing in Germany.

Temasek To Lift Stake in Merrill, Betting on Rebound
Temasek Holdings Pte, the biggest shareholder in Merrill Lynch & Co., may acquire a larger stake in a bet the U.S. securities firm will rebound.

"If there's an opportunity, we would like to look at it," S. Dhanabalan, chairman of the Singapore state-owned investment company, said in a speech in the city state today. "Whether we do it depends on our assessment and risk diversification."
Merrill's shares have fallen 55 percent since Dec. 24, when Temasek first paid $5 billion for about 5 percent of the third- biggest U.S. securities firm.

Temasek is seeking to raise its overseas holdings to diversify beyond Singapore, where it controls six of the city's 10 biggest companies by market value. Sovereign wealth funds including Temasek, Kuwait Investment Authority and China Investment Corp. have helped banks such as UBS AG and Citigroup Inc. replenish more than $200 billion of capital after losses and writedowns from the U.S. subprime meltdown.

Temasek is often considered Singapore's second sovereign wealth fund. Government of Singapore Investment Corp., or GIC, manages more than $100 billion of the country's reserves. Temasek's assets rose 13 percent to S$185 billion ($131 billion) in the year ended March from S$164 billion a year earlier, Dhanabalan said today. The MSCI World Index fell 5.1 percent during that period.

The company said last month it's committing a further $900 million in Merrill after it was compensated for the initial investment. Temasek said it will use a $2.5 billion so-called reset payment for losses from its earlier purchase toward buying $3.4 billion of Merrill stock.

Merrill will book the reset as an expense, as well as $5.7 billion of additional writedowns. The purchase would push Temasek's stake beyond the 10 percent limit for foreign investors. A portion of its new stock requires regulatory approval, Temasek said. Temasek's investment comes after Merrill booked $51.8 billion of writedowns and credit losses following the collapse of the U.S. subprime mortgage meltdown, the second-highest after Citigroup's $55.1 billion.

Merrill's losses led to the replacement of Chief Executive Officer Stan O'Neal with John Thain, who in May raised $9.8 billion in a share sale and sold collateralized debt obligations for 22 cents on the dollar to Lone Star Funds, a Dallas-based investment manager.

GIC, which has invested about $18 billion in UBS and Citigroup, may add more bank assets as it chases returns over periods as long as 30 years, Singapore's Minister Mentor Lee Kuan Yew, chairman of the sovereign fund, said in an April 29 interview.

Temasek increased its banking assets with a second investment in Barclays Plc in June, when it committed a combined 4.5 billion pounds ($8.4 billion) with China Development Bank. The shares were bought at a lower price than what the two paid when they invested 3.6 billion euros ($5.3 billion) a year ago.

"One has to believe in investing in the longer term, whether locally or globally," said Tan Teng Boo, who helps oversee about $250 million at i Capital Global Fund in Kuala Lumpur. "The pessimism driving the Western financial institutions down is so extreme right now that for longer term investors like Temasek it does make sense to get some exposure."


Rachel said...

Thank you for the truth.

"It is time for a lot more people to realize what is going on. I'd find that a much more meaningful consolation."
Find consolation in your courage to speak/blog it and that some have heard.

Anonymous said...

Thanks for your valuable reflections and all the informative links.

Being a peace/environmental activist, a liberal arts major and someone with no investments outside of a bank acccount with my life savings and a paid for simple home, I've neglected the specifics of economic/financial collapse. Thanks for opening my eyes. I still don't understand a lot of stuff -- hedge funds, etc. but I'm getting the gist of it.

To have a piece of land and learn to grow one's food without fossil fuels (organically grown)is of utmost importance. A congenial community is important, too.


Michael said...

The one thing that gets me a bit is the whole thing about reduced Government spending / income tax etc.

Mish has been on the "bandwagon" to get the Government out of peoples businesses for quite a while. I find it somewhat ironic as the "New Deal" was in large parts what created the middle class in the US not to mention built a lot of the public infrastructure. Then "Friedman happened" (yes, oversimplifying here) and the mess we're in now started, so why is there still a persistant push by people to remove the Government out of people's life's?

It seems to be mostly a North American thing, most of the commentary I read in the European press seem to lean the other way. I wonder which one in the end will be proven right.


Anonymous said...

Yes, Michael. And many Americans complain about too many "entitlements" or the public sector, etc. Yet, I seldom hear people complain about the enormous military budget. More than 50% of our income taxes go to the military. The bailing out of corporations (investment and commercial banks) after they carried out their corrupt deals is totally disgusting. Our complicity is disgusting as well. I'm tempted to withdraw my savings from the bank and have nothing to do with the banking system or the financial sector.


Bigelow said...

“Normally moving money out of a government in excess of the total taxes that year would be hard to do. However, I could use securities fraud. I could issue a lot more government securities and government agency (like mortgage agencies) securities than I recorded on the government books and sell them abroad. I would have to make sure not to publish audited financial statements as that would increase the liabilities of engaging in this kind of fraud. It would help a lot if I could pool mortgages and sell government agency securities to finance those mortgages in a process where the same mortgage could be sold many times into the same pool. Investors would not notice or care because the securities were government guaranteed.”
Mortgage Market Musing

Anonymous said...

It seems that when this reaches a critical mass and the herds start to panic, the likely scenario will be freezing of assets, IRAs, brokerage accounts, bank accounts, limiting amounts of withdrawals, etc. Since I'm not well read about historical economic crisis and deflations, I'd welcome feedback from someone who is. For example, if FDIC has a hundred years to pay out, they will give you up to 2 grand of your account every year, or something like that until inflation takes off and turns it into cheap money. Or if you own treasuries, you can only liquidate a specified amount during a certain time period, etc. This would also be a great equalizer.

Anonymous said...

Thank you to both ilargi and stoneleigh for the insight you have shown us during these past few months. What do you foresee to happen as credit drys up in the next few months? You have alluded that more banks will fail and the media to begin discussing the crisis, but what else? Some are aware of people losing jobs and houses being foreclosed. But this crisis has not yet affected most people. At what point will the average joe/jane figure out that there is a financial crisis?
Anonymous Reader

Zeuss said...

We all know that fable about the upstairs neighbor who takes off one of his shoes, drops it on the floor, and then the downstairs neighbor waits in anticipation for "the next shoe to drop".

I feel like we are all living downstairs, except our friend upstairs has more legs than we can count and we don't know how many shoes will be falling on our heads.

Will it be consumer credit, Alt-A mortgages, commercial real estate, government sponsored entities, or a major bank?

Nobody can say with certainty, but at least one thing is for sure. Our neighbor has no shortage of shoes to let go of.

Andrew said...

Michael wrote: "why is there still a persistant push by people to remove the Government out of people's life's?"

Its probably down to the fact that government in the USA is entirely bought out by corporate interests, so more government intervention simply means more control by the big end of town.

FDR's New Deal was for the benefit of the people at the expense of the robber barons. Today the robber barons run the show.

I'd like to add my thanks as well Ilargi & Stoneleigh - this is a wonderful blog that's helped me & my family a great deal.

scandia said...

Just returned from a 2 week journey...noting some new posters....noting the trend identified by I & S continues...
The genuine apprection expressed for I & S reminds me of the tip jar.

Greenpa said...

It's Friday- Bank Seizure Day, as soon as the markets close. Any predictions on who? :-) Too early for Citi, I think- but Wachovia has been kind of quiet lately-

Michael said...


exactly because the Government has been bought out by "special interest" the solution should be to take it back.

Citizens CAN own their Government, they will be hard pressed to own a company (shareholder ownership not withstanding).

But then again, what goes for "political discussion" these days in North America seems to be reduced to talking points that one can shout very loudly.

And yeah, as you may have guessed I didn't grow up in North America, I just chose to live here for the last decade.

Samael said...

I would like to ask for advise from the participants here.

We have a second mortgage on our home. Call it $20,000 USD.

We also happen to have put together around $20,000 USD in cash. This came about as the result of a period of accelerated savings and was pushed over the threshold by this year's bonus.

Our plan all along has been to pay off the second mortgage with this money. I have an inherent distaste towards debt and would very much like to see this debt gone.


I believe that we are about to enter a deflationary period. I believe that during a deflationary depression, one should avoid debt and hoard one's cash.

So how would the readers here recommend I prioritize? I could extinguish one debt, but that would mean the elimination of this large cash nest-egg which will not be easily replaced. Despite having spotless credit, there is no guarantee we could "borrow it back" if we needed this cash again.

So, what should we do? Hoard the cash or extinguish the loan? I'm of very mixed feelings...

Anonymous said...

Andrew, the bond between the corporations and the government (elected plutocracy that has nothing to do with a true democracy)is too deeply rooted for individual citizens or the common people to be able to take back the government. We would never be allowed to do so. One just has to examine the Patriot Acts, Military Commission Act of 2006, executive orders, etc. to come to this conclusion.

I do agree with you, though, that government must play a role in serving the common people, not the rich. Govt. should be altruistic. Programs that nurture the needy among us should never be eliminated just because today's govt. is utterly corrupt and controlled by corporations. Govt. plus corporations may be one (Fascism), but this is no excuse to eliminate social programs that help the needy in our society.

I have no hope in the system, neither do I have any hope that the common people (for the most part distracted by bread/circus/addictions and indoctrinated by an imperial/materialistic culture) will be able to affect policy or take over the govt. via activism or violence. Oppressive laws are in place to destroy dissent. Enforcement of those laws is all that is needed at this point. No need to enforce them yet since most people are in a dormant state.

Economic/financial collapse is here , as well as Peak Oil and climate change.


Anonymous said...

My apologies, I meant to address Michael above.


Anonymous said...

Illargi, I'm so glad I found you. I've never heard you mention American Funds--does this seem like a good investment house from what you know? Also, our advisor has repositioned our assets into three groups: world growth fund, corporate fund, and treasury fund. Just wondering what you or anyone else thinks about corporate funds in general now...

Thanks for all you do.

Anonymous said...

To Samael:

I am no expert at all, but if your payments are manageable and you aren't hurting for cash, I would make six month's of extra payments just in case things tighten even more, and hold on to the remaining cash. You never know what is going to happen with Iran, Russia, etc. It is something all the naysayers (wise people) are yelling from the rooftops: have cash on hand.