Washington DC, Southern Railway. Ladies' car, reserved for women and their escorts.
Ilargi: The economic prospects around the world are getting so bad now, or should we say they are finally increasingly recognized to be what they have been for a long time, that we must ponder the potential consequences.
For one thing, I am wondering these days what the likelihood is for what is left of our democratic institutions, to survive much longer. A democracy cannot exist where all wealth is in the hands of a few, while the rest of the population lives in utter misery, marked by hunger, thirst and disease. Still, that looks certain to be where we are headed.
Money as we know it, buying power, is disappearing. It is a process that cannot be halted. Along with it will vanish our jobs, infrastructure, health care and much more. A look at the present state of pension funds makes me shudder; and that's while I've been warning about exactly that for a long time.
At the Jackson Black Hole, the people who have made our situation what it is are deciding how to divide amongst each other what is left. The pension funds look to be the last juicy bit that's left, after citizens' future earnings for decades to come are signed away to cover the market makers' casino losses.
And soon after the last bits of the meal have been fed to the dogs, the decision will be made to pull the plug on the American population. As Lou Reed put it: "Stick a fork in their ass and turn them over. They're done."
Last Great American Whale
Well Americans don't care for much of anything
land and water the least
And animal life is low on the totem pole
with human life not worth more than infected yeast
Americans don't care too much for beauty
they'll shit in a river, dump battery acid in a stream
They'll watch dead rats wash up on the beach
and complain if they can't swim
They say things are done for the majority
don't believe half of what you see and none of what you hear
It's like what my painter friend Donald said to me
"Stick a fork in their ass and turn them over, they're done"
World must brace itself as the US banking sector 'fesses up' to losses
It's August. Nothing is meant to happen. Global markets are supposed to be asleep. If only that were true.
Last week attention focused, or refocused, on the world economy's much weaker growth prospects. The catalyst was alarming new evidence that the credit squeeze, far from abating, is tightening its vice-like grip.
On Friday we learnt that, here in the UK, GDP growth was flat during the second quarter of 2008. Grim economic headlines have also emanated from the eurozone and Japan. But the reaffirmation that "sub-prime" is so much more than a US problem doesn't mean, for one second, that America's problems are over.
For all the talk of "de-coupling" and the new emerging markets, the US is still the world's biggest economy. In this age of "ultra-connectedness" and "financial innovation", the health of America's banking system matters more than ever to the rest of the world. We should be very worried, then, that this pivotal sector's predicament will get much worse before it gets better.
The latest Federal Reserve data shows that between April and June, American banks significantly tightened their lending standards and are about to do so even more - across all types of credit. What started, just over a year ago, as a squeeze on the dodgy end of the mortgage market has now spread to all forms of household and corporate borrowing.
A net 62 per cent of US banks turned the screw on the prime mortgage sector during the second quarter - with almost 75 per cent signalling a further tightening in the third. A similar pattern prevails across credit cards and other consumer lending, as well as commercial and industrial loans.
This credit contraction has had a serious impact on economic activity - an impact that's about to become more severe. Some stock ramping Wall Street institutions and their pet in-house economists have suggested lately that the US "will avoid recession".
Ignore them. In many cases, they're the same institutions that used to make hay ramping "mortgage-backed securities" - those toxic packages of sub-prime waste which caused this crisis in the first place. The on-going credit crunch - combined with America's huge overhang of unsold homes - explains why US house prices will keep falling.
The futures market has priced in a further 14 per cent decline in the S&P/Case-Shiller 10-city composite house price index over the next year. What's more, once American house prices do hit rock-bottom, it will take a long time for them to come back.
Prices will only recover once US households are willing and able to start buying homes again, which means taking on more debt. But that won't happen soon - with consumers nervous, and banks more nervous still. The financial sector's paranoia is rooted in the on-going reality that there are still a lot of nasty mortgage-backed securities out there, burning holes in bank balance sheets - holes which many banks continue to deny are there.
As US house prices keep falling, repossessions rise and defaults increase, banks will eventually have to "fess up" to the scale of their losses. So far, this sub-prime debacle has seen US banks endure around $505bn - some £270bn - in "write-offs". There is a lot more to come - as defaults spread to credit cards, auto loans and other consumer debt, to say nothing of corporate debts going bad as the recession really kicks in.
Not known for hyperbole, the International Monetary Fund suggests total write-offs by all US banks could reach $1,000bn before this episode is over. Serious industry experts think $2,000bn is more likely - four times what we've seen so far.
Over the coming months, US banks will have to increase their loan loss provisions even more - which, of course, will further depress their share prices and ability to raise new capital. That's why a major banking crisis is brewing.
I don't say this lightly, but up to 100 US banks could go bust over the coming year. Many of them will be small, but some could be large. Last week, Harvard Professor Ken Rogoff, a former IMF chief economist and Fed insider, said "we're going to see a whopper, a really big one" - suggesting a big US bank is about to go belly-up.
Conventional wisdom has it that America's well developed system of deposit insurance will shield savers from any losses. But the Federal Deposit Insurance Corporation has assets of only $50bn, while the combined assets of the banks in danger total around $900bn.
Not all those loans will be bad, of course, but up to 20 per cent could be. FDIC - generally funded by levies on the banking industry - is going to need buckets of government cash. And then there's Fannie Mae and Freddie Mac - which, between them, own or guarantee a mind-boggling $5,300bn of US mortgages - half of all outstanding home loans.
As defaults have risen, these quasi-private lenders have swallowed massive losses - they've lost 90 per cent of their value in 12 months - and are now in grave danger of collapse. That would spark systemic meltdown - which is why Congress recently passed a bill allowing an unprecedented taxpayer funded bailout.
Last week, the share prices of Fannie and Freddie plunged -understandably given that a government rescue would see shareholders wiped out. Such drastic events are now almost unavoidable and could very soon be upon us. And when they happen, a sense of shock will pervade not only the US financial sector, but the Western world and, in fact, the entire global economy.
Last week, BHP Billiton delivered a record set of annual results for the seventh successive year. The world’s largest mining outfit – listed in both London and Sydney – made a cool £12.6bn during the twelve months to July, a rise of 22 per cent. BHP is clearly benefiting from high prices for its main products – iron ore, copper, coal and crude oil.
This latest display of strength allowed Marius Kloppers, BHP’s boyish chief executive, to turn up the heat on rival Rio Tinto, observing that a takeover now “makes more sense than ever”. To pull off such a deal, Kloppers will, of course, have to find the right price to tempt Rio Tinto shareholders. But he’ll also have to keep walking a thin line between two arguments that, in many ways, conflict.
While China may be in for a slowdown, growth is unlikely to dip below 8 per cent. The commodity needs of the People’s Republic – the biggest driver of global resource demand – will continue to escalate.
Similarly in India, Indonesia, Brazil and the other emerging economies, rapid urbanisation and fast-population growth generates the need for an awful lot of metals, minerals and cement – all of which is great news for mining companies. On the other hand, Kloppers needs to point to soaring mining sector costs, and the recent fall in commodity prices, to highlight the logic of his proposed take?over of Rio Tinto.
Certainly, mining inputs such as diesel and explosives, along with ever more scarce skilled technicians, are now extremely expensive. That’s putting pressure on industry margins – a process likely to continue – so making economies of scale and other synergies look more attractive.
Many industry insiders think Kloppers will win the day. US competition authorities have already given approval. Australian regulators want more time and the Europeans, also, are unlikely to give a verdict before next year.
But the signs are that BHP will soon find a way through the anti-trust maze, particularly if it sells off some of its iron ore mines, so allaying fears that it over-dominates global supplies of a key steel-making input. A BHP-Rio mega-deal would, of course, change the face of global mining. But it could also have a much wider impact – not least among the world’s biggest energy companies.
The oil majors – the likes of Exxon, Shell and BP – are suffering from the same sky-high costs as the mining giants, to say nothing of a severe lack of accessible new reserves. Over the next couple of years, while also subject to regulatory approval, a big ownership shift at the top of the global oil industry – either merger or takeover – should not be ruled out. And BHP-Rio could be the deal that sparks it.
Outlook: Americans living hand to mouth
Home sales in the U.S. probably teetered near a 10-year low, property values dropped and consumer spending cooled, signaling the economy has taken another turn for the worse, reports this week are projected to show.
A total of 5.435 million new and existing homes were purchased in July at an annual pace, according to the median estimate of economists polled by Bloomberg News. June's 5.39 million rate was the weakest since at least 1999. Spending probably rose 0.3 percent in July, half the prior month's gain.
The real-estate recession will persist into next year as stricter lending rules and higher borrowing costs shackle demand. At the same time, equity is disappearing as home prices fall, and wages aren't keeping up with inflation, depriving Americans of the means to maintain spending, the biggest part of the economy.
"The economy is going down a shaky path," said Maxwell Clarke, chief U.S. economist at IDEAGlobal Inc. in New York. "We're not going to see a rebound in housing anytime soon. Consumers are living hand to mouth, and the outlook for spending is very weak."
Purchases of new houses dropped 0.9 percent to an annual rate of 525,000, according to the median estimate of economists polled ahead of a Commerce Department report on Aug. 26. March's 513,000 pace was the lowest since 1991. Resales of existing homes, compiled from closings and reflecting contracts signed weeks or months earlier, will be reported by the National Association of Realtors tomorrow.
Purchases gained 1 percent to a 4.91 million annual rate, staying near June's 10-year low, the survey median showed. While sales of previously owned homes account for about 85 percent of the U.S. market, new-home purchases are considered a timelier indicator because they are based on contract signings.
The slump in demand is keeping property values under pressure. The S&P/Case-Shiller index of home prices in 20 metropolitan areas probably fell in June, the survey showed. The figures, due on Aug. 26, would extend a string of declines that began in August 2006. Consumers, after getting a temporary lift from the government's tax rebates earlier this year, are focusing on buying necessities and hunting for bargains to stretch their paychecks following the jump in food and fuel costs.
Home Depot Inc., the world's largest home-improvement retailer, said second-quarter profit fell 24 percent, its eighth straight quarterly drop. The Atlanta-based company forecast a decline in sales and earnings for the year. "We continue to see pressure on our market and the consumer," Chief Executive Officer Frank Blake said in a statement on Aug. 19.
Commerce Department figures on Aug. 29 will underscore the dimming outlook for consumer spending, according to the Bloomberg survey. The report is also projected to reinforce concern over inflation. The price gauge tied to spending patterns probably rose 4.5 percent in the year ended July, the biggest 12-month gain since 1991.
The measure that excludes food and energy costs, the one tracked by Federal Reserve policy makers, probably rose 2.4 percent from a year earlier, the biggest gain since February 2007, the survey showed. Concerns about slower growth and the pickup in prices led Fed policy makers to hold the benchmark interest rate at 2 percent this month. Minutes of the Aug. 5 meeting, to be released Aug. 26, may shed more light on the debate within the central bank about the future direction of rates.
The one bright spot for the economy remains the narrowing of the trade deficit. A surge in exports caused the economy to grow even faster in the second quarter than previously projected. Revised figures from the Commerce Department, due Aug. 28, may show the economy expanded at a 2.7 percent annual rate from April through June, up from an advance estimate of 1.9 percent issued last month, according to the survey median.
"The data releases this week should illustrate the stark contrast between how well the economy performed in the second quarter and how bad the outlook for the second half of the year is," said Paul Ashworth, international economist at Capital Economics Ltd. in London.
Other reports this week may show orders for durables goods stalled in July and confidence among American consumers was little-changed this month from multiyear lows reached earlier this year, even as gasoline prices retreated.
The Ponzi Scheme that Tops The Housing Bubble
The Boogey Man - Yesterday I left off with a promise to talk about the Boogey Man. Well, the Boogey Man is the dark side of the pension funds. Let’s start off with our dear friend Hank Paulson and his latest plan to allow Wall Street to acquire and manage pension funds.
I swear to you, I didn’t make that up. Paulson actually sent a plan to Congress to allow Wall Street firms to buy and manage pension funds. These are the same guys that brought us Auction Rate Securities (ARS), Credit Default Swaps (CDS), Collateralized Mortgage Obligations (CMO) and Structured Investment Vehicles (SIV) and all the derivatives and funny-money plans to extort fees from you and me.
Busted Pension Funds – Most pension funds are underfunded and will never be able to meet the obligations they have promised their members. That’s a fact that we can’t avoid. Wall Street and the managers of pension funds can spin it anyway they way, but the bottom line is . . . pension funds are underfunded. READ: The Ponzi Scheme that Tops The Housing Bubble.
The Players - In addition to the usual Wall Street suspects, along with Paulson at the head of Treasury, we have Charles Millard who is the top doggie at the Pension Benefit Guaranty Corp. (PBGC). Millard and his predecessors have not done their jobs over the past 20+ years. If we think Greenspan was the creator of “look-the-other-way” regulatory management, you’ve got to read up on PBGC.
By the way, for those of you not familiar with PBGC, this is the Federal Government backing of pension funds, just like FDIC for banks. Basically, we the taxpayers are paying for all the fraud Wall Street executives can heap on us. And nothing will ever be done to stop the thievery, because the guys with power to stop it are paid handsomely to look the other way.
Just look at Andrew Cuomo, and his handling of the Auction Rate Securities fraud. He could easily send hundreds of Wall Street boys and girls to jail for fraud. They’ve already admitted it, but they can buy their way out . . . with our money. C’est la vie. Andrew Cuomo will go down in history as one of the World’s Grandest Hypocrites . . . and he will be handsomely rewarded for letting the Wall Street boys and girls off the hook.
But let’s get back to the Boogey Man.
Housing Bubble – What financial story would be complete without referring back to the Housing Bubble. One of the problems starting to unravel in the Pension Fund arena, is how much money pension funds have lost as a result of horrible investments in real estate and real estate related securities. Just take a look at the largest pension fund in the country CALPERS – California Public Employees Retirement System - with close to 10% of their assets in real estate and real estate related assets.
In fact, I spoke with one person that believes CALPERS has as much as 35% of their assets in real estate related assets. But it gets worse. The boys and girls at CALPERS did deals just to do deals. A perfect example is how Lennar and LNR dumped LandSource on CALPERS. This was a deal CALPERS had no business even getting close to. CALPERS was scalped.
And they are not the only pension fund to be scalped by builders, developers, land owners and the boys and girls on Wall Street that did deal after deal after deal after deal . . . to the point most of them had no clue what they were buying or selling.
One-Two Punch - It wouldn't be fair to say all the problems with pension funds are attributable to the housing bubble, greedy Wall Street managers and failed regulation. The second component to all of this . . . is we are living longer and inflation is as reliable as the EverReady Bunny. We should have built the two latter components into all of the models, but we didn't. And all the Kings Men couldn't put Humpty Dumpty together again.
Out of Sight – Out of Mind – For the most part, the pension problem is totally out of sight. It’s long term, down the road for most people. And as with any good Ponzi Scheme, the alarms don’t go off until it is too late. When we finally wake up and realize Wall Street raided the pension funds, it will be too late and the boys and girls with the money will be long gone.
Japan Too – Japan’s public pension fund is the largest public pension fund in the world. Last year it lost almost $6 trillion Yen ($50B US). The fund has more than $150 trillion Yen that is run by Japan’s bureaucrats. Japan is also exploring ways to boost the returns with alternative investments run by outside managers with performance based compensation. This might sound good, but the bottom line doesn’t change. You can’t get more out than you put in. And that is exactly what pension funds around the world are trying to do.
And the UK – The Pension Protection Fund (PPF) in Great Britain just announced that their aggregate funding position for UK defined benefit plans has dropped to a surplus of 8.3B Pounds at the end of June, from surplus of more than $53B Pounds just one month prior! That’s not a warning sign. That’s a big slap in the head.
One of the UK’s consulting firms, Redington Partners, released a report showing the FTSE100 pension plans have a $9B Pound deficit, down from a $21B Pound surplus. Startling numbers? You better believe it. And things get worse. Much worse.
PBGC downplays investment plan risks, report says
The federal agency charged with backstopping pension benefits for 44 million Americans has understated the risks of its new investment policy, a congressional watchdog said Monday.
The Government Accountability Office said in a report that the Pension Benefit Guaranty Corp.'s new strategy could significantly boost the PBGC's investment returns, but it "will likely also carry more risk than acknowledged by PBGC's analysis." The PBGC said earlier this year that it would take a more aggressive investment approach by investing more in stocks and adding new alternative investments, such as real estate and private equity funds.
The agency, which has assets of $68 billion, hopes the strategy will help it close a $14 billion gap between those assets and its liabilities. Otherwise, taxpayers could be called upon to pony up extra funding, the director of the PBGC has warned. The PBGC has said its new approach will reduce risk because it will result in a more diversified portfolio of 45 percent stocks, 45 percent bonds, and 10 percent in alternative investments.
Previously, its targets were 75 percent to 85 percent bonds and 15 percent to 25 percent in stocks, though the actual figure reached 28 percent last year. The agency is seeking bids from Wall Street firms to help manage the switch. The GAO, however, said that under certain scenarios the new strategy would have more volatile results than the old approach. The report said that's risky because PBGC pays out more than $4 billion a year to retirees and needs access to cash.
That need increases the risk of "any investment strategy that allocates significant portions of the portfolio to volatile or illiquid assets," the GAO said. Funds allocated to private equity, for example, may not be returned for up to seven years, the report said.
But Charles Millard, PBGC's director, said the report shows that even under the GAO's calculations, the new strategy takes on less risk than most institutional investors and could provide an additional $20 billion to $40 billion in investment gains over 30 years. That's enough to close the agency's deficit.
"The whole point of the new policy is to make it far less likely that Congress will have to engineer a bailout," he said. The PBGC is one of the government's largest corporations and insures approximately 30,000 defined benefit pension plans. Defined benefit plans pay benefits based on years of service, salary levels and other factors. They are being increasingly replaced by 401(k)-style plans in which benefits depend on the employee's contributions. The PBGC doesn't insure 401(k) plans.
The PBGC's finances have come under strain as it has taken over several large pension plans in recent years from bankrupt airline and steel companies, including a $17 billion plan maintained by UAL Corp., parent of United Airlines. United emerged from bankruptcy in 2006.
The PBGC is funded by fees paid by the companies it insures, assets from failed pension plans, recoveries from bankruptcies and returns on invested assets. It doesn't receive taxpayer funds. The agency now covers pensions for 1.3 million Americans who are either retired or soon will be. That's up from 624,000 in 2001.
The GAO report also urged the PBGC's board, which is chaired by the Labor Secretary, to more closely monitor the agency's investments. The board "has not taken an active and engaged role," the GAO said, and should require more formal reporting by the PBGC's director about the new investment plan.
Labor Secretary Elaine Chao, in a letter included in the report, said the board has increased its oversight recently and reviews the PBGC's investment policy "at least" every two years and approves it "at least" every four years. The GAO report was requested by four senators, including Sens. Max Baucus, D-Mont., and Charles Grassley, R-Iowa, chairman and senior Republican on the Senate Finance Committee.
Some members of Congress have criticized the PBGC for taking a conservative investment approach. It adopted the 15 percent to 25 percent equity limit in 2004. Rep. Earl Pomeroy, D-N.D., said in an interview last week that the adoption of the equity cap cost the agency "billions of dollars."
In its 2007 annual report, the PBGC acknowledged that an investment portfolio with 60 percent in stocks and 40 percent bonds would have produced $7.3 billion more in returns over five years than the more conservative approach.
Subprime Mortgage Bonds Lead 'Extinct' Credits, Moody's Says
Subprime mortgage-backed bonds lead credit products rendered "extinct" by the collapse of the U.S. housing market, according to Moody's Investors Service.
Collateralized debt obligations packaging loans and structured investment vehicles will also disappear as investors refuse to buy debt linked to U.S. housing market losses, Jennifer Elliott, Moody's group managing director in the Asia- Pacific, said today at conference in Melbourne.
"These are products that have just disappeared and we certainly don't expect to be coming back," Hong-Kong-based Elliott said. "There is an overwhelming level of investor concern about what will happen in credit markets, as opposed to what has happened, that is impacting issuance."
The worst U.S. housing slump since the Great Depression has triggered more than $504 billion of writedowns and losses at the world's biggest financial companies, many of which sold and invested in securities based on American mortgages. Subprime mortgage bonds made up almost half of the world's home loan debt securities prior to the housing collapse, Elliott said.
Structured investment vehicles, which operated by selling short-term debt to buy higher-yielding assets, have been forced to wind down or have defaulted after the seizure in credit markets cut their funding avenues. Investors are also avoiding CDOs, which package mortgage-backed bonds and use the income to pay investors. "We have seen far more contagion of risk than anyone anticipated," she said.
Sales of bonds backed by U.S. commercial and residential loans have fallen about 90 percent this year from the same period in 2007, Elliott said. Derivative-based securities have also plunged 90 percent and high-risk, high-yield bonds sales have been cut by 70 percent.
"We are not seeing much happening at the moment and yes it is the height of the vacation season in U.S. and Europe, but I think it is deliberate nothing is being done," Elliott said. "We haven't had any real bad news for a while and that makes me nervous for the beginning of September."
The Devil’s in the Swaps: What Will Mac ’n’ Mae Cost You and Me?
The inevitability of a taxpayer-funded bailout of Freddie Mac and Fannie Mae, the hobbled mortgage behemoths, shook investors last week, and shares in both companies plummeted on fears that existing stockholders would be wiped out.
These government-sponsored entities guarantee or hold $5.2 trillion in mortgages and have been hammered by defaults across the nation. Fannie Mae’s shares closed on Friday at $5, down from almost $70 a year ago. Freddie Mac fell to $2.61, which is down from about $65. Their heavily leveraged balance sheets magnify even a small rise in delinquencies.
There is no certainty about what form a Mac ’n’ Mae rescue would take. Naturally, this is giving investors the jitters. Up and down Fannie’s and Freddie’s capital structure, debt and equity holders want to know how a bailout would affect them. It is widely assumed that debt issued by Fannie and Freddie will be backed by the taxpayers. Call it “too big to fail times two.”
But in our highly interconnected financial world, where one company’s ills have the potential to infect many others, no bailout exists in a vacuum. And the ripple effects that may result from shoring up these giants extend from the obvious — hammering their shareholders — to the fairly obscure, involving participants in the market for credit default swaps.
This is the huge arena where participants buy and sell insurance to protect against defaults by issuers of debt. Some $62 trillion of insurance has been written, with a fair value of $2 trillion at the end of 2007. Back to the bailout du jour. Many analysts hypothesize that the Treasury will put cash into Fannie and Freddie, receiving dividend-paying preferred shares in return.
Such an investment has occurred before, as noted last week by UBS research analysts in Mortgage Strategist, a weekly research report from the firm. In 1954, when the government began to change Fannie Mae into a shareholder-owned company, preferred stock was issued to Uncle Sam to help finance the process. Those shares were retired in 1968 when Fannie Mae became a publicly traded corporation.
If preferred shares are again issued in exchange for taxpayer cash, common stockholders could lose the most because new preferred shares would take precedence in the payment of dividends and if the companies were liquidated.
Investors holding the preferred stock already issued by Freddie and Fannie could also be vulnerable if the bailout puts the taxpayers’ investment ahead of them for dividend payments. Regional banks and savings and loans hold most of these shares; with these institutions already hurt by the mortgage mess, it seems unlikely that the Treasury would structure a Mac ’n’ Mae rescue in a manner that would pound them again.
But the potential effects of a rescue become more complex for the holders of Fannie’s and Freddie’s $19 billion in subordinated debt, so-called because it ranks below other bonds in the companies’ capital structures.
As UBS analysts point out, because Fannie’s and Freddie’s subordinated debt is used when they calculate capital — the financial cushion regulators require to support the companies’ operations — interest payments on the debt may have to stop if a bailout occurs. Such a hiatus could last up to five years.
While this would hurt subordinated debt holders, a deferral of interest payments has even broader ramifications. Halting those payments would put the bonds into default and force payouts on credit insurance that has already been written. In the debt market, this is known as a “credit event.” On its Web site, and in language that only a lawyer could love, Fannie Mae describes some terms of its subordinated debt.
For the debt to qualify for capital calculations, it must require the deferral of interest payments “for up to five years if (1) Fannie Mae’s core capital falls below minimum capital and, pursuant to Fannie Mae’s request, the secretary of the Treasury exercises discretionary authority to purchase the company’s obligations under Section 304(c) of the Fannie Mae Charter Act, or (2) Fannie Mae’s core capital falls below 125 percent of critical capital.”
Here’s a translation: A bailout could mean no interest payments on the subordinated debt. “If we reasonably assume that the Treasury would only intervene in the event that Fannie or Freddie is declared significantly undercapitalized by its regulator,” UBS analysts wrote, “then interest payments on the qualifying subordinated debt is automatically deferred for up to five years.”
Because nonpayment of interest would be seen as a credit event, UBS added, entities that have bought protection on Fannie’s and Freddie’s subordinated debt would be entitled to payment by the entities that wrote the insurance. This, even though taxpayers are standing behind Fannie’s and Freddie’s debt, not allowing it to fail. Talk about the laws of unintended consequences.
It is not clear how much insurance has been written on the subordinated debt. The actual holders of the debt very likely hedged their stakes with credit insurance, which is intended to protect buyers in the event of a default.
But speculators may have bought credit default swaps on the companies’ subordinated debt even if they did not own any of the debt. A gutsier gamble than selling short Fannie or Freddie shares, buying credit insurance on the companies’ debt was essentially a bet against the implicit government guarantee that many felt was backing all the companies’ obligations.
Because of the implied guarantee — and the belief that it meant they would never have to pay out on the swaps — sellers of credit insurance may have been overly eager to write contracts on Fannie’s and Freddie’s debt. So the burning questions are these: Who wrote the insurance and do they have the money to pay those who bought it? If they don’t, what happens?
If the market for credit insurance were more transparent, we might know the answers. But these deals are private and largely hidden from view. It is possible, of course, that a Mac ’n’ Mae bailout will be structured so as not to force credit default swap payouts. Or regulators could step in and require parties on both sides of the Fannie and Freddie credit insurance trade to unwind their stakes at heavily discounted levels.
Such has been the nature of recent deals struck by financial guarantors like Ambac at the behest of the New York State Insurance Department. In one deal, the credit default swap buyer got just 13 cents on the dollar; in another deal, the buyer got 61 cents.
If regulators make such a move related to Fannie and Freddie, sellers of the insurance could escape dire financial problems associated with paying on the claims. But buyers of credit protection are apt to get far less than they think they are owed on the insurance. And if they have written the values of their holdings way up to reflect the increased likelihood of a default event, they will soon have to write them down again.
Nobody knows how the Fannie and Freddie situation will play out. But the implications of a default on the companies’ subordinated debt shows how complex and confounding — not to mention costly — this business of bailouts has become.
Fannie, Freddie derivatives trade normally (?!)
Panicked investors are dumping shares of Fannie Mae and Freddie Mac, but derivatives trading is likely to continue normally with two of the largest players in the market, a trade group official and a bank risk manager said.
Shares of the two ailing government-sponsored enterprises have plummeted in recent weeks as shareholders braced for a possible nationalization. However, what's bad for shareholders will likely have minimal impact on either debt holders or banks that have derivatives trades with Fannie Mae or Freddie Mac, said one risk manager.
"To the extent that they're nationalized, they're not going to default on their debt or derivative obligations," said Robert McWilliam, an official in counterparty exposure management at the Royal Bank of Scotland.
"I'd be pretty relaxed about that," he added, explaining the bank has collateral arrangements with the entities and its positions are margined.
The two largest mortgage finance companies are among the largest users of interest-rate swaps. These derivatives can be used to lock-in interest rate expectations and help the two manage the risks in their combined portfolio of mortgages, which totals more than $1 trillion.
Bob Pickel, chief executive of trade organization the International Swaps and Derivatives Association, added McWilliam's view is held widely. "I think most parties would look at it as the U.S. government stepping in and guaranteeing the obligations of Fannie and Freddie," Pickel said.
"To that extent a counterparty to a derivatives contract with Fannie and Freddie would take great comfort in that," Pickel added. Both Fannie and Freddie have posted large write-downs on their mortgage portfolios as a result of the credit crisis and record home loan defaults.
Fannie Mae has derivatives contracts referencing more than $1.14 trillion of fixed income instruments, while Freddie Mac holds contracts referencing more than $1.3 trillion.
Ex-Bank of England Official Skewers Fed
A former Bank of England official on Saturday sharply criticized Federal Reserve Chairman Ben Bernanke's handling of the credit crunch, saying Mr. Bernanke has been too cozy with Wall Street at the expense of economic stability.
"Throughout the 12 months of the crisis, it is difficult to avoid the impression that the Fed is too close to the financial markets and leading financial institutions, and too responsive to their special pleadings, to make the right decisions for the economy as a whole," Willem Buiter, a former member of the Bank of England's monetary policy committee, wrote in a paper for the Kansas City Fed's Jackson Hole conference. Mr. Buiter is now at the London School of Economics.
In his paper, Mr. Buiter also examined actions taken by the Bank of England and European Central Bank in the past year. While Mr. Buiter concedes that the Fed "has done many things right" in its efforts to expand liquidity, much of his 100-plus page paper read as an indictment of Mr. Bernanke and his Fed colleagues.
The Fed "performed worst both as regards macroeconomic stability and as regards one of the two time dimensions of financial stability -- minimising the likelihood and severity of future financial crises," wrote Mr. Buiter. When it comes to dealing with the immediate crisis, the BOE "gets the wooden spoon," he wrote, while the ECB, "partly as the result of an accident of history, did best as regards putting out fires."
One of Mr. Buiter's main beefs with Mr. Bernanke is that he focused too much on the potential fallout from strains on Wall Street. Indeed, the credit crunch's pain on Wall Street seems more severe than in the U.S. as a whole. Economic activity, as measured by gross domestic product, continues to expand and while joblessness has risen, it hasn't jumped as much as in prior downturns.
Part of that sensitivity comes from the Fed's role as a banking supervisor. And unlike the BOE and ECB, it doesn't have an explicit inflation target to guide its monetary-policy decisions. "Cognitive regulatory capture of the Fed by Wall Street resulted in excess sensitivity of the Fed not just to asset prices (the 'Greenspan-Bernanke put') but also to the concerns and fears of Wall Street more generally," Mr. Buiter wrote.
