Debt Rattle, August 3 2008: Awful News for British Banks Day

National Photo Company Collection Housing Boom 1923
"Allied Asphalt Products Co., 4700 block of 8th St."
The Joseph Shapiro Company Exhibit House at Eighth and Crittenden streets N.W. in Washington, D.C.

Ilargi: With Friday now renamed "US Bank Failure Day", we should perhaps opt to re-baptize Sunday as "Awful News for British Banks Day".

British home prices fell by 10%. That returns them to 2006 levels.

Now, remember, a few days ago, Meredith Whitney said that even a return to 2002-2003 home price levels in the US is "mathematically impossible", i.e. prices will go below what they were then (33% lower than the 2006-2007 peak).

She based that on the fact that 85% of the capital involved since 2000 was provided by mortgage securitization, and that instrument has now largely disappeared. Hence: there is no equity left in the system, whether it’s real or virtual. As Whitney stated, all equity that is now raised is used only to plug the holes that were created prior.

UK price levels in 2002-2003 were also about 33% lower, at least. And in Britain the mathematical possibility -and likelihood- follow the same pattern as that in the US. In other words, British prices also MUST come down more than 33%. UK banks are beyond life support, hanging on by their toe-nails, and not capable of lending: mortgage approvals are down 68%! Standard & Poor’s predicts a further 17% fall in the next 8 months, a loss of $60.000 dollars per average home, $7500 per month, or about $250 every single day.....

There is, however, yet another added factor in the UK, compared to the US. Whereas American home prices doubled from trough to peak, those in Britain about tripled. That points to an even far steeper decline. The 10% reported today, then, is merely a beginning. Housepricecrash has a hilarious (and deeply sad, if not downright criminal) list of predictions for where prices will be next year.

Logic and history dictate that prices must come down by 50% in the US and over 60% in the UK, just to get back to where they came from. However, that is still not the whole story: a large trendline-breaking upswing in a system is typically followed by an even larger downswing.

But let’s forget about the oscillation factor for a moment. Respective real estate value declines of 50% and 60% can only lead to one outcome: the complete destruction of the US and UK economies. In systems terminology: there is no flexibility or resilience left in the economic and financial systems. They have been stretched to the limit, and are about to snap.

And that is why I am 100% sure that home prices will keep on falling, and lose over 80% of their peak values. In the US, Canada, all of Europe, Australia, and most of Asia, including China and Japan. It is inevitable in a world where money and credit are busy vanishing into thin air.

A house is worth only what someone is willing to pay for it.



Halifax: British house prices slump by 10%

The housing market is falling at more than 10 per cent year on year, the most dramatic collapse in the sector's recorded history, the Halifax mortgage bank will reveal this week.

Even in the 1990s, Britain did not face double-digit annual falls in house values. The figures will show the cost of the average UK purchase fell below £180,000 in July, returning prices to mid-2006 levels. That compares with a peak of £199,600 last August.

In June, Halifax forecast house prices would fall by up to 9 per cent this year but its figures will show the annual rate already exceeds that. However, when the bank's parent, HBOS, last week revealed profits hit by provisions against falling property values it admitted the consensus is for prices to fall 15 to 20 per cent during 2008 and 2009.

The market has been hit as the credit squeeze restricts loans to would-be buyers and reduces demand from people reluctant to purchase an asset falling in value. Halifax's former chief executive, Sir James Crosby, told the Government last week that the market will remain mired for at least three years.

Halifax prepares its statistics amid great secrecy and regards them as so stock-market sensitive it will not even confirm when they will be announced to the City. It now calculates its headline rate by comparing quarterly figures with the same three-month period a year earlier rather than comparing month with month.

It claims this method smooths out short-term fluctuations but it has consistently underestimated the rate of fall. Halifax claimed the annual fall in June was 6.1 per cent, for instance, when house prices were actually 8.9 per cent below June 2007's level. July's headline rate will be suppressed by using the quarterly calculations but the actual fall will exceed 10 per cent for the first time.

The previous fastest fall in house prices was 8.7 per cent in 1992. Between 1989 and 1993 the market fell by 14.7 per cent.

---

Banking goes from bad to worse as more big names see profits fall

The health of Britain's retail banks will once again come under the microscope this week with HSBC, Barclays and Royal Bank of Scotland (RBS) all expected to detail hefty falls in profits during the first half of the year.

Only Standard Chartered, the Asia-focused bank led by Mervyn Davies, which reports on Tuesday, is expected to post a growth in profits. Analysts expect profits during the first quarter to have jumped by more than one fifth.

In contrast, RBS's chief executive, Sir Fred Goodwin, is expected to announce that the bank lost £1.2bn during the first half of the year at its interim results on Friday. The first half of 2007 saw RBS scoop profits of £5bn.

Sir Fred is also set to update the market on whether the floundering sale off the company's insurance business (RBSi), which initially came with a price tag of near £7bn, will be scrapped. It is thought that Allstate, the American insurance group, which is being advised by Lehman Brothers and JPMorgan, is the only serious bidder left in the race.

Sources close RBS attempted to talk up the chances of a deal last week, saying: "There really isn't as much distance between Sir Fred's valuation and the price coming from the bidder."

Failure to offload the RBSi unit is likely to heap further pressure on Sir Fred, who is still out of favour with many City investors over his U-turn on a £12bn rights issue and the bank's role in the £72bn purchase of ABN Amro at the top of the market last year. Some investors have told RBS's adviser Merrill Lynch that Sir Fred has a year to save his job.

Shares in RBS closed up more than 1 per cent on Friday at 215.25p – nearly 400p shy of the bank's stock price a year ago. Meanwhile, John Varley, Barclays' chief executive, who lost out in his tussle with Sir Fred to win the Dutch bank ABN Amro last year, is expected to reveal a fall in profits during the first half of the year of £1.5bn to £2.6bn, amid continued City cynicism that the bank is underplaying the extent of its losses linked to the credit crunch.

In June, Barclays tapped up a raft of sovereign wealth funds to the tune of more than £4bn to shore up its balance sheet and improve its ailing capital ratios. Shares in Barclays closed up more than 1 per cent on Friday at 341.5p – less than half the value of the company a year ago.

On Monday HSBC, the UK's biggest bank, will kick off the week's proceedings when it is expected to reveal that profits during the first half of the year have plunged by £2bn, compared with £5bn at the same time last year. The spotlight will once again fall on the performance of the group's US operation, the failure of which prompted the first-ever profits warning in its 143-year history in February last year.

Analysts expect American impairment charges to come in at $7bn (£3.5bn), a fact that is sure to be seized upon by a rebel shareholder, the Monaco-based hedge fund Knight Vinke, which has been mounting a campaign for the break-up of HSBC for much of the past year.

But one City source said scathingly: "After their [Knight Vinke's] showing at the recent AGM, I doubt they'd have the gall to pop up again." This week's slew of banking results comes after Lloyds TSB and HBOS posted profit falls in excess of 70 per cent at the end of last month.

Alliance & Leicester, which is subject to a bid from the Spanish banking giant Santander, said last Friday that its pre-tax profits during the first half of the year had come in at just £2m, compared with nearly £300m during the same period last year.

---

Royal Bank of Scotland poised for biggest loss in UK banking history

The Royal Bank of Scotland is poised to unveil the biggest loss in UK banking history after taking a hit of almost £6 billion from the credit crisis.

Britain’s second-largest bank is this week expected to reveal a pre-tax loss of at least £1 billion for the first six months of the year, with analysts warning it could slide to as much as £1.7 billion in the red. The loss would be roughly five times higher than the deficit racked up by Barclays in 1992 at the height of the last recession.

RBS chairman Sir Tom McKillop is already under pressure from investors after the bank’s recent £12 billion rights issue. His chief executive, Sir Fred Goodwin, who marks 10 years at the bank this weekend, also faces shareholder scrutiny. The bank is scouring the world to find three new non-executive directors to shore up its board in response to shareholder concerns.

The RBS figures will cap another terrible week for Britain’s biggest banks as the credit crisis continues to take its toll. HSBC is expected to write off almost $7 billion (£3.5 billion) in bad debts at its struggling American business from the first six months of the year. The charge will drag its profits roughly 30% lower to about $10 billion.

Barclays is forecast to reveal a 35% drop in profits to £2.6 billion as bad debts around the world, particularly in South Africa, combine with further losses from its exposure to the credit markets. Some analysts believe Barclays could chalk up another £3 billion of writedowns, in addition to the £1.7 billion it recorded in the first quarter.

The only bright spot will be results from Standard Chartered, which makes its money in emerging markets, particularly in Asia. The bank is expected to announce a 21% jump in profits to $2.4 billion. Across the banking sector, analysts and investors are fretting about rising bad debts. Figures from HBOS and Lloyds TSB last week revealed that the credit crisis has now worked its way into the real economy, with individuals and companies struggling in almost equal measure.

Both banks announced that bad debts had jumped more than 30%. Alliance & Leicester, which is poised to be sold to Spain’s Santander, revealed that its profits had been wiped out by problems caused by the credit crunch. All Britain’s big banks are considering selling parts of their businesses.

HBOS confirmed last week that it was reviewing a number of potential asset disposals, and admitted it had begun to wind down its off-balance-sheet funding vehicle, Grampian. Expectations are mounting that the bank’s Australian business could be put up for sale.

RBS is in advanced talks with Allstate, the American insurance group, about a sale of its insurance operations, which include Direct Line and Churchill. Allstate is said to be willing to pay substantially less than the £7 billion asking price attached to the business when RBS put it up for auction in April.

However, RBS holds the business on its balance sheet at a carrying value of only £3 billion. Even a sale priced at £5 billion may prove tempting to Goodwin, who has promised investors that he will generate £4 billion of capital from disposals before the end of the year.

The £3.6 billion sale of Angel Trains, coupled with the £1 billion sale of Tesco Personal Finance and a handful of smaller deals, are thought to have generated about a quarter of the total target. RBS is also thought to be close to selling an Australian corporate-finance business, acquired when it took over ABN Amro, to Commonwealth Bank of Australia. A sale of Saudi Hollandi Bank could also be on the cards.

---

Ilargi: A thorough overview of the UK finance fiasco from the Times. Click the link for the whole article.

Just when British banks thought it was safe to go back into the water . . .

Matthew Prest knows he is about to get busy. As head of Close Brothers’ European restructuring business, he gets going when companies find themselves in trouble. After reading the accounts posted last week by HBOS and Lloyds TSB, two of Britain’s biggest banks, Prest is preparing for a bonanza.

The banks last week revealed that bad debts jumped by more than 30% in the first six months of the year, resulting in a collapse in profits. On Friday, Alliance & Leicester also revealed increasing problems in parts of its business, saying its profits had been all but wiped out by the credit crisis. This week, similar trends of rising bad debts, particularly in corporate loans, are expected to emerge from HSBC, Barclays and Royal Bank of Scotland.

One year on from the onset of the global credit crunch, the deeper consequences of the crisis are beginning to emerge. What started as a problem in the financial system, sparked by American sub-prime mortgages, is now hitting business squarely on the chin.

Within the next few weeks a fresh wave of corporate insolvencies is likely to swamp the British economy. While that spells good news for Prest and his peers in the insolvency business, it also means that Britain’s banks have a long and difficult road ahead of them. “This is just the tip of the iceberg,” said Prest. “There’s a lot more to come. The problems in the corporate economy are only just beginning to appear.”

Corporate Britain owes its banks a shade over £545 billion, according to figures from the Bank of England. This figure is within a hair’s breadth of the total annual spending of the British government, across all departments. While the threat of crisis in the mortgage market has been looming for some months, corporate Britain had until recently been considered more resilient.

Now, as soaring energy costs add further pressures to an economy weighed down by the credit crisis, bad loans to UK plc look set to create the second wave of the problem. “Companies went into this downturn looking very strong,” said Peter Spencer, chief economic adviser to the Ernst & Young Item Club. “Profitability, even in manufacturing, was high. In the service sector it was remarkable — an all-time high. Cash flows were very strong.

“Companies had been rebuilding their balance sheets rather than spending on investment, much to the prime minister’s chagrin. I thought that was quite a strong platform. Having said that, when you look at some of the latest Bank of England data, there are some real weak spots. Companies are now in exactly the same kind of jam that consumers are in.”

HBOS last week wrote off close to £1 billion to cover losses from its corporate loan book. The charge is almost twice the size of the provision the bank took against its £237 billion mortgage book, which had been thought by many commentators to be a bigger concern.

The size of the debt charge is comparatively small, amounting to less than 2% of its total corporate lending. Given the boom in the value of loans, however, the percentage figure does not need to be very high to run into many billions of pounds. This matches historical trends. Across the British banking industry, the default rate on corporate loans was about 0.6% last year.

Even at the height of the recession in the early 1990s, only about 2% of corporate loans ended up defaulting, causing considerable problems for the banking sector. HBOS chief executive Andy Hornby did little to boost confidence, warning of “upward pressure on impairment losses”. He added that “in corporate, we are not currently seeing material signs of tenant default, but the deteriorating economic climate is likely to put some further pressure on impairments”.

Lloyds TSB, meanwhile, revealed that bad debts had almost doubled in its commercial banking business, which deals with smaller businesses. Again the percentage figure was low, but across the banking sector as a whole it is corporate loans that are now worrying analysts more than anything else.

“Lloyds has been the bank that has been telling everyone that nothing is as bad as it seems,” said one analyst. “When they came out with their results, it became a little more difficult for them to argue that. As the reporting season goes on we are going to see more bad debts, more problems.”

Alliance & Leicester’s business bank was performing better than most, with arrears actually falling in its small, specialised corporate lending book, though this does not reflect the broader story. Barclays and Royal Bank of Scotland will inevitably come under the same close scrutiny over their corporate bad-debt charges later this week, along with HSBC. The City is unanimous in its belief that the figures will show further signs of weakness.

“We believe that corporate-lending credit-loss charges will once again prove the biggest variable in bank profits in an economic downturn,” said Robert Law, an analyst at Lehman Brothers. One of Britain’s biggest banks conducts regular surveys of its corporate customers. At the start of the year, 70% of business leaders polled said they expected their order books to increase this year.

“When we repeated the exercise a month ago the figures were completely reversed,” said a senior executive at the bank. “There are now 70% of businesses telling us they expect their order books to decrease this year.” That drop in corporate confidence is expected to be reflected later this week in closely watched reports due to be published by the CBI and the Purchasing Managers’ Index.

The fragility of consumer confidence was hammered home last week when the key GfK consumer confidence index slipped further than expected to a 34-year low. The latest report from Nationwide, meanwhile, revealed that UK house prices have dropped more than 8% in the past year, after a ninth consecutive month of declines.

The rating agency Standard & Poor’s then predicted a further 17% fall between now and next April, which would knock another £30,000 or so from the value of the average British home. The projection is in line with estimates produced by HBOS and Lloyds TSB, and would leave some 1.7m British households in negative equity, Standard & Poor’s said.

Senior executives at some of Britain’s biggest banks say they are starting to monitor consumer spending patterns through transactions on credit cards and current accounts. “Our customers are pulling back somewhat,” said one banker. “People are not going to pubs but buying beer and staying at home. They are denying themselves luxuries and spending more on necessities.”

This behaviour is probably good news for the banking sector’s retail-lending operations, but could spell further disaster for parts of corporate Britain. Floors 2 Go, a wooden flooring retailer, went into administration two weeks ago. The General Trading Company, a Chelsea-based emporium that provided the wedding list for the Prince of Wales and the Duchess of Cornwall’s 2005 wedding, has also collapsed recently.

Wrapit, an online wedding-list firm, is teetering on the brink of administration and Sister Ray, an independent record store in London’s Berwick Street, went into administration late last week. Dozens of other retailers have already gone under this year as a result of heavy borrowing costs and falling consumer spending.

Insolvency experts are now waiting for September 25, the next “quarter day” for retailers, when store rents are due to be paid. Expectations are mounting that these rent payments could sound the death knell for a number of struggling outfits. This would in turn spell trouble for the banks that are owed money.

“We have had a primarily consumer-led economy in Britain for the past 10 years,” said Close’s Prest. “Every indicator tells you that consumers are feeling the pinch. Things are very bad out there.”

---

Ilargi: SeekingAlpha throws the last bits of hope out the window in a pretty brilliant analysis.

Is the U.S. Banking System Safe?

• "Treasury Secretary Henry Paulson delivered an upbeat assessment of the economy, saying growth was healthy and the housing market was nearing a turnaround. 'All the signs I look at' show 'the housing market is at or near the bottom,' Paulson said in a speech to a business group in New York. The U.S. economy is 'very healthy' and 'robust,' Paulson said. (CBS Marketwatch 4/20/07)
  
• “At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”  (Ben Bernanke during Congressional Testimony 3/2007)
  
• "We will follow developments in the subprime market closely.  However, fundamental factors—including solid growth in incomes and relatively low mortgage rates—should ultimately support the demand for housing, and at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system."  (Ben Bernanke 6/5/07)
  
• "It is not the responsibility of the Federal Reserve—nor would it be appropriate—to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy." (Ben Bernanke 10/15/07) 
  
• “We’ve got strong financial institutions…Our markets are the envy of the world. They’re resilient, they’re…innovative, they’re flexible. I think we move very quickly to address situations in this country, and, as I said, our financial institutions are strong.” (Henry Paulson 3/16/08)

                     
After reading the above quotes, it should be clear to you that these gentlemen do not have a clue. Our economy and banking system is so complex and intertwined that no one knows where the next shoe will drop. Politicians and government bureaucrats are lying to the public when they say that everything is alright. They do not know. Therefore, it is in our best interest to cut through all the crap and examine the facts with a skeptical eye.

Last week, bank stocks, which had been falling faster than President Bush’s approval rating, soared higher based on earnings reports that were horrific, but not catastrophic. Again, the talking heads, like Larry Kudlow, were calling a bottom in the financial crisis.

The bank with the largest increase in share price was Wells Fargo. Their earnings exceeded analyst expectations and the stock went up 22% in one day. Wells Fargo has $84 billion of home equity loans, with half of those in California and Florida.

Coincidently, Wells Fargo decided to extend its charge-off policy in the 2nd quarter from 120 days to 180 days, in an effort to give troubled borrowers more time to reach a loan workout. A skeptical person might think that they did not change this policy out of the goodness of their hearts. Maybe, just maybe, they changed this policy to reduce their write-offs for the 2nd quarter, to beat analyst expectations.

There are many stories of people who are still living in houses, twelve months after making their last mortgage payment. Their banks have not started foreclosure proceedings. Is this due to incompetence by the banks, or is this a way to avoid writing off the loss?

The FASB has joined the cover-up gang by delaying the implementation of new rules that would have made banks stop hiding toxic waste off-balance sheet. The new rule would have made banks put these questionable assets on their balance sheet and would have required a bigger capital cushion

What a surprise that bank regulators, the Treasury and Federal Reserve urged a delay in implementation. Manipulate the facts because the average American doesn’t understand or care. Sounds like Enron accounting standards to me.

During the S&L crisis in the early 1990s, 1,500 banks failed. So far, seven banks have failed in 2008, the largest being IndyMac. The FDIC has about $53 billion in funds to handle future bank failures. The IndyMac failure is expected to use $4 to $8 billion of those funds.

Average Americans will lose $500 million in uninsured deposits in this failure. The FDIC says that they have 90 banks on their “watch list”. They do not reveal the banks on the list, so little old ladies with their life savings in the local bank will be surprised when they go belly up. Based on the fact that IndyMac was not on their “watch list”, I wouldn’t put too much faith in their analysis.

There are 8,500 banks in the U.S. Based on an independent analysis by Chris Whalen from Institutional Risk Analytics, they have identified 8% of all banks, or around 700 banks as troubled. This is quite a divergence from the FDIC estimate. Should you believe a governmental agency that wants the public to remain in the dark to avoid bank runs, or an independent analysis based upon balance sheet analysis? The implications of 700 institutions failing are huge.

There is roughly $6.84 trillion in bank deposits. It is almost beyond belief that $2.6 trillion of these deposits are uninsured. There is only $274 billion of the $6.84 trillion as cash on hand at banks. This means that $6.5 trillion has been loaned to consumers, businesses, developers, etc. The FDIC has $53 billion to cover $6.84 trillion of deposits. Does that give you a warm feeling?

Based on the chart below, I would estimate that we are only in the early innings of bank write-offs. The write-offs will at least equal the previous peaks reached in the early 1990s. If a large bank such as Washington Mutual or Wachovia were to fail, it would wipe out the FDIC fund.

If the FDIC fund is depleted, guess who will pay? Right again, another taxpayer bailout. What’s another $100 or $200 billion among friends.


What is a Level 3 Asset? Other banks have been moving assets to Level 2 and Level 3 in order to put off the inevitable losses. The definition of these levels according to FAS 157 are as follows:

1. Level 1 Assets that have observable market prices.
   
2. Level 2 Assets that don’t have an observable prices, but they have inputs that are based upon them. 
   
3. Level 3 Assets where one or more of the inputs don’t have observable prices. Reliant on management estimates. Also known as mark to model. 

This is Warren Buffet’s view on the financial institution practice of valuing subprime assets on the basis of a computer model rather than the free market price.

In one way, I'm sympathetic to the institutional reluctance to face the music. I'd give a lot to mark my weight to 'model' rather than to market.

So, the managements of the banks that loaned money to people who could never pay them back are now responsible for estimating what these assets are worth. According to Bill Fleckenstein:

Recently, the portfolio of Cheyne Finance, one of the more infamous structured-investment vehicles, or SIVs, was sold at 44 cents on the dollar. I suspect that similar assets are not marked anywhere near that valuation on financial institutions' balance sheets. So, the game of "everything's contained" continues, albeit in a different form.

Merrill Lynch – Poster Child for Lack of Bank Credibility. John Thain is the Chairman and CEO of Merrill Lynch. He makes in excess of $50 million per year in compensation. He previously held positions as President, COO and CFO at Goldman Sachs. He is a good buddy of Hank Paulson.

• "We deliberately raised more capital than we lost last year ... we believe that will allow us to not have to go back to the equity market in the foreseeable future." (April 8, 2008 -- Thain to reporters in Tokyo, as reported by Reuters)
  
• "Right now we believe that we are in a very comfortable spot in terms of our capital." (July 17, 2008 -- Thain on a conference call after posting Merrill's second-quarter results)

Merrill Lynch reported a loss of $4.7 billion for the 2nd quarter on July 17. On July 28, eleven days after this earnings report they announce a $5.7 billion write-down and the issuance of $8.5 billion of stock. Thain, the $50 million man, is either lying or completely clueless regarding the company he runs. The SEC needs to investigate him, rather than short-sellers. Their books are a fraud and anything their CEO says cannot be trusted. Below is Barry Ritholtz’ assessment of the Merrill Lynch deal:

• Merrill appears to be moving $30.6 billion dollars of bad paper off of their books.
  
• This paper was carried at a value of $11.1, meaning there was almost $20B in prior   related write downs. 
  
• After this transaction, Merrill’s ABS CDO exposure in theory drops from $19.9 billion to $8.8 billion (hence, the $11.1B number). 
  
• The $6.7B purchase price relative to the $30.6B notational value is 21.8% on the dollar.
  
• Merrill is providing 75% of the financing –- and MER’s only recourse in the event of default is to retake the CDO paper back from the buyer.
  
• While Merrill hopes to be made whole, the reality is they still have potential exposure to these ABS CDOs via the financing; 
  
• Actual sale price = 5.47% on the dollar 
  Less than five and half cents on the dollar? That's an even cheaper sale than originally advertised. What this transaction actually accomplishes is getting the paper -- but not the full liability -- off of Merrill's books. How very Enron-like !

Merrill Lynch has a market cap of $24 billion and has raised $30 billion since December just to keep making their payroll. How long will investors be duped into supporting this disaster? You can be sure that the other suspects (Citicorp, Lehman Brothers, Washington Mutual) will be announcing more write-downs and capital dilution in the coming weeks.

The one person who has been consistently right regarding the housing market is Yale Professor Robert Shiller. (He also called the top in the stock market in 2000). The following chart clearly shows that home prices are so far out of line with historical averages that there is no doubt that further decreases are in store.


Home prices have historically tracked inflation and are likely to revert to the mean. The latest data from Case-Shiller does not paint a pretty picture. Sale prices of existing single family homes declined by 15.8% in the past year, with markets in California declining by 22% to 28%. Over 10% of the U.S. population lives in California. Bank of America, Wells Fargo, Washington Mutual, and Wachovia have a large exposure to California.


Many pundits have been downplaying the resetting of adjustable rate mortgages, saying that the worst is over. I don’t think so. There are $440 billion of adjustable mortgages resetting this year. That means that the majority of foreclosures will not occur until 2009.

This means that the banks will still be writing off billions of mortgage debt in 2009. The reversion to the mean for housing prices and the continued avalanche of foreclosures is not a recipe for a banking recovery. Home prices have another 15% to go on the downside.


Fannie & Freddie Fiasco President Bush signed the Housing Recovery bill this week. We are now on the hook for all of their bad decisions. We believe in capitalism when there are obscene profits, but we prefer socialism when it comes to losses. The CBO estimates that we will pay $25 billion for their mistakes, with a 5% chance that it reaches $100 billion.

The only problem is that they have been given an open ended guarantee. According to former Fed governor William Poole, Fannie Mae is technically insolvent. Their shareholder equity was $35.8 billion at the end of 2007. It plunged by $23.6 billion to $12.2 billion as of March 31, 2008. Does anyone think that as of June 30, they have any equity left? We’ll know shortly. Fannie Mae has guaranteed $2.4 trillion of mortgages.

According to the Mortgage Bankers Association, as of June, 2.5% of U.S. mortgages were in foreclosure and 6.4% of mortgages are delinquent. Fannie and Freddie are on the hook for $5.2 trillion in mortgages. It doesn’t take a rocket scientist to figure out that about 4% of the $5.2 trillion of guaranteed mortgages will default.

This would be $208 billion in defaults. If they are able to recover 50% (current recovery rate) from foreclosure sales, their losses would be $108 billion. Oh yeah, that would be our losses. This is assuming things don’t get worse.

How High Will the Losses Go Banks and security firms have reported $468 billion of losses thus far. Bridgewater Associates, a well respected analytical firm, thinks things will get much worse. According to Bridgewater, the models used have grossly underestimated the actual losses. They doubt the financial institutions will be able to generate enough capital to cover the losses. According to the report,

Lenders would have to curtail loans by roughly 10-to-one to preserve their capital ratios. This would imply a further contraction of credit by up to $12 trillion worldwide unless banks could raise fresh capital.

Not all of these losses are in the sub-prime market. According to the report, more than 90% of the losses from sub-prime loans have already been written off. Unfortunately, the losses from the prime and Alt-A loans could be much larger than we have already seen. The sizes of these loan portfolios are much larger than the sub-prime portfolios. Further, Bridgewater expects about $500 billion in corporate losses that must be written off. This leads to the current estimate of more than $1 trillion in losses yet to be written off.


Bill Gross, the well respected manager of the world’s largest bond fund, expects financial firms to write down $1 trillion.

About 25 million U.S. homes are at risk of negative equity, which could lead to more foreclosures and a further drop in prices. The problem with writing off $1 trillion from the finance industry's cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth.

Nouriel Roubini, economist at NYU, believes that losses could reach $2 trillion. The other shoes have begun to drop. Last week Amex reported a 40% decline in earnings as their wealthy super-prime customers are not paying their bills. So, even the well off are struggling.

This week, CB Richard Ellis, the largest commercial real estate broker in the country reported an 88% decline in earnings. So, commercial real estate is imploding. Bennigans’s and Mervyn’s filed for bankruptcy this week. The consumer is being forced to cut back on eating out and shopping.

The marginal players will fall by the wayside. Big box retailers, restaurants, mall developers, and commercial developers are about to find out that their massive expansion was built upon false assumptions, a foundation of sand, and driven by excessive debt.

The U.S. banking system is essentially insolvent. The Treasury, Federal Reserve, FASB, and Congress are colluding to keep the American public in the dark for as long as possible. They are trying to buy time and prop up these banks so they can convince enough fools to give them more capital. They will continue to write off debt for many quarters to come.

We are in danger of duplicating the mistakes of Japan in the 1990s by allowing them to pretend to be sound. We could have a zombie banking system for a decade.

---

Recession fears as America sheds jobs

Americans have begun to lose their jobs at the fastest rate in five years as the slow poison of the US credit crunch spreads through the broader economy.

Fresh unemployment claims reached 448,000 last week - the highest since the dotcom bust - heightening fears that