"Between the TAF, TSLF, the PDCF, the rescue of Bear Stearns and the opening of the discount window to (Fannie Mae and Freddie Mac), the Fed and the US tax payer have effectively underwritten directly all of the "household name" U.S. banking system...and probably also, indirectly, most of the other large highly leveraged institutions," he wrote.
The Term Auction Facility, Term Securities Lending Facility and Primary Dealer Credit Facility were aimed at channeling liquidity to strained parts of credit markets. Those moves have been praised in some circles as a creative use of the Fed's powers. But they are too favorable for primary dealers, Mr. Buiter wrote.
Meanwhile, Mr. Buiter accused the Fed of overreacting to the economic slowdown through a "remarkable collection of analytic flaws" about the transmission mechanism of monetary policy. "These errors are shared by many (Federal Open Market Committee) members and by senior staff," he wrote.
Mr. Buiter repeatedly singled out Mr. Bernanke. "Although the Bernanke Fed has but a short track record, its too often rather panicky and exaggerated reactions and actions since August 2007 suggest that it also may have a distorted and exaggerated view of the importance of the financial sector for macroeconomic stability," Mr. Buiter wrote.
Fed Attention to Wall Street 'Dangerous,' Buiter Says
The Federal Reserve pays a "dangerous" amount of attention to the concerns of Wall Street, constraining its ability to influence the economy, former Bank of England policy maker Willem Buiter said.
"The Fed listens to Wall Street and believes what it hears," Buiter said today in a paper presented to the U.S. central bank's annual symposium in Jackson Hole, Wyoming. "This distortion into a partial and often highly distorted perception of reality is unhealthy and dangerous."
The central bank has drawn criticism from some officials in the U.S. and Europe by trying to end the yearlong credit crisis through an expansion of lending. The steepest interest-rate cuts in two decades risk stoking inflation, while the Fed has been too generous in aiding banks, Buiter said.
In addition to rescuing Bear Stearns Cos. from bankruptcy, the Fed created a program to swap Treasuries for mortgage bonds, opened up lending to Wall Street firms and reduced the premium for direct loans to commercial banks. Buiter, a founding member of the Bank of England's independent rate-setting board in 1997, said the Fed's behavior over the past year represents an example of "regulatory capture."
In such a relationship, policy makers take on "as if by osmosis, the objectives, interests and perception of reality of the vested interest they are meant to regulate and supervise in the public interest," he said. Buiter's paper sparked the most heated debate of any item on the two-day conference agenda.
Bank of Israel Governor Stanley Fischer opened the question-and-answer session by holding up a fire extinguisher and saying, "I asked the organizers for some technical assistance in dealing with this discussion." Former Fed Vice Chairman Alan Blinder said that the central bank's performance, while not flawless, has been "pretty good under the circumstances."
Fed Governor Frederic Mishkin, one the strongest advocates of the "risk management" approach to financial crises, said after Buiter's presentation "there are a lot of unguided missiles that have been shot off." Under Bernanke and his predecessor, Alan Greenspan, the Fed has cut rates in response to falling stock prices more than is justified to safeguard economic growth, Buiter said. On Jan. 22, as global stock markets tumbled, the Fed slashed its overnight lending rate by 75 basis points.
Bernanke has argued that policy makers' actions were necessary to safeguard the economy from the impact of the credit crisis. Greenspan engineered rate cuts in 2001 through 2003 at a time when joblessness climbed in the aftermath of the recession seven years ago. The Fed by law is mandated to achieve stable prices and maximize employment.
Buiter also criticized the Fed and other central banks around the world for not providing more information about the valuation of collateral they accept from banks. Such information would allay concerns financial institutions will use public funds to subsidize financial institutions, he said. This is "most acute" in the case of some of the Fed's emergency lending programs created in the past year.
Two economists echoed Buiter's concern in another paper presented today, saying the Fed's program allowing institutions to swap Treasuries for mortgage bonds and other debt enables firms to "window dress" their balance sheets.
"Financial institutions can hold low-quality securities for the period where no reporting is required," wrote Franklin Allen of the University of Pennsylvania and the University of Frankfurt's Elena Carletti. "Temporarily increasing the supply of Treasuries makes this kind of deception easier. It helps remove market and regulator discipline."
The financial crisis is also forcing the European Central Bank to rethink aspects of its money market operations, which provide a flexibility that has been favorably compared with programs at the Fed and the Bank of England. The ECB plans to tighten collateral rules to head off the risk of abuse by some financial institutions, ECB council member Yves Mersch said in an interview today.
Buiter won some praise for openly confronting the Fed's record at its summer retreat in the Teton Mountains. "Willem's papers don't pull punches, they have attitude," Blinder said. "You have to give credit to a guy with the nerve to come here with black bears on the outside and the FOMC on the inside and be this critical of the Federal Reserve."
Wall Street bailout aid questioned at Fed event
Do Washington policymakers listen too much to Wall Street? A possible bailout of Fannie Mae and Freddie Mac, on the heels of similar action involving investment firm Bear Stearns, seems to send a loud signal to financial companies that the government will clean up their messes.
That's the feeling of some analysts and academics here Saturday, the final day of a high-profile economics conference. The Federal Reserve's handling of the worst financial crisis to hit the country in decades spurred much debate.
"The Fed listens to Wall Street," said Willem Buiter, professor of European political economy at the London School of Economics and Political Science. "Throughout the 12 months of the crisis, it is difficult to avoid the impression that the Fed is too close to the financial markets and leading financial institutions, and too responsive to their special pleadings, to make the right decisions for the economy as a whole," he wrote in a paper presented to the conference.
Critics like Buiter worry that the Fed's unprecedented actions — including financial backing for JPMorgan Chase & Co.'s takeover of Bear Stearns Cos. — are putting taxpayers on the hook for billions of dollars of potential losses. They also say it encourages "moral hazard," that is, allowing financial companies to gamble more recklessly in the future.
Fed Chairman Ben Bernanke, who spoke to the conference on Friday, defended the Fed's actions, saying they were "necessary and justified" to avert a meltdown of the entire financial system, which would have devastated the U.S. economy. Yet, Bernanke also acknowledged that mitigating moral hazard is one of the critical challenges policymakers face as they weigh steps — including strengthening regulation — to make the financial system better able to withstand shocks down the road.
"If no countervailing actions are taken, what would be perceived as an implicit expansion of the safety net could exacerbate the problem of `too big to fail,' possibly resulting in excessive risk-taking and yet greater systemic risk in the future," Bernanke said.
At the start of the conference, on Thursday night, Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, which sponsored the forum, gave Bernanke a white hard hat — like those worn by construction workers — in case he needed protection from critics during the sessions.
Even as Bernanke and others discussed these thorny issues, concern on Wall Street grew about the financial health of Fannie Mae and Freddie Mac. Investors are becoming increasingly convinced that a government bailout of the mortgage giants will be inevitable. Those fears hammered the companies stocks again this week. The Treasury Department, under a new law enacted last month, has the power to inject the companies with huge amounts of cash — through loans or buying stock in them.
"It creates a troubling perception when Washington policymakers appear to be hitting the fast-forward button when major institutions are on the line but are between the pause and the slow-motion button when massive home foreclosures are on the line," said Gene Sperling, a former official in the Clinton administration and now a senior fellow for economic studies at the Council on Foreign Relations.
The roots of the current crisis can be traced to lax lending for home mortgages — especially subprime loans given to borrowers with tarnished credit — during the housing boom. Lenders and borrowers were counting on home prices to keep rising. But when the housing market went bust, home prices plummeted in many areas of the country. Foreclosures spiked as people were left owing more on their mortgage than their home was worth. Rising rates on adjustable mortgages also clobbered some homeowners.
"Market participants failed to soundly manage, measure and disclose risks, with ignorance, greed or hubris playing their customary roles," said Mario Draghi, the governor of the Bank of Italy, who is involved in international efforts to deal with the worldwide financial crisis.
As U.S. financial companies racked up multibillion-dollar losses on soured mortgage investments, and credit problems spread globally, firms hoarded cash and clamped down on lending. That has crimped consumer and business spending, dragging down the national economy — a vicious cycle the Fed has been trying to break.
To brace the wobbly economy, the Fed has slashed its key interest rate by a whopping 3.25 percentage points, the most aggressive rate-cutting campaign in decades. Yet, those cuts also aggravated inflation. Some wonder whether the Fed made money too cheap, something that could feed into other bubbles in the future.
"The alarms of the financial sector have been overstated. The real economy has slowed down but is not yet in severe difficulty," said C. Fred Bergsten, director of the Peterson Institute for International Economics. Anil Kashyap, professor of economics and finance at the University of Chicago's Graduate School of Business, however, said the Fed did the right thing. "It headed off disaster. The history of financial crises tells you the economy doesn't get sick the next week. It takes a while."
In fact, a growing number of analysts believe the economy could hit a deep pothole later this year as the bracing impact of the government's tax rebate checks wears off. The Fed also has taken a number of unconventional — and some controversial — actions to shore up the shaky financial system and to get credit, the economy's lifeblood, flowing more freely.
It agreed in March to let investment houses draw emergency loans directly from the central bank. And, in July, the Fed said Fannie Mae and Freddie Mac also could tap the program. For years, such lending privileges were extended only to commercial banks, which are subject to stricter regulatory supervision.
In providing financial backing to JP Morgan's takeover of Bear Stearns, the Fed worried that the investment house's collapse could cascade, taking down others. But some were skeptical. "In the case of Bear Stearns it is not clear from publicly available information how much contagion there would have been had it been allowed to fail," according to a paper presented at the conference by Franklin Allen, professor at the University of Pennsylvania, and Elena Carletti, professor at the University of Frankfurt.
Bruised bears maul the bulls
Terry Smith, chief executive of the broker Tullett Prebon, sat in his City office earlier this month, taking the measure of the credit crisis.
“Yachts,” he said. In previous summers the ruling families of the Gulf came to Monte Carlo to tie up next to western bankers. This summer, Smith said, western financiers are taking their yachts to the Gulf to curry favour with the families overseeing Middle Eastern sovereign wealth funds.
“I ring my contacts and they’re all in Abu Dhabi,” said Smith. These are not bankers but men who own and run large private companies. “These are the guys the sovereign wealth funds want to work with – guys so far off the radar they make the hedge funds look transparent.”
Smith reeled off other offbeat indicators of how the credit crunch is changing the world until his sense of humour failed him. “The West is screwed,” he said. Like most observers, Smith expects bad economic data between now and the end of the year. After 16 years of growth – during which the British economy expanded by half – many see recession on the horizon. Unemployment could rise above 6%.
“People say we are in a downturn like the early 1990s,” said Smith. “I think it’s going to be worse than that. We’re in for something like the 1970s or even the 1930s.” Like most observers, Smith traces the roots of the financial crisis to cheap money flooding the financial system between 1998 and 2007. People lent and invested stupidly. Reality impinged when poor Americans fell behind on mortgage payments. The bubble burst.
Smith breaks a City taboo and mixes his economic analysis with politics. He traces the cheap money to Alan Greenspan, the former Federal Reserve chairman, and his refusal to raise interest rates to bring surging asset prices under control. “Greenspan was part of a new political culture that started in the 1990s and violated the integrity of his predecessor, Paul Volcker,” said Smith.
“Feel-good politicians like Bill Clinton and Tony Blair started telling people only what they wanted to hear.” Gordon Brown stirred his pride into the pot of rotten political culture, said Smith. Brown positioned Britain in the slipstream of the American bubble economy, then attributed the debt-fuelled prosperity to his economic policies.
Smith stands outside the City consensus but is not alone. Sir Steve Robson, a former Treasury official and now City non-executive director, offers a similarly maverick, if less politically charged, view. Robson traces the credit crunch to the failure of the West to adapt to intensifying competition from China and other emerging nations.
“Stoking up the economy on debt was a way for the West to sustain an unsustainable standard of living,” he said. “In this sense the financial system wasn’t the cause of the problems. It was the messenger.” Where, asked Smith, are politicians telling it like it is? “Living standards are going to fall,” he said. “House prices should fall. They are too high.”
Robson wonders how America and China will stabilise their unhealthily symbiotic economic relationship. America relies on Chinese savings to fund its deficits, he said, and the Chinese rely on the American export market to sustain their high growth rate. “The yuan is too low against the dollar,” said Robson. “If the Chinese won’t revalue it, the US needs to talk about import tariffs.” In hock to the Chinese, however, America is in a weak position to get tough.
“Regulatory reform, proper incentives for bankers . . . these are valid issues,” said Robson. “Ultimately, though, they are displacement activity.” Bears say there is no end in sight to the credit crunch and believe its repercussions on the economy could last for years. Bulls say the worst is past and the broader economic downturn will be over by 2010.
The bull case was put by Barclays at the bank’s half-yearly results press conference this month. Presiding over the occasion with poker-faced concentration, chief executive John Varley reported that Barclays earned £2.7 billion in pre-tax profit for the first six months.
A visitor who had somehow missed the news of the past year might have thought: “Almost £3 billion in six months. Not bad.” But Varley and Barclays Capital chief Bob Diamond were far too aware of the anger of investors to give any such sign of complacency.
Varley apologised to shareholders for the 40% drop in the bank’s share price over the past year. He attributed his bank’s performance to general conditions. Diamond spoke of the worst conditions in his 25-year career. On the same day as the Barclays press conference, a group of Wall Street wise heads led by former New York Fed chief Gerald Corrigan sent a letter to US Treasury secretary Hank Paulson.
They said: “The root cause of financial-market excesses on both the upside and downside of the cycle is collective human behaviour — unbridled optimism on the upside and fear, bordering on panic, on the downside.”
The Corrigan group and other policymakers in tandem with the private sector are labouring to bring the boom-bust cycle back under control. The International Monetary Fund (IMF) estimates that banks will write off $1 trillion as a result of the credit crunch. In the first half of the year Barclays offloaded £6.3 billion of impaired loans and securities. “Assets are moving,” said Diamond. “There are new buyers, new structures, new prices.”
At the same time, Barclays and its rivals have begun to recapitalise themselves. While others have tapped the sovereign wealth funds of China and Singapore, Barclays went to the Qatar Investment Authority, where Barclays Capital does extensive business.
The bulls accept that tight credit conditions will exacerbate the broader economic slowdown — in airlines, the motor industry, construction and retailing, to name just a few struggling sectors. In line with other bulls, however, Barclays is not forecasting a recession. Varley said he saw global growth in 2009 approaching 4%, American growth of about 2% and UK growth at between 0% and 1%.
In an interview after the press conference, Jerry del Missier — who as heir-apparent at Barclays Capital is one of the fortysomethings holding the City’s future in his hands — said: “To think that the US will not come back is short-sighted. We are building in the US while competition there is weak.”
The bankers are bullish and some investors agree with them. Take the case of Anthony Bolton at Fidelity. From 1979 to 2007 he chalked up annualised growth of 19.7%, against 13.8% for the market. In the first six months of 2008 hedge funds made money buying commodities and selling bank stocks. Then in July commodity prices fell, bank stocks rebounded and the trade went pear-shaped.
July was a terrible month for hedge funds but not for Fidelity. Bolton had said in June that it was time to stop buying commodities and selling bank shares. Bolton said the banks have written off about half the $1 trillion in bad assets the IMF deems necessary. This means that, numerically, the financial crisis is only half over. But, said Bolton, “the problem is now known”.
Banks have recapitalised for problems of the past, not the future. Heading into a downturn, there could be new write-offs. “Still,” Bolton said, “I don’t think it will be too bad. The stock market is down about 20%. Maybe it needs to go down by 30%-40% and there could be one more shock, a large European company could fail. But my instinct is for a market upturn by the end of the year.”
Bears say global finance remains out of control and is likely to produce further bank failures as a new round of defaults on debts — ranging from credit cards to loans for leveraged buyouts — overwhelms the system. “We don’t have a sub-prime mortgage crisis,” said New York University economist Nouriel Roubini in a recent interview. “We have a sub-prime financial system.”
Bulls say the unravelling is over. Passing through London en route from Beijing to Italy for a short break, Citigroup chairman Sir Win Bischoff last week made the case that banks were now healing themselves. Banks still face billions in mortgage-linked writedowns. But Bischoff said “the final tally will depend in large measure on US house prices and the broader stabilisation of the credit markets”.
Bischoff said that bank share prices were down by about half from before the credit crunch and this had cleared the way for rebuilding. “There may be encouragement for consolidation,” he said — bank mergers and the like. “But large bank failures are unlikely.”
Bulls and bears have always inhabited different universes. But now the differences seem greater than ever. Neither Keynesians on the left nor laissez-faire economists on the right appear to have the analytical tools to integrate the financial, economic, party-political and geopolitical elements of what is happening.
Sitting in a City Starbucks, George Magnus, senior economic adviser at UBS investment bank, attempted a modest synthesis. Inflation fuelled by rising energy and food prices was peaking, he said. The world was deflating. As the economy slowed, inflation and interest rates would fall and shares could enjoy another bear-market rally.
Such a rally will end, Magnus said, as company profits fall. The world could go the way of Japan in the 1990s, when Tokyo proved powerless to stimulate the economy. “Most economic cycles are self-correcting,” said Magnus. “This one could be different.”
Andrew Smithers at Smithers & Co, a second forecaster with a good track record, is less gloomy. Smithers, who knows Japan well, said it was unlikely the world would sink into a Japan-style deflation. “More likely,” he said, “is reasonably controlled, sub-trend growth until 2010.”
In Britain, analysts said, the interaction of the credit crunch and politics would play out through the soap opera of whether Gordon Brown — whose reputation for economic competence is in tatters — held on to power. Vying for headlines this autumn will be wage negotiations. Adam Lent, chief economist of the Trades Union Congress, said the public was frightened by the downturn and fed up with the widening gap between rich and poor.
The TUC will urge the Bank of England’s monetary policy committee to cut interest rates. “The MPC needs to respond to recessionary, not inflationary, expectations,” said Lent. The TUC will also push for pay rises. “People are worrying about a replay of the wage-price spiral,” he said. “But that happened 30 years ago and the economy has moved on.”
The CBI takes a different view. The risk of a wage-price spiral remained real, it said. Now was not the time to cut interest rates or cave in to union demands. “I would be astonished and horrified if the government accepted the TUC’s advice,” said CBI director-general Richard Lambert.
Seeing itself as a kingmaker in a divided Labour government, the TUC thinks it has a strong hand in wage negotiations for public-sector workers. Businessmen think the opposite. “The unions don’t want a Tory government,” said one. “A winter of discontent would ensure they get what they don’t want.”
Looking at the debates generated by the credit crunch in London, Washington and New York, a former Middle Eastern sovereign wealth fund manager sees negativity — squabbling over how to divide up a shrinking pie. “Many people in the West are full of fear now,” he said over coffee in a London hotel where he and his family were taking a break from the Gulf heat. “They are not seeing clearly.”
Laughing off questions about the pattern of yachts moving through the Suez canal, he said western leaders should redirect public attention to the issue of how industrial economies relate to the emerging economies. “How you deal with the coming changes — say half the General Motors assembly line moving to China — will determine where the downturn comes out,” he said.
The former wealth-fund manager also pointed to an elephant in the room. “How much has the West spent on the Iraq war?” he said. “Three trillion dollars? Bush may have thought he was getting a new source of oil for that money. But has he?” The main factor determining where the credit crunch goes from here is the competence of the American government, he said.
Not wanting to interfere, he hesitated, but then blurted it out: “The US election is the most important thing happening this autumn. A Barack Obama victory would signal a new beginning to the world.” So who, then, is right? City bulls who say the situation is bad but manageable and will be back to normal by 2010? Or City bears who say the situation is very bad, out of control and set to drag on indefinitely?
In a way, the former wealth-fund manager said, both are right. “The West — especially America with the entrepreneurial energies of its new immigrants — will come back,” he said. But as the boom lasted a generation, it may take a generation to get over the bust.
ECB's Trichet says the storm is not over
European Central Bank President Jean-Claude Trichet on Saturday defended central bank responses to the financial turmoil that has roiled global markets for the past year and warned the storm is not over.
"We still are in a market correction," Trichet said at the Kansas City Federal Reserve Bank's annual monetary policy conference that draws central bankers, economists and business people from around the world.
"What has been done until now has been pretty well done, it seems to me, under those very difficult circumstances," he said, responding from the conference audience to a paper critical of the reactions of the U.S. Federal Reserve, the ECB and the Bank of England to financial turbulence.
The annual conference took place as market and economic conditions remain gloomy amid persistent worries about bad credit, inflation, sluggish growth and high energy and commodity prices. "This turmoil is not going to go away quickly and will require serious efforts to overcome it," a top official of the International Monetary Fund, John Lipsky, told Reuters.
The forum has focused on fallout from the financial crisis that erupted in 2007. In the conference keynote address on Friday, Fed Chairman Ben Bernanke said the year-long financial storm "has not yet subsided." The U.S. economy may hit another bump in the final months of the year as the boost to spending from the government's $152 billion stimulus package wears off, a congressional budget official said on Saturday.
"The stimulus helped to support consumption in the middle part of this year," Congressional Budget Office head Peter Orszag told Reuters. "One of the things we'll be experiencing later this year is the withdrawal of that effect, leading to economic weakness."
Initial U.S. government data reported last month showed the economy grew by an annual rate of 1.9 percent in the second quarter, after meager growth of 0.9 percent in the first quarter.
At the symposium, a former Bank of England official, Willem Buiter, took the BoE, the ECB and the Fed to task for their responses to the crises that began last summer as the extent of problems resulting from risky subprime mortgages -- loans made to borrowers with spotty records of repaying debts -- became known.
Buiter in a paper presented at the symposium directed his harshest critique at the Fed, saying the U.S. central bank's steep interest rate cuts to counter the crisis would lead to higher inflation. The Fed misjudged the effects of the housing contraction and overreacted by bringing benchmark rates down by 3.25 percentage points to the current 2 percent level, said Buiter, now a professor at the London School of Economics.
Fed Governor Frederic Mishkin, however, said the U.S. central bank's bold moves were justified to stop a vicious circle of shrinking credit and weakening economic activity. "When you can get an adverse feedback loop ... that argues that what you need to do is act more aggressively," he said in response.
U.S. inflation hit a 17-year high in July of 5.6 percent, driven by higher energy and food prices. Oil prices have declined since mid-July. The ECB, in contrast to the Fed, has raised rates, citing worries about record euro zone inflation. A European policy-maker said at the Fed conference it was premature to declare that falling oil prices would curb euro zone inflation.
"We will have to see where it will go. It is too early to give a comment on that," ECB governing council member Yves Mersch told Reuters. Meanwhile, another paper said the European Union urgently needs a better plan to share the costs of dealing with large bank failures to prevent the risk of a severe "contagion effect."
Economists Franklin Allen and Elena Carletti said that without clearer guidelines, European and global capital markets could be at risk.
The next credit crisis timebomb could be the credit cards you carry
Malcolm Hurlston, chairman of the Consumer Credit Counselling Service (CCCS), has spotted an uncomfortable trend. "This half-year we've seen a substantial and sudden uplift in demand for advice on unsecured debt problems," he said. "In the past six weeks it has got even worse. We reckon there's been an increase in calls of about 25 per cent."
Hurlston is not alone. The Citizens Advice Bureau and the National Debtline have both experienced a surge in calls from people struggling with credit card debts and personal loans. The Debtline said it has taken 9.2 per cent more calls on the subject in the past six months than last year and CAB has noticed "an increase in demand for our advice".
It may seem like a statement of the obvious, given the pressure households are under from soaring utility, food and fuel bills, but recent statistics have told a different story. According to The Insolvency Service, the number of personal bankruptcies fell 1.3 per cent between the first and second quarters of the year. On individual voluntary arrangements, or IVAs (the popular alternative to bankruptcy), the numbers were down a sharper 3.2 per cent.
Banks, too, have seen credit card and personal loan impairments shrink for the past 18 months. After a profligate 2003 and 2004, when credit card lending grew by 20 per cent a year and bad debts got out of control, the worst after-effects of the public's decade-long credit binge were supposed to have been slain. Mortgages were the new and all-consuming problem.
Unfortunately, Britain's banks can no longer ignore the public's £232bn of credit card debt and unsecured loans. With unemployment rising to 5.4 per cent in July, increasing by 60,000 to 1.67m in just three months, and fuel costs rocketing, the banks' unsecured loan books are once again a ticking time bomb.
"We make sure households classify debts as priority and non-priority when they call for advice," said National Debtline's Beccy Wilks. "Priority is when you risk losing something - like your house or your utilities." That leaves credit cards and overdrafts at the bottom of the pile.
Banks are already acutely aware of the threat of rising unsecured bad debts. At their recent half-year results, the chief executives of Britain's biggest high street lenders tacitly accepted that provisions would start rising again. HSBC is very conscious of the dynamic in the US, where the downturn is about a year ahead of the UK and the bank has already been flattened by the sub-prime housing crash.
HSBC finance director Douglas Flint said: "The issue now is the US slowdown and whether it enters a technical recession, and what that does to the credit card and unsecured books." Arguably, the UK is in a worse situation. Plastic is far more ingrained in the fabric of life in America, where - unlike the UK - households in negative equity know they can throw in their keys and not be pursued for any outstanding debt.
In Britain, it is hard to imagine anyone risking their home for their credit card. Credit Suisse goes further, reckoning that falling house prices will lead directly to a spike in unsecured bad debts. British homeowners, the investment bank says, account for 65 per cent of unsecured lending and, to date, have cleared problem debts by remortgaging and taking equity out of their properties.
As a result, they have been "a very small proportion of unsecured problem loans". "We suspect, however, that this will change moving forwards," Credit Suisse's analyst team wrote in a recent note. "There are signs of increasing strain in the homeowner segment, highlighted by... the fact that almost 40 per cent of IVA proposals are now coming from people who own property.
"Historically, over 50 per cent of struggling homeowners would refinance or remortgage themselves out of trouble, but this option is less readily available today." Higher mortgage rates and reluctant lenders mean that stretched households no longer have an easy pool of equity available from which to bail themselves out of trouble.
The fear now is that the situation has reversed and people are using their credit cards to pay their mortgages, now that repayments are soaring given that 1.4m people come off attractive fixed-rate deals this year. Peter Crook, chief executive of doorstep lender Provident Financial, has heard such stories and described them as a "big red warning sign".
Certainly, the statistics suggest the public retains an unhealthy appetite for debt. Bank of England figures show that growth in credit card lending has accelerated since the crisis struck. Credit card debt rose 1.3 per cent in June last year compared with June 2006. Annual growth was 7.1 per cent this June and now stands at £55bn.
Apacs, the payments network, suggests this could hit £160bn if those 31m credit cards are taken to their limit. Overall, the public is still taking roughly £1bn of new unsecured debt every month, numbers from the Bank show. Including mortgages, Britons have £1,440bn of personal debt.
The numbers are staggering and unsettling. For banks, as the table shows, the big figures are in mortgages but the big risks lie in the consumer credit portfolios. In the recession of the early 1990s, impairment provisions on the banks' mortgage books increased to 0.4 percentage points. By comparison, the impairment on the unsecured loan book was 3.69 percentage points (the corollary of the higher risk, of course, is that it is a more expensive product).
Credit Suisse reckons the extra provisions from unsecured credit could be higher than mortgage impairments this time. A "sensitivity" study on HBOS' loan book conducted by the investment bank shows the unsecured bad debt charge running up to £3.25bn in a 1990s-style Armageddon scenario compared with a £1.66bn charge against its much bigger mortgage portfolio.
The banks' overzealous lending back in 2003 and 2004 may return to haunt them. Bad debts on the unsecured book are already double the 1990s peak. Lloyds TSB, which can be used as a proxy for the industry, broke the numbers down in its results - showing the bad debt charge as a percentage of lending on personal loans at 5.43 per cent and 7.84 per cent on credit cards. In the 1990s, the recession saw impairment levels more than double. Debt specialists say they would not be surprised this time if credit card provisions hit 20 per cent.
Concerns have already been raised by the recent Bank of England credit conditions survey, which revealed that banks were surprised by the level of bad debts run up on their credit cards in the second quarter of the year. A study out last week from market research group Maritz Research added to the general gloom. A survey of 1,000 homeowners found that "40 per cent already have acute financial problems".
HSBC also revealed recently that its 8.2m current account holders typically have 5 per cent less money in their accounts than a year ago, graphically illustrating the rising cost of living. Joe Garner, head of HSBC's personal financial services in the UK, said: "People are really feeling the squeeze. There is definitely some strain there."
So why do the insolvency and bank impairment figures tell a different story? Analysts say this is because banks are rejecting more IVAs and working with customers to solve debt problems. "Banks are opting for debt management plans and have been clamping down on IVAs," said one analyst, who asked not to be named. "It flatters their provisioning policy. They would have had to write down an IVA almost immediately. Debt management plans delay the impairment and the banks are likely to lose less."
Delaying bad news may not seem prudent but, given the £10bn of writedowns against structured credit assets that Britain's banks had to take in the first half, the less bad news the better. The more provisions they have to take, the less cash left to lend out to prospective house-buyers and corporates - prolonging any downturn.
Royal Bank of Scotland, Barclays, HBOS and Bradford & Bingley have recapitalised with £21bn of funds from shareholders, which will cushion them against some of the increase in provisions and allow them to continue their vital service of lending to people and companies. But the jury is out on just how long this extra capital will last.
Some believe the banks' unsecured credit problem after 2003 and 2004, when the bad debt charge hit 6 to 7 per cent, was a warped blessing by encouraging them to rein in lending and improve standards. Banks certainly seem to believe they have got their unsecured debts under control. But, as the credit crisis has shown, such confidence is not always an encouraging sign.
Higher Fees for US Mortgages
Mortgage rates are typically driven by the financial market’s outlook for long-term interest rates, but not always. Policy changes at Fannie Mae and Freddie Mac, the two government-sponsored companies that buy most mortgages issued by United States lenders, recently helped drive that point home.
This month, Fannie and Freddie increased the fees they charge lenders for many loans, effectively bumping up interest rates for many borrowers who have marginal credit. The companies also tightened their policies on refinance loans that enable an owner to take cash out of a home.
Fannie Mae was the first of the two mortgage companies to increase its fees for lenders, doubling its current charge on most loans, to a half of one percentage point, and Freddie quickly followed with similar fee changes. Professionals expect lenders to pass these charges along to borrowers by increasing the mortgage rates they quote.
This doesn’t mean every new consumer loan will increase by a half point, though. First, the policy applies only for borrowers with credit scores lower than 680. Credit rating agencies do not disclose “average” credit score figures, but the Fair Isaac Corporation, whose software is used by many credit rating agencies, said the median score was about 723.
Also, since lenders will spread that charge over four or five years — the average duration of a loan until a home is sold or a loan is refinanced — the rate increase will amount to only about one-eighth of a point. On a 30-year fixed-rate mortgage of $250,000, that charge will bump up the borrower’s monthly payment from $1,559.57 at 6.375 percent to $1,580.17 at 6.5 percent.
Those buying homes will have little choice but to absorb the cost. But the new policies will be felt more by those thinking of refinancing mortgages. Such loans have grown less attractive in recent months, as 30-year fixed-rate mortgage rates pushed beyond the 6.5 percent range. (As of Thursday, the average rate was 6.54 percent in the Northeast, according to Freddie Mac.)
Personal finance specialists advise homeowners to consider refinancing their mortgages when interest rates drop well below the loan’s existing rate.
To help decide, borrowers should determine the cost of a new mortgage at current rates, then, using the amount saved monthly, calculate how long it would take to recoup the cost of refinancing; they should proceed with the refinancing only if they are fairly sure they will be in the home that long. (Closing costs for refinanced mortgages are about $3,000 in the New York City area for a mortgage of $200,000, although New York City co-ops incur additional taxes of $3,600.)
Many owners with long-term mortgages refinanced their loans when interest rates were below 6 percent in recent years. Now that rates are inching higher, the only reasons that one might refinance a loan at a higher rate, lenders and brokers said, would be to extract cash or to shift from an adjustable-rate loan to a fixed-rate one. But Fannie and Freddie’s recent policy changes have reduced the number of people who qualify for such transactions.
Even those with excellent credit will not be able to take cash out of their homes if, after the loan, they have less than 15 percent equity in the homes. Previously, the threshold was 10 percent, and people with low credit scores could not get such deals.
Thatcher Zuse, president of Sound Mortgage, a Connecticut mortgage brokerage firm, said that on a $400,000 home, the changes reduce the equity available to owners by $20,000, on top of any decline in home value. “A lot of people have already cashed out,” he said, “but for the ones who haven’t, this takes a lot of money off the table.”
UK taxpayers on hook for fast rising Northern Rock losses
Taxpayers stand to lose at least £450m on the nationalisation of Northern Rock, according to warnings from the government’s own advisers. Goldman Sachs told the Treasury in February that losses to the public purse could stretch to £1.28 billion even in benign market conditions, leaked court documents have revealed.
The explosive revelations will add to concerns over the level of public subsidy for Northern Rock, which still owed the Bank of England £17.5 billion at the end of June. Alistair Darling, the chancellor, has defended the nationalisation by arguing that the taxpayer’s exposure to Northern Rock is secured against a high-quality mortgage book. The new documents, however, offer the first indication that the government believes it could lose money on the deal.
The figures have been revealed by John Kingman, the senior Treasury official in charge of Northern Rock, in written evidence submitted to a judicial review into the decision to nationalise the lender. Kingman’s evidence, seen by The Sunday Times, states that “under none of the scenarios was it contemplated that the government would, taking this subsidy into account, make a net profit from taking Northern Rock into the public sector”.
Advisers from Goldman Sachs, who shared in a £45m pot of fees for their work on Northern Rock, told the Treasury that in a “base case scenario” the Treasury would be left with a “net subsidy” to the bank of some £1.28 billion. Even on the “optimistic scenario” there was estimated to be a shortfall to the public purse of £450m, Kingman’s evidence claims. The documents do not disclose an exact figure for the taxpayer’s liabilities should Britain go into recession, which some economists now believe is a real danger.
Kingman’s testimony suggests that Treasury officials did not consider it likely that house prices would fall by 15%-25% – a level that begins to put Northern Rock’s mortgage book into danger. The ratings agency Standard & Poor’s has since predicted that a fall on this scale will be witnessed by next April. HBOS and Lloyds TSB have made similar predictions.
The evidence comes in response to claims made by SRM Global and RAB Capital, the two hedge funds that were Northern Rock’s biggest shareholders at the time of its collapse. They have alleged that part of the reason the government nationalised Northern Rock was that ministers knew they could profit by selling it back to the private sector at a later date.
Kingman also said that both the Virgin takeover and a separate proposal put forward by the bank’s previous management team, led at the time by former chairman Bryan Sanderson, claimed they could have reaped profits for the taxpayer of up to £230m, through a profit-sharing scheme. The private-sector bidders, however, would have made ten times as much money under these circumstances.
“Ministers considered that this share of the returns was disproportionate to the share of risk borne by the taxpayer – or in other words the private provider would receive an excessive return relative to the risk taken,” the documents claim. Northern Rock’s recent results showed that it lost £584.5m in the first six months of the year. The level of arrears in its mortgage book had more than doubled over this period.
The Treasury also converted £3 billion of its loans to Northern Rock into equity, to provide an additional cushion of capital for the bank to see it through the credit crisis. In a letter sent this month to John McFall, chairman of the Treasury committee, the chancellor said “the value of the additional equity will be reflected in the sale price for Northern Rock on return to the private sector”.
However, the advice from Goldman Sachs ahead of nationalisation assumed that the government would achieve a sale price of only about £1.24 billion for the bank, according to Kingman.
Stocks brace for another whipsaw week
What should be a holiday lull of a week looks set to be anything but, with Wall Street on high alert for the latest twists and turns in the credit crisis, more volatility in commodity prices and key developments in the race for the White House.
Fallout from the credit crisis continues to plague markets, with investors increasingly believing in the likelihood of a federal bailout of home-funding giants Fannie Mae and Freddie Mac. Some market watchers expect the Federal Reserve and U.S. Treasury Secretary Henry Paulson to take action as early as this weekend.
"Look for the Fed and Paulson to take steps on Fannie and Freddie -- the time is ripe. The market wants resolution here," said John Schloegel, vice president of investment strategies for Capital Cities Asset Management in Austin, Texas.
Lehman Brothers will also remain firmly in the spotlight, after state-run Korea Development Bank KDB.UL said on Friday that the U.S. investment bank was one of its options for acquisitions. That announcement came a day after veteran bank analyst Dick Bove said Lehman could become a target of a hostile takeover.
Financials aside, the sharp and frequent turnarounds in the direction of the price of oil have played a key role in the market's daily fortunes. Mounting geopolitical tensions between the West and Russia and any economic data showing slowing global growth could tug oil either way next week.
The U.S. presidential campaign also will take a more central role, with Republican John McCain and Democrat Barack Obama set to reveal their vice presidential running mates and the Democratic Party's national convention in Denver. Investors will look for how Wall Street-friendly the vice presidential picks are, analysts said.
"There are a lot of cross-currents here. You've got oil, financials and politics coming together, and it's hard to see that combining in a way that's a perfect storm to the downside or a perfect environment to the upside," said Jeffrey Kleintop, chief market strategist at LPL Financial Services in Boston.
All these cross-currents come in the week before the Labor Day holiday, and analysts said the low trading volume could exacerbate swings in the major stock indexes. "I think it's important that the week ahead is the last week in August and so whatever happens, we should take it with a grain of salt," said Linda Duessel, market strategist at Federated Investors in Pittsburgh.
Housing will be a dominant theme at the beginning of the week, with July existing home sales on Monday, followed on Tuesday by the S&P Case-Shiller home price index and new home sales for July. "What we've been saying about housing is, 'Just show us some stability!' We're looking for a silver lining," said Federated Investors' Duessel.
Consumer confidence data on Tuesday, plus consumer sentiment and personal income data on Friday could give the market more clues about the health of consumer spending and the economy as the boost from tax-rebate checks wanes, said John Praveen, chief investment strategist at Prudential International Investments Advisers LLC in Newark, New Jersey.
The personal income data includes the Fed's preferred inflation gauge. Preliminary real GDP data on Thursday is expected to show second-quarter growth at an annual rate of 2.7 percent, compared with 1.9 percent in the first quarter.
"The second-quarter GDP data will be revised higher because of the trade numbers, but the market will be looking more closely at some of the more forward-looking data to see what will happen next, what is the extent of the economic slowdown going forward," said Prudential International Investments' Praveen. July durable goods orders on Wednesday and initial jobless claims data on Thursday could also provide more clues on the economic outlook, Praveen said.
The world's biggest bank is Chinese
As of today, there should be no remaining doubts as to the tectonic shift in the global economy -- the world's largest and most profitable bank is Chinese.
While banks in North America and Europe are still counting massive credit crunch losses, Industrial and Commercial Bank of China has surged ahead of its international competitors thanks to a booming domestic economy that has dramatically boosted profits.
In a statement from Beijing last night, ICBC said its half yearly earnings jumped an astonishing 57% to US$9.4-billion, up from US$5.9-billion last year. The results catapult ICBC ahead of international global powerhouse HSBC PLC -- the most profitable bank in the world last year -- where earnings fell 29% in the first six months of 2008 to US$7.7-billion. Even before Thursday's earnings announcement, ICBC was already the world's biggest bank with a market capitalization of about US$235-billion.
Beijing-based ICBC , which has 380,000 staff, is benefiting from huge demand for loans and other banking services from its 2.7-million commercial clients and 170-million retail customers. Lending, investment banking and wealth management all saw significant increases as the Chinese economy continued to outpace much of the rest of the world.
The country's overall growth cooled slightly in the first half of 2008, after four and a half years of double-digit increases. But China is still expected to produce growth of around 9% to 10%, a rate that would be the envy of many other nations. Fixed asset investment continues to rise, driven by a number of multi-billion dollar infrastructure projects. Bank loans to real estate developers and house buyers are on the up too, soaring 22.5% in the first six months of 2008.
"China may still grow significantly faster than developed economies for at least another one or two decades," said JP Morgan's Hong Kong-based bank analyst Samuel Chen in a recent report. Investors should assume Chinese banks will grow long-term earnings ahead of banks in more developed markets, he added.
The rise of ICBC -- which went public in 2006 with a US$19-billion IPO that was the world's biggest at the time -- is matched by China's other leading banks. Already this week China Citic Bank Corp and China Merchants Bank have each said their half-year profits rose by more than 100%. China Construction Bank, the nation's second largest bank by assets, is expected to announce profits have leapt 70% when it publishes half-year results Friday.
The fortunes of the Chinese banking industry, which has been relatively insulated from the global credit crunch, contrasts sharply with slashed profits at banks on Wall Street and Bay Street and across Europe. Canadian banks will report third-quarter earnings down roughly 6% from 2007 levels next week, said Credit Suisse analyst Jim Bantis in a note Wednesday. The picture is worse in the U.S. where profits at the big banks may drop by a third this year, according to Credit Suisse's estimates.
There may be tougher times ahead for some Chinese banks including ICBC. The government in Beijing, fearful of inflation, has targeted lenders, recently increasing the amount of deposits bank must set aside as reserves, imposing loan quotas and hiking interest rates. There are also concerns about rising loan defaults especially if China's manufacturing sector struggles to come to terms with recent changes to employment laws, stricter environmental legislation, higher energy and transportation costs and a lower appetite for Chinese goods in the United States.
In Hong Kong, ICBC's stock price has slipped by 6.6% this year, outperforming a near 25% drop in the benchmark Hang Seng Index, according to Reuters. At current valuations the shares are rated a "Buy" by Citigroup Global Markets analyst Simon Ho. China's biggest bank is "defensively positioned for a slowdown" thanks to relatively conservative lending and aggressive provisioning for loan defaults, said Mr. Ho in a report this week.
Too big to fail? We'll see about that
The mess in the U.S. financial system is making me nostalgic for the dot-com collapse of 2000-2002. That, too, was a cataclysmic bursting of an insane market bubble.
But, as we are painfully learning, it's one thing for the economy to lose Pets.com and a few hundred, or thousand, similar start-ups; it's another thing entirely to watch the market bet on the demise of, say, the nation's two largest providers of mortgage money.
The U.S. credit crunch turned 1 year old this month, and the situation clearly isn't improving. Major financial companies continue to reel from huge losses on defaulted home loans. Barring a dramatic turnaround in the economy, commercial real estate loans could become the next black hole -- although the banks will say, as they did initially with home loans, that commercial losses should be "manageable."
The unwinding of any market mania takes time, of course, and produces many casualties. That's the ugly side of capitalism at work. But the casualties of the tech bubble mostly were little companies that weren't important in the greater economic scheme of things. Titans like Cisco Systems Inc. saw their stock market values plummet from 2000 to 2002, but there was never a danger that Cisco would go kaput.
By contrast, the enduring memory of the financial bubble's collapse will be the number of marquee companies either swept away or forced to shrink drastically to survive.
That issue was a key element of a speech that Federal Reserve Chairman Ben S. Bernanke delivered Friday. The central bank chief focused on how regulators might deal with "future systemic shocks" within the financial industry -- company failures or near-failures so large they could trigger chain reactions with potentially dire consequences.
We've already lived through several such systemic shocks this year. Countrywide Financial Corp., brokerage Bear Stearns Cos. and IndyMac Bancorp are history, the first two rescued just in the nick of time by larger rivals, the third seized by the government. Now, shares of mortgage titans Fannie Mae and Freddie Mac trade for less than a fast-food lunch as the market bets that a government takeover is inevitable, if not imminent.
This week was another rumor-fueled ride on Wall Street. Fears of an impending failure of another major financial company were stoked by a speech early in the week by Kenneth Rogoff, a former chief economist at the International Monetary Fund and a historian of financial crises.
"The worst is yet to come," he said of the U.S. financial system. "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." By late in the week Lehman Bros. Holdings Inc., long on the list of the most at-risk institutions, was said to be shopping itself to potential foreign buyers, including a state-run South Korean development bank.
And shares of Washington Mutual Inc., the biggest U.S. thrift institution, on Friday fell to their lowest level since mid-July on renewed jitters about the Seattle-based company's viability. U.S. regulators are in a trap. They'd prefer to simply allow ruined banks and other financial companies to fail, thus purging the system.
But the list of potential victims now includes too many of the biggest institutions, which in turn have financial ties to countless other players in the business. Every huge tree that falls can take down a lot of other trees.
Even so, Bernanke said Friday that regulators would have to be more disciplined in how they handle future shocks, with the goal of "reducing the range of circumstances" in which a threat to the financial system's stability "might be expected by markets to prompt government intervention" -- i.e., a bailout.
For Fannie Mae and Freddie Mac, a bailout of some magnitude already is baked in the cake, thanks to the authority Congress gave Treasury Secretary Henry M. Paulson Jr. last month. "Too big to fail" is synonymous with Fannie and Freddie, given that they own or guarantee nearly half of all U.S. home loans.
But if regulators are ready to play tougher with other financial companies in jeopardy, they are likely to have plenty of opportunities to demonstrate their resolve. That's because the banking and brokerage businesses have entered a second phase of the bad-asset workout, according to one large hedge fund manager whose views circulate on Wall Street but who doesn't seek or want publicity.
The first phase, the manager says, involved attempts by loss-ridden financial companies to raise fresh capital from investors. Some were successful, some were not. The second phase, now underway, involves fire sales of assets by banks and brokerages that have no choice but to shrink themselves because there isn't enough willing and able capital out there to buttress every damaged balance sheet that needs it.
And as assets are dumped at fire-sale prices, that will trigger markdowns of similar assets, further weakening the finances of banks and brokerages across the board. "We are approaching a solvency crisis that we think is about to result in an avalanche of asset sales," the hedge fund manager says. Good luck, Chairman Bernanke.
Peak Oil!! Peak Inflation ?!? Peak Credit??
Does Peak Credit inevitably follow piqued credit? Well if you're my age, and you thought so and positioned accordingly, you'd have been bankrupted a very long time ago - possibly as early as the late 1980s.
And if you were a glutton for punishment, you'd have been toasted again in 1994, another time in 1998, yet again in 2002, and rubbing one's nose in it, perhaps every year after that until midsummer two-thousand-and-seven. Dog days indeed for those bearish on the ability of the financial system to manufacture, distribute, and service debt, whether in real or nominal terms, or in relation to any measure of the economy or change in the growth thereof.
Yet as pessimistic on its sustainability (and wrong!!) as one would have been in the past, one should now be as optimistic one's assessment that this is The Big One, that we've smacked head-first into the boundary of the maximum amount of debt that can be assumed by households, corporates and governments in our economy and be reasonably sustained with the fruits of our labour, and investment.
Actually, I would posit that we long-ago pierced any reasonably sustainable threshold, and only through sheer inertia and the fortuitiousness of pulling of rabbits-out-of-hats have we lasted this long. But it is the anchoring of popular belief in faith and absent solvency from days long passed combined with the extrapolation a series of non-extrapolatable macro income streams which could cause any sensible human being believe or have believed that the boundary lay somewhere in front of us and not far behind us.
Culpability is not singular. Stern-Stewart, investor short-termism and systemic mono-focus, along with greedy managers replete with agent/principal dilemmas must assume blame on the corporate side.
Selfish American Voters repeatedly demanding representatives requite incongruous financial goals with cynically lame and unsustainable fiscal policies, along with a near complete detachment from reality in regards to present consumptive desires in relation to both incomes and longer-term savings requirements are just as at fault as the monetary wrecktitude resulting from an unwillingness to accept mild deflation and cyclical recessions where required for reasons that - to this day remain inexplicable given that Continental Europeans seemingly had little difficulty distinguishing a bubble or accepting that both taxes and economic brush-fires are not inherently bad in The Big Picture.
So IF what we are currently witnessing, commonly termed as The Credit Crunch, is in fact, an expression of what I will term Hubbert's financial equivalent - "Peak Credit" phenomena , and IF as I posit, we long ago untethered the financial wagon from the real economic train, what does this mean?
Many things, but first and foremost, that we are at a major and painful inflection that will impose a real Kunstleresque austerity upon Americans converging their desires with their means. In a word, this means "revulsion", a somewhat arcane and long-forgotten term for large-scale write-downs and/or economy-wide elimination of outstanding debt(s). For this reflects the implausibility of servicing, let alone paying off obligations, and the consequences to those whose capital and assets were/are/will be vaporized.
It will, undoubtedly, be fought by authorities, with certain costs borne by the state and socialized upon unwitting voters. Japan wallowed in their own debt-shite for more than decade, and in the US it is (in present political climate of denial) even more natural that attempts to band-aid and stave off the inevitable reality will likewise be tried. In another time and another place, natural growth and demographics might have met inflation somewhere in the middle and the cycle would resume again without massive dislocation.
But this time it is different. This time, the encumbrances are too large. This time, there is competition for markets, and their value propositions are surpassing Americas. This time the patient is too soft, obese, relatively uneducated, faux-faithful, weak, politically compromised, and cronily corrupt. This time, the business cycle is turning dramatically for the worse, wealth effects are only beginning to bite, oil has peaked with a generation of adjustment between any remotely plausibly cost-effective replacement.
And competition is even heating up in the emerging world for the remaining high-margin business. This does not sound like an environment that will assist households or government to rebuild balance sheets and make good on obligations without great sacrifice from ordinary people and even greater sacrifices from the monied class.
This sounds like an environment where creditors and debtors will be required to sit down and negotiate what can and might plausibly be paid, or converted into equity, or stretch maturity with lower rates - anything to keep it as an "asset" and a performing one.
"Peak Credit", like Peak Oil, thus forlornly reflects the necessity of increasing demand for credit from borrowers to sustain the unsustainable, at precisely the time when supply is constrained and shrinking, for suppliers are squarely confronting the reality that new sources are limited, and in any event, the demanders (even if supplied) have diminishing hope in the current environment of returning what was lent.
Some will think that these ruminations border on the insane. And I will admit that when I walk out of my office door to the local trendy coffee bar, there is scant evidence where I live that Peak Credit is anything but a financial phenomena - limited to the flippers in Vegas or the spec developers in Fla. or CA. But perhaps that's because the most insidious aspect of Peak Credit is its disruption to the chain of dependencies that bore its hallmark over the past two-and-one-half decades.
So inexorable and complete has the rise of credit been in its permeation of every crevice of life that no one blinks when multi-trillion dollar GSE balance sheets are supported by but the thinnest veneer of equity - even AFTER large potentially (no, probably) impermanent increases in underlying asset values; when dogs receive pre-approved credit cards by mail; that its sheer ubiquity produces persistently negative rates of saving; when corporates use leverage in lieu of a margin of balance-sheet safety on the enterprises they are meant to steward in order to conform and placate the markets' twisted short-sighted ideal of optimal capital structure leaving them woefully exposed to cyclical fluctuations; where data-mined models themselves based on limited data replace good common sense; where leaders defer to unsustainable plebeian notions of what constitutes prudent fiscal policy producing errors in judgment that make the trench warfare of the first world war appear sane.
If this is what God's country resembles, imagine the financial horror in hell... "Peak Credit" will wreak as monumental changes upon American consumptive life as Peak Oil, and these cannot help but exert a massive deflationary pull - at least until such time as the parties agree to squarely face reality that confronts them, and in an interconnected world, everyone else.
U.S. and Global Economies Slipping in Unison
Economic trouble has spread far beyond the United States to major countries in Europe and Asia, threatening American businesses with the loss of foreign sales and investment that have become increasingly vital to their sustenance.
Only a few months ago, some economists still offered hope that robust expansion could continue in much of the world even as the United States slowed. Foreign investment was expected to keep replenishing American banks still bleeding from their disastrous bets on real estate and to provide money for companies looking to expand. Overseas demand for American goods and services was supposed to continue compensating for waning demand in the States.
Now, high energy prices, financial systems crippled by fear, and the decline of trading partners have combined to choke growth in many major economies. The International Monetary Fund expects global growth to slow significantly through the end of this year, dipping to 4.1 percent from 5 percent in 2007.
“The global economy is in a tough spot, caught between sharply slowing demand in many advanced economies and rising inflation everywhere,” the I.M.F. declared last month in its official World Economic Outlook. All this means that economic troubles in the United States could intensify into the presidential election season and beyond.
It could also make it harder for financial companies like Lehman Brothers — which has been seeking fresh investment in South Korea — and the government-backed mortgage giants Fannie Mae and Freddie Mac to attract much-needed capital from abroad.
As the United States and many other large economies slip in unison, the reality of integrated markets is being underscored: just as globalization spreads prosperity — linking cotton farmers in Texas to textile mills in China — the same forces spread hurt when times go bad. “The slowdown has reached such a wide range of countries that they’re now feeding on one another,” said Alan Ruskin, chief international strategist at RBS Greenwich Capital.
The impact of the downturn is reflected by the experience of the Vermeer Corporation in Pella, Iowa. The company, which manufactures farming and construction equipment, has become accustomed to looking abroad for growth as the real estate bust in the United States has crimped purchases of its gear by American home builders.
Its overseas sales have doubled in the last five years as a percentage of its total business and now make up nearly a third of its revenue, the company’s senior director of international sales, Steve Heap, said. But in recent months, even as growth has continued over all, some parts of the world have sunk into malaise.
“The U.K. has been really soft for the last six months,” Mr. Heap said. “Western Europe overall has been flat. We’ve not seen the growth we’ve seen in the last few years.” Many other major economies are either stagnant or shrinking as well. Japan, whose fortunes are tethered to exports, saw its economy contract at a 2.4 percent annual rate from April through June after accounting for inflation.
Germany, another export power, slid at a 2 percent clip. France and Italy slipped slightly. Spain and the United Kingdom — both grappling with hangovers from their own real estate binges — were both flat amid talk that they have already slipped into recession. The festivity of easy money has given way to recriminations over bad loans, unemployment and inflation.
“The year 2009 in Europe is going to look significantly worse than 2008,” said Marco Annunziata, chief economist at the Italian bank UniCredit. Even China and India, whose swift growth has occasioned talk of a new global order, have been cooling in recent months, though still expanding at rates that would bring envy in nearly any other land.
“We had buoyant world growth for a few years,” said William R. Cline, a senior fellow at the Peterson Institute for International Economics in Washington. “It was too hot not to cool down, as the song goes.” There is a potentially significant upside to the downturn under way: it could knock down rising prices for food and energy, which have been driven higher by swelling demand in a swiftly expanding world economy.
The chairman of the Federal Reserve, Ben S. Bernanke, has been betting on that very scenario as he has rejected calls for higher interest rates to suffocate inflation. The recent drop in commodity prices, combined with “a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year,” Mr. Bernanke said Friday at the Fed’s annual economic symposium in Jackson Hole, Wyo.
Still, concern centers on the possibility that slowing global growth could hurt sales of American goods and services overseas. Exports have been a conspicuous bright spot in an economy colored by falling home prices and declining consumer spending.
The dollar has been strengthening against many currencies in recent weeks — not because of a newfound belief in American prospects, economists say, but because investors are edging out of markets that are weakening, like Britain and other parts of Europe, sending down the pound and the euro.
“It’s the rest of the world going down, not the United States going up,” said Kenneth S. Rogoff, a former chief economist at the International Monetary Fund and now a professor at Harvard. A stronger dollar makes American goods more expensive on world markets. If the dollar keeps strengthening, it could pinch sales.
“Exports have been sort of holding us out of the graveyard,” said Martin N. Baily, a former chairman of the Council of Economic Advisers in the Clinton administration, and now a senior fellow at the Brookings Institution in Washington. “That may begin to peter out a little bit if the dollar continues to climb.”
Some economists argue that the dollar’s recent strengthening is a correction after six years of declines that have sapped it of one-fourth of its value against the currencies of major trading partners. Others maintain that the dollar has further to fall, noting that the United States remains on the short of end of a lopsided balance of trade, with imports outstripping exports by nearly $800 billion at the end of last year.
Regardless of the dollar’s value, sales of American goods may be eroded by a more decisive force: a global loss of appetite for goods. “If the rest of the world economy slows, the demand just isn’t going to be there,” Mr. Ruskin said.
That could be painful for American companies that rely on overseas markets.
In 2001, large American companies that disclosed foreign revenues logged about a third of their sales abroad, according to an analysis by Howard Silverblatt, senior index analyst at Standard & Poor’s. By last year, the foreign take had climbed to 46 percent. Europe made up 29 percent of the total. Some American businesses say it is too early to worry about a global downturn.
“When I see the headlines, I worry, but when I look at my order book, I stop worrying,” said James W. Griffith, president and chief executive of the Timken Company, a Canton, Ohio, manufacturer of industrial bearings and power transmission equipment with operations in 27 countries.
Roughly half of Timken’s bearing business is overseas, cushioning the company against the loss of sales in the American auto industry — a trend Mr. Griffith says he is confident will continue. “When China decides they want to build a car, somebody runs a steel mill with coal and iron ore out of Australia, and they mine it with Caterpillar dump trucks which are full of Timken bearings,” Mr. Griffith said. “What is driving our success is the globalization of markets.”
Still, the transformation of foreign shores from a refuge for American business into a source of anxiety is a testament to how swiftly trouble can proliferate in the global economy. India’s customer service call centers — heavily dependent on American demand — are now girding for cuts. In China, the pace of growth has dipped from an annual rate exceeding 12 percent as recently as last year to something closer to 9 or 10 percent, according to most economists.
China’s leaders have become concerned about flagging exports, recently altering priorities from seeking to squelch inflation to instead sustaining economic growth. The government is easing restrictions on bank lending, which were imposed to put the brakes on the economy.
When China makes fewer computers, it needs fewer computer chips forged in Taiwan and designed in the United States. It needs less steel, and so less iron ore from Brazil and Australia. Which means those countries need less construction equipment made in Germany, Japan or Ohio. “The global slowdown is going to create some headwind for the United States,” said Stephen Jen, an economist at Morgan Stanley in London.
Analysts See Change At Lehman In The Next Few Months
Out of necessity, in the next few months Lehman Brothers Holdings Inc. will be structured and operate in a different way than the firm that exists today.
Whether Lehman sells its Neuberger Berman asset-management arm to raise capital or has a foreign investor take a large position in the company - both of which are being explored - some action needs to occur to restore investor confidence. The stock rose Friday on the talk of change, recently up $1.72, or 12.5%, to $ 15.44 on volume 85 million compared with average daily volume of 57.6 million.
Market participants might be wondering why Lehman hasn't taken any action in the past few months or why Chief Executive Richard Fuld has not announced a game plan. Ladenburg Thalmann analyst Richard Bove believes it may be "because management's perception of the company's value is meaningfully different than the investors' perception."
However, shareholders and Lehman employees are becoming increasingly upset their stock is worth nothing. Many Lehman employees' compensation packages include stock options. The 158-year-old investment bank, which employs over 28,000 professionals, has been affected by the recent global credit crisis, with the situation worsening within the last year.
The rumors began after Bear Stearns was acquired by JPMorgan Chase & Co. that Lehman Brothers may be the next bank to collapse. Lehman has tried to calm investors' nerves ever since, but with the stock falling in value by more than 76% in the past 12 months, it is getting harder to defend its position.
One issue is that Lehman Brothers is holding toxic assets on its balance sheet - a $24.9 billion portfolio of residential mortgage loans and securities. Selling off risky assets, such as mortgage-backed securities, will improve the outlook on Lehman. "Solvency concerns, like trading errors, do not age well. We believe the longer the market frets about Lehman's balance sheet exposures, the more likely counterparties are to pull back from the firm, which could cause lasting damage to its franchise," said Jeff Harte, analyst at Sandler O' Neill & Partners, in a research note.
Lehman Brothers has been weighing options on how it can raise desperately needed capital. Selling Neuberger Berman, which it acquired for $2.6 billion five years ago, is one possibility. Private equity firms such as Blackstone Group and Kohlberg Kravis Roberts & Co. have said to be interested in the division. Neuberger Berman is valued between $9 billion to $13 billion by some analysts.
Another alternative for Lehman Brothers is an infusion of capital from a foreign investor, or an outright takeover. Bove upgraded his rating to buy Thursday, which caused a jolt to the stock, on belief that a hostile takeover is a possibility. "Investors are convinced that this company cannot survive or that it will be forced into taking huge losses that will devastate book value," Bove said.
State-owned Korea Development Bank said Friday it had considered buying a stake in Lehman Brothers, but no details had been worked out. It would make sense for a foreign bank looking to expand its presence in the U.S. to be interested in Lehman Brothers, but a Korean bank would face a number of hurdles to buying a U.S. investment bank.
If a Korean bank was to acquire Lehman, it would need to team up with another firm to make a bid, one that is considered more acceptable to U.S. regulators, said Bove. Bove believes change is coming for Lehman. Fuld would benefit from structuring a deal this weekend to get rid of commercial real estate loans and inject some equity in the firm, Bove said. If a deal is not structured, a number of firms will likely try and make a bid for Lehman next week, he said.
The 2009 "Consumer Crash" Call is understated
I was directed this morning to a lovely article over at The Prudent Bear calling for a 2009 "Consumer Crash".
It is full of charts and documentation, and I strongly suggest you read it. All of it. It should in fact be required reading for our political entities and every high school student in the nation, along with every literate adult.
It is very heavy on charts and statistics, some of which I am going to unabashedly quote, and expand on.
Yes, expand on.
Here's the first pair:
Now this looks very bad, but in fact it is much worse than it looks. Why? For the same reason the rest of these charts are worse than they look - they portray averages, but not distributions.
And it is the latter - distribution - that is the real problem.
See, there are a very large number of people - perhaps much as 25% of America, that have no debt at all. Not even a car loan. I'm one of them, and in fact this has been, in the main, my viewpoint since I was a youngster.
Yes, I've had car loans and mortgages, but I never was one to run a credit card balance or charge plate at a store. Ever. There are quite a few people like me, some of them older, some younger, but not everyone is in debt up to their eyeballs.
This may sound encouraging. In fact, its not. Its quite discouraging, and seriously so, because for every person who is prudent, there is one who is doubly underwater to the degree depicted in the graph.
The impact of this will not sink in until you think about it. There are plenty of people, including those on Kudlow every night, who try to claim that "the consumer's debt load, while rising, is manageable."
They're looking at this same graph you are above, and while they are alarmed, they're saying "oh, yes, its a bit over 1x income, but that's not horrible given that debt service is in the low teens as a percentage."
What they're missing is that there is 20% of our population that is being utterly smashed, with debt to income ratios north of 300% and total debt service requirements in the 60% range or more!
Then there is "Joe Median" who has debt service in the teens.
And then there are people like me, who pay no interest to anyone.
Why does this matter? Because that 20% of the population is part of our "consumption lifestyle" - its the lady that I saw a few weeks ago at the opening of Dark Knight who had to pull out three credit cards before she found one that wasn't declined (over limit?) to pay for the $50 worth of popcorn for her and her brood.
For those people accustomed to spending like there is no tomorrow, the pattern of the last few years has been:
- Run up credit cards, rolling balances over from one to another "0% intro offer" as required, then opening a new line to charge up.
- When that gets to be difficult, HELOC out the money, pay down the credit cards, and repeat.
The problem is that now the HELOC window is closed, as home prices are no longer going up. We have seen an absolutely stunning drop-off in securitization of these loans, as there is simply nobody willing to buy them any more - their value on the secondary market has literally gone to zero, and those who currently hold them, including banks, are praying nightly that they don't default, as they're subordinate to the first mortgage and thus utterly uncollectable should the homeowner simply stop paying.
For that 20% of Americans who were goaded into "spend spend spend" following the 9/11 attacks and actually did so beyond their means, the train has hit the wall - we are now witnessing the "slow motion" pileup of cars as they derail.
This is bad.
But it gets much worse, because all of this "phantom home appreciation" in fact came from nothing more than speculative froth, and that translated into literally all sectors of the economy. There are now over 4,100 WalMarts in the United States alone, with almost the entire expansion over the last ten years being driven by the "McMansion boom" in the suburbs and exurbs of America. This "demand" was in fact false speculative froth, in that in 2005 we had nearly fifty percent more "home sales" than were justifiable by actual demographic demand!
Here's the next piece of bad news that you are going to like even less:
The bad news here is that the correction in prices, in inflation-adjusted terms, is only half-over. We've seen about a 20% decline thus far; another 20% is in front of us, and just as the first half took two years, the next half will probably take another two, meaning that prices are unlikely to finish correcting until some time late in 2010.
What this means for you is that if you think home prices will "bottom" in the next six to nine months you are sadly mistaken and are about to get a very expensive and nasty lesson in the reality of economics.
In addition we are likely to see an overshoot in prices - perhaps by 1/4 to 1/2 of the "height" of the bubble. If so, that would take inflation-adjusted home prices down to around $100,000, which is a decline of another fifty to sixty percent - not 30% - from today's prices.
You think this projection is "overblown"? Take a gander at this piece:
"He was selling houses for $300,000. That means a buyer would have needed a household income of about $100,000 to comfortably make the payments. But Merced’s per capita income of $23,864 ranks among the lowest for metropolitan areas in the country. “None of us paid much attention,” Mr. Glieberman says."
Now it is true that for every home that is valued at four times the sustainable maximum there are some that are much closer to a "real" price. But folks - does this not put a "face" on what's really going on, and those who claim "it will all be ok"?
What's the take-away from this?
If you owe more than 70% of today's value of your home, you will be underwater with certainty. If you owe more than half, there is at least a 50% chance you will be underwater within the next two years. 30% of all buyers in the last five years are underwater now. The other 70% of those buyers will be with nearly 100% certainty.
This puts into stark relief the outright fraud of programs like "Hope Now" and similar game-playing, in that such a refinance, if you take it, removes the no-recourse nature of your original mortgage. That is, you will lose the ability to walk away in the future, assuming you even qualify for one of these sucker-refinance "opportunities", as the bank will gain the ability to come after you in perpetuity and garnish your wages.
Don't do it!
Instead, if you are underwater today or at risk of becoming underwater in the next two years, go talk to a good bankruptcy attorney right now and figure out what your options are when, not if, your home value declines by another 30% - and whether you might be better off accelerating what is a certain future bankruptcy so you can start rebuilding your credit and life now.
If you still have equity but won't with reasonable certainty sell the house now and rent, then buy it back at 30-50% off in two or three years.
Don't let the sucker be you!
Why is this important? Because in two years if you intentionally default and rent a home for a while you will be able to buy your house back for 30-50% less than it is "worth" today, cutting your mortgage payment by 50% permanently and winding up with a sustainable mortgage. You will also have two years to build a 20% down payment on the much lower purchase price, and that same two years to start rebuilding your credit.
Again - this isn't legal advice - and you need it if you're going to practice what is known as "efficient breach" in contract parlance. I know I've been preaching this for nearly a year now and will repeat it once more - go get that advice today and figure out if this is the right course of action for you. For a very large percentage of those who bought homes in the last five years, it is.
When you analyze all of this you come to an ugly and inescapable conclusion - we're in deep trouble as an economy, and this is not going to be a "short and shallow recession."
It is instead going to be a very deep and long one, because credit growth - not earnings power - is what has driven the economy for the last 20 years, with the worst of it - a parabolic blow-off - happening in the last six.
This is utterly unsustainable and yet, as it corrects back to sustainable levels, it must by definition impact your lifestyle in a severe, impossible-to-avoid fashion.
Unfortunately the 20% of America who "geared up" and tried to "live large" is and will be screaming for bailout after bailout from our government. If they go down this path it will be a near-exact repeat of what Herbert Hoover did in the early part of The Depression, and will lead to the same result!
If you've been prudent for the last few years your job is to ride your government officials to stop this nonsense and instead focus on ring-fencing the government's balance sheet while forcing bloated asset prices, especially housing, to contract to affordable levels.
The key point is that irrespective of the path taken, the pain and business failures will occur. We are now arguing over who gets to eat the losses - not whether they will happen - and how long it will take before we find a "clearing price" for those assets that are overextended in their valuation, whether it be McMansions or shopping mall footage.
Paulson Risks Goldman Standard as Fannie, Freddie Shares Erode
As soon as he became secretary of the U.S. Treasury in July 2006, Hank Paulson started preparing for a crisis. In August 2006, at a meeting with President George W. Bush and his economic team at Camp David, Maryland, the former Goldman Sachs Group Inc. chief executive officer gave a talk about the capital markets.
Paulson held up over-the-counter derivatives as an example of financial innovation that could, under certain circumstances, blow up in Wall Street's face and affect the whole economy. "My point was that we had gone eight years since the last serious problem in capital markets and that there'd been all of this innovation," Paulson said in an interview in late July. Paulson also revived the President's Working Group on Financial Markets, a council of regulators consisting of the Federal Reserve, the Treasury, the Securities and Exchange Commission and the Commodities Futures Trading Commission.
Founded after the stock market crash of 1987, the group had fallen into disuse. Paulson began to build relationships among the agencies, figuring that the financial markets panel would be key to addressing the next crisis, no matter what that would be. "No one would have predicted the Russian default in '98 or some of the things that happened in Asia," he says. "But you still need to get ready to respond."
In his two years at the Treasury, Paulson has witnessed some of the most turbulent economic times since the Great Depression. Just in the past year, he's had to wrestle with a slumping economy and increasing home loan foreclosures, the subprime crisis, the collapse of Bear Stearns Cos. and the weakening of Fannie Mae and Freddie Mac. "I can't remember when Treasury has been so deeply involved in the structure of securities markets," says James Cox, a professor at Duke University who specializes in securities law.
Paulson, 62, who was a football offensive lineman in college, hasn't just been spending his time fending off economic assaults. He brought his own list of things he wanted to accomplish in the 2 1/2 years remaining of the Bush administration. A sampling: overhaul the Social Security system, improve economic relations with China, jump-start African financial markets and combat global warming by setting up a fund to help finance new energy-efficient technologies.
"One of my management principles is to define your job expansively," Paulson says. "I think I've defined the job here expansively." Not all of his initiatives have been successful. The Social Security plan and a bid to create Treasury-backed institutions to buy home mortgages were notable non-starters. And he has drawn sharp criticism from some conservatives. Former presidential candidate Steve Forbes, a Republican, says Paulson could have avoided the Fannie-Freddie crisis altogether by cracking down on the two companies earlier.
For years, Republicans have called the firms ticking time bombs due to their private ownership and implied government guarantees. Paulson, says Forbes, should have made moves to fire their boards, recapitalize them and sever their ties to the government. "Hank Paulson blew a supreme opportunity to make a substantial reform," Forbes says. "He's caved in to the political pressure in Washington, which is, in essence, keep Fannie and Freddie largely as they are."
During the past week, investor confidence in Fannie Mae and Freddie Mac has dwindled amid rising speculation that government intervention is inevitable. Share prices have plunged, as Wall Street watches for any sign that the two companies are no longer able to roll over their debt. Fannie has about $120 billion of debt maturing through Sept. 30, while Freddie has $103 billion, according to figures provided by the government-chartered companies and data compiled by Bloomberg.
Since Paulson's plan was enacted, several prominent critics have spoken out in favor of nationalizing the two companies. Former Fed Chairman Alan Greenspan said the government should create a company like the Resolution Trust Corp. to sell off the assets of any failing financial institution while limiting taxpayer losses, in a new epilogue to his memoir.
Meanwhile, Bill Gross, who manages the world's biggest bond fund, said Aug. 6 the U.S. Treasury will probably be forced to buy as much as $30 billion of preferred shares in both Fannie Mae and Freddie Mac. Richard Syron, Freddie Mac's chief executive, that same day said he believed his company would be able to avoid Treasury intervention.
While Paulson has made deals with politicians across the spectrum, he's also expanded his authority beyond the scope of any previous Treasury secretary. That's a big change for the Bush administration, which ousted its first Treasury secretary, Paul O'Neill, for his independent views and made his successor, John Snow, a traveling salesman for Karl Rove-designed economic policies. During Snow's tenure, the Treasury complained of being left out of efforts to revamp Fannie and Freddie, says Vincent Reinhart, former director of the Fed's Monetary Affairs Division who's now at the American Enterprise Institute in Washington.
"The Treasury's back in business," Reinhart says. At the Treasury, Paulson is drawing in large part on the skills he honed during his 32 years in investment banking. Paulson's signature style is to confront issues early, hold private meetings and build a consensus before announcing a deal, so that he's sure it will get the necessary backing, according to members of Congress and government staff who've worked with him.
Goldman, which was a partnership until 1999, has a culture of collegiality, says Edward Yingling, executive director of the American Bankers Association. The bank has produced prominent political figures such as former Treasury Secretary Robert Rubin, former Deputy Secretary of State John Whitehead and Jon Corzine, who was a senator from New Jersey before becoming governor of that state.
Rubin, who served at the Treasury from 1995 to '99 after 26 years at Goldman and a stint at the White House, dealt with financial crises in Mexico and Asia, pushed for free trade and promoted budget policies that led to federal budget surpluses. When he retired, former President Bill Clinton called him "the greatest secretary of the Treasury since Alexander Hamilton."
Yingling says he asked Robert Steel, a former vice chairman at the investment bank who was Paulson's top domestic finance aide at the Treasury for almost two years, why the firm generates so many high-profile Washington officials. "He said the culture at Goldman Sachs was not hierarchical and that people learned to work in teams and to work with people well," Yingling says. (Steel left the Treasury in July to become CEO of embattled bank Wachovia Corp.)
Executives like O'Neill and Snow, both of whom had a background in industry, tended to make a decision and have people go implement it, Yingling says. "This town doesn't work that way," he says.
Paulson's consensus building doesn't mean he isn't forceful enough to win people over to his point of view. As chief of Goldman Sachs, he was often called in to woo clients and persuade them to sign with his firm. In January 2005, a month after Procter & Gamble Co. abandoned efforts to acquire Gillette Co., he helped revive discussions between the two firms with a phone call to A.G. Lafley, P&G's chief executive officer.
The $57 billion deal, hammered out three weeks after Paulson's call, was the biggest that year. As Goldman's chairman and CEO, Paulson also established relationships with politicians including Angela Merkel, now Germany's chancellor, Russian leader Vladimir Putin and former Chinese President Jiang Zemin. He says he's traveled to China at least 70 times during his career.
In the past 12 months alone, he went in December and March and was on vacation in Beijing in August to attend the Olympics. He may go again for the next round of high-level U.S.-China talks. Paulson says he treats President Bush like a client, too. "When you're advising a principal, you need to have a role where you are candid," Paulson says. "But outside, there's never daylight between you and your boss."
Paulson's coalition building faced one of its toughest tests in July, when the stocks of the two mortgage companies that account for almost half of the country's $12 trillion mortgage market began to collapse. Shares of Fannie Mae and Freddie Mac had lost more than 75 percent of their value in the first half of this year, as investors worried about the impact of the housing crisis on their holdings. While the two are government-chartered institutions, there was no explicit guarantee that the government would bail them out if they were to default.
On the morning of Friday, July 11, Paulson met with the president and convinced him to make a public comment about Fannie and Freddie. At the Energy Department later that day, Bush told reporters that the firms are "very important institutions." He said he had discussed market concerns with his Treasury secretary. Paulson also tried to calm the markets, issuing a statement supporting the mortgage giants "in their current form."
Both moves failed to stanch the bleeding. Fannie Mae declined $2.95, or 22 percent, to $10.25 in New York Stock Exchange trading on July 11, after passing through a low of $6.68 during the day. Freddie Mac fell 25 cents, or 3.1 percent, to $7.75 after reaching a low of $3.89.
Paulson's efforts were just beginning. He decided to seek sweeping new authority to extend emergency credit to the two companies and also to buy equity stakes in them if needed. He made "unspecified" powers the heart of his plan, which didn't spell out the amounts of money or terms of any bailout.
If investors knew the Treasury had power to rescue the mortgage giants, then an actual rescue might never be needed, Paulson says. Earlier in the year, Paulson had hoped Congress would create a stronger regulator for Fannie and Freddie before the firms reached a crisis point. "I was hopeful we'd get the reform and we wouldn't have to use the plan," he says.
Still, Paulson knew that putting taxpayers on the hook for a possible bailout would be a tough sell on Capitol Hill. So he turned to Fed Chairman Ben S. Bernanke, whose support would be critical to convincing skeptical Democrats to back the plan. During one of their weekly breakfasts, Paulson and Bernanke, 54, discussed the proposal and the possibility of the Fed extending an interim line of credit to Fannie and Freddie while Congress weighed the Treasury's proposal.
Bernanke noted that such a move would be outside the Fed's normal duties, but that he'd consider it if Paulson thought Congress would quickly approve the Treasury's plan. Paulson says Bernanke asked him if he believed that, in the middle of a presidential campaign, he could persuade a Democratic Congress to grant sweeping new powers to a lame-duck Republican administration. "I took a deep breath and said yes," Paulson says. Paulson immediately began calling congressional leaders to discuss the plan, making use of relationships he had been cultivating since his arrival at Treasury.
Among others, he spoke with House Speaker Nancy Pelosi, a Democrat; Senate Majority Leader Harry Reid, also a Democrat; and House Minority Leader John Boehner, a Republican. Having Bernanke's backing helped with skeptical Democrats, says Reinhart, the former Fed official. "Bringing the Federal Reserve into it brings a measure of independence that is consoling to the Congress," he says.
Paulson also lobbied the president, who'd threatened to veto any bill that contained major federal funding for community grants to enable municipalities to buy defaulted mortgages and help people stay in their homes. The measure was sponsored by Democrats led by U.S. Representative Barney Frank, chairman of the powerful House Financial Services Committee.
Paulson convinced Bush to back down from the veto threat, says White House spokeswoman Dana Perino. That helped to ensure the support of Frank and other Democrats. "I think he's been very constructive," says Frank, 68, a Massachusetts Democrat. "It's important to have a secretary of the Treasury that the president would listen to and respect."
By the afternoon of Sunday, July 13, Paulson was confident enough to go public. Speaking on the steps of the Treasury Building, just hours before nervous Asian markets would open, he asked Congress for enormous new authority to backstop and oversee the beleaguered mortgage companies.
By Wednesday of that week, Fannie Mae's stock had rebounded 31 percent and Freddie Mac's was up 18 percent. On July 23, the House voted 272-152 in favor of the bill. Of the nays, only three were Democrats. Three days later -- just 13 days after Paulson's request -- the Senate passed it 72-13. All those opposed were Republicans.
Frank, a longtime foe of the administration, praised the bill after it was passed. "Of the problems that were created by the reckless deregulation that led to the subprime crisis and the neglect of affordable housing that has marked Republican rule in Congress, this package of measures is the best response we could make," he said in a statement after the House vote. "This will begin to lay the groundwork for a turnaround in the housing market."
The legislation gives Paulson all of the major items he asked for, including unlimited authority for 18 months to make emergency loans to Fannie Mae and Freddie Mac and possibly buy stakes in the two mortgage giants. The legislation also created a long-sought new regulator to oversee Fannie and Freddie. Bush signed it into law on July 30.
Trading the presidential objections for Democratic backing was classic Paulson, says Edwin Truman, a senior fellow at the Peterson Institute for International Economics and a former Treasury official. "He's a dealmaker," Truman says. "It's one skill that Treasury secretaries need to have." That's especially the case when the economy is in danger, says Glenn Hubbard, Columbia Business School dean and the first chairman of Bush's Council of Economic Advisers.
"The time to judge economic policy management is in times of crisis, and I think he has brought the right skills to bear," Hubbard says. "Even if I don't necessarily agree with everything he's done, I think he's been incredibly thoughtful, incredibly careful and a real leader." Paulson says timing played a big role in getting the program through.
"We recognized quite early on that if there was some concern or lack of confidence in their access to capital, this could create a serious problem," he says of the mortgage companies. "But we certainly couldn't go to Congress and ask for these powers that would make it a self-fulfilling prophecy - - or we wouldn't have gotten the powers."
That the crisis in the share prices occurred on a Friday also worked for Paulson. As in the Bear Stearns bailout, Paulson cobbled together the Fannie and Freddie deal over the weekend, when markets are closed and the capital is quiet. "He's used the fact that everyone in Washington goes out of town as his strength, because he stays in town and then works the phones and then gets a plan that he can unveil Monday morning," says Steven Bartlett, a former congressman who now leads the Financial Services Roundtable, a Washington-based advocacy group that represents large financial services companies.
Bartlett calls the negotiating marathons Paulson's "famous weekenders." Since the plan was enacted, Paulson has reiterated that a bailout won't be necessary. "We aren't going to comment on speculation," a Treasury spokeswoman, Jennifer Zuccarelli, said on Aug. 18. "As the secretary has said, we have no plans to use these authorities." Yesterday, the Treasury's position was unchanged despite the plunging stock prices. "We continue to stay in touch with the companies and their regulators and are staying on top of the situation," Treasury spokeswoman Michele Davis said.
Paulson likes to gather his staff in a room to hear from each of them before debating the merits and dangers of various policies, says David McCormick, who as Treasury undersecretary for international affairs is Paulson's top international aide. "He really likes to sit down, go around the room and get conflicting views," McCormick says. "People feel, I think, empowered."
McCormick's first interaction with Paulson came in his previous job at the White House, when both were new to government. A Paulson aide asked McCormick, 43, to look at a draft of a speech for the Treasury secretary that addressed some international issues. McCormick sent the aide a note saying that he liked the text but that it seemed a tad long. Five minutes later, he says, his phone rang and the Treasury secretary was on the line, wanting to know where the speech was too long and how to fix it.
Behind closed doors, Paulson's comments can have an edge. "He is incredibly blunt," McCormick says. "There's never shading with Hank, in the sense that I think you always are getting the straight picture." Paulson, who doesn't drink or smoke, has little time for frivolity on the job. Colleagues and lawmakers say he likes to limit interactions to serious discussions. "I believe in substance," he says. "I don't believe that you get things done just by getting together and having a drink or laughing, or interacting personally. While that's never a negative, you need to bring value."
Henry M. Paulson Jr. developed a taste for hard work and a love of nature while growing up in Barrington, Illinois, a semirural community of 10,000 about 35 miles from Chicago with large areas of wetlands and forest preserves. Paulson still owns a farm there with his wife, Wendy, whom he married 39 years ago in September. His father was a wholesale jeweler who raised Paulson to be a Christian Scientist and to become an Eagle Scout.
At Dartmouth College in Hanover, New Hampshire, Paulson earned a degree in English and was a member of Phi Beta Kappa. He also was an all-Ivy League football player and a member of the Green Key Society, an honorary service group. He now has two adult children, one of whom, Henry M. Paulson III, owns the Portland Beavers baseball team, the Triple-A affiliate of the San Diego Padres. His daughter, Amanda, runs the Chicago bureau of the Christian Science Monitor.
In 1970, Paulson earned a Master of Business Administration from Harvard Business School in Boston and then entered public service. From 1970 to '72, he was a staff assistant at the Defense Department, and from '72 to '73 he was a White House staff assistant, working alongside John Ehrlichman, the Nixon aide later jailed for crimes related to the Watergate break-in.
Paulson joined Goldman Sachs's Chicago office in 1974. There, he rapidly moved through the ranks, becoming managing partner and co-head of the firm's investment banking division. He was named co-chairman and co-CEO in 1998 and gained sole possession of those posts a year later, when he and other top executives pushed out Jon Corzine and took the firm public.
Paulson sold his 3.23 million shares in Goldman, worth about $500 million at the time, when he took the Treasury job, according to regulatory filings. He was exempted from paying capital gains tax on the sale of those stakes under a rule meant to avoid penalizing wealthy people who take government jobs and are forced to sell assets.
Paulson also sold about $25 million of holdings in a Goldman fund whose sole asset was a stake in Industrial & Commercial Bank of China, the world's largest publicly traded financial institution. The bank raised $22 billion in its initial public offering in October 2006, the world's biggest IPO. Managing the U.S. relationship with China is an increasingly important part of the Treasury secretary's job. During the Fannie and Freddie crisis in July, Paulson used his credibility with Chinese leaders to reassure them that the U.S. mortgage companies weren't in jeopardy.
"I clearly talked with the Chinese through this," Paulson says. "They've worked with me enough that they knew I wouldn't say it unless I believed it." Chinese institutions own more than $30 billion of Fannie and Freddie paper, according to estimates by CLSA Ltd., the Hong Kong-based investment banking arm of France's Credit Agricole SA. Two-thirds of that, or $20 billion, is owned by Bank of China Ltd., the country's third-biggest lender. China Construction Bank owns the second-largest amount, $7 billion.
Paulson has had some success with his attempts to get the Chinese to allow their currency, the yuan, to strengthen against the dollar. In 2005, while Snow was Treasury secretary, the People's Bank of China, the central bank, abandoned a system of fixed exchange rates and began setting a daily "reference rate" for the yuan versus the U.S. currency. The Chinese central bank, which has the largest currency reserves in the world, allows the yuan to fluctuate as much as 0.5 percent on either side of the daily rate.
U.S. officials argue that China -- the second-largest U.S. trading partner -- keeps its currency artificially weak, which makes Chinese exports more attractive in global markets. The U.S. trade deficit with China was $117 billion in the first six months of 2008, almost unchanged from a year earlier, according to Commerce Department data.
Paulson has cajoled the Chinese into letting the currency strengthen. Since he arrived at the Treasury, the yuan has risen about 14 percent against the dollar. That's a start, Paulson says. He'd like it to increase more. Paulson says he's laid the groundwork for the two countries to work out future problems with the Strategic Economic Dialogue, a twice yearly U.S.-China economic summit he established in September 2006. The summit is a dialogue, not a negotiation, with both sides able to set the agenda.
"You can't have a discussion if one side doesn't want to talk about it," says China expert Donald Straszheim, vice chairman of Roth Capital Partners, a U.S. investment bank specializing in emerging markets. Paulson also convinced lawmakers, some of whom had been calling for measures to punish China, to be more patient with the emerging economic behemoth. Paulson has tried to focus the talks with China on the potential benefits an exchange-rate overhaul could bring to China's economy, McCormick says.
The Treasury secretary wrote an article for the September/October issue of Foreign Affairs outlining how a stronger currency could benefit China, including curbing inflation, which has been rising there. Paulson's bid to revamp Social Security failed to change policy. Democrats balked at the Bush administration's proposal to create private investment accounts for individuals to manage their retirement money.
Republicans, meanwhile, ruled out raising payroll taxes to help bankroll the pension deficits that loom as baby boomers retire. In 2007, Paulson tried to revive the issue by establishing a set of assumptions about the pension program that both parties could live with. Despite Paulson's efforts, they couldn't agree.
Paulson says just getting the issue on the table is an accomplishment. "My objective -- and we put out a series of reports and continue to -- has been to depoliticize the issue and do some things that make it easier for the next person sitting in the seat," he says. Paulson was able to bridge the divide between the two parties with the economic stimulus program, aimed at keeping the U.S. economy from tipping into a recession.
Paulson says he began to lay the groundwork in December 2007 and early 2008. He held hours of conversations on Capitol Hill with a wide swath of lawmakers. Finally, he hammered out the details of the plan behind closed doors with House Speaker Pelosi and Minority Leader Boehner. Congress passed a $168 billion package in February, marking Paulson's first major success in Washington. Some $92 billion in rebate checks had been mailed out to taxpayers at the end of July, with the aim of stimulating spending.
So far, the economy hasn't sunk into a recession: It grew 1.9 percent in the second quarter, up from 0.9 percent in the first quarter. Paulson's consensus-building style has its critics, too. He has been slow to respond to market crises and is overactive when he does engage, says Congressman Ron Paul, a Texas Republican who ran an unsuccessful 2008 presidential campaign. "Behind the scenes, they're always trying to prop things up," Paul says. "I think Barney Frank sort of likes him, which to anybody who may have believed in the free markets ought to raise questions."
One of Paulson's next challenges is to try to build a U.S. market for covered bonds. The instruments allow banks to raise money while keeping mortgage loans on their books, using the actual assets as collateral, instead of packaging them into mortgage-backed securities. First used in the 18th century by Prussia's Frederick the Great, covered bonds are a thriving $3 trillion market in Europe, where there is no equivalent of Fannie Mae or Freddie Mac. The bonds never caught on in the U.S., where just two banks, Bank of America Corp. and Washington Mutual Inc., have issued them.
Paulson sees the bonds as an opportunity to shore up the $12 trillion housing finance market. The idea has potential, observers say. "I think it will give investors confidence," says Texas Tech law professor Ann Graham, who edits the Banking Law Prof Blog. "It's another way to get liquidity into the housing market, and that's very important if we want a turnaround."
Paulson used his Wall Street connections as well as those he's made in Washington. In June, Treasury officials met with banks and investors behind closed doors to see what the market was lacking. Paulson also backed the Federal Deposit Insurance Corp.'s efforts to update regulations on how the bonds would be treated during a bank failure.
Then, in July, Paulson held a press conference to announce new guidelines for a U.S. covered-bond market. He was flanked by all four major U.S. bank regulators and representatives from "future issuers" -- the four largest U.S. banks. The goal was to advance the covered-bond market without putting anyone out on a limb, says Neel Kashkari, a Treasury assistant secretary who followed Paulson from Goldman Sachs. "If we get the issuers, the dealers and the investors to move at the same time, nobody has the risk of going first," he says.
As he navigates through economic turmoil, Paulson has still found time to work on one of his favorite causes: the environment. He's trying to start a $10 billion international fund under the auspices of the World Bank that would help emerging-market countries avoid investments in heavily polluting infrastructure. The proposed Clean Technology Fund has gotten $6 billion in informal commitments so far, McCormick says. Congress is considering the administration's request to kick in $2 billion.
Even in his globe-trotting days at Goldman, Paulson served as chairman of the Nature Conservancy and sat on the board of the Peregrine Fund, which works to protect endangered birds of prey. His office at Treasury is overrun by critters: photographs of otters, alligators and birds, as well as snapshots of him holding snakes and fish he caught.
Paulson, who's ruled out staying on at Treasury after Bush leaves office in January, says his next role may well be at an environmental group. "A big part of my life will be devoted to conservation and the environment," he says. "The only thing that isn't a certainty is whether that will be my primary or sole focus." Whatever the role, this will be the first plan in a long time for which Paulson doesn't have to consult anybody other than his wife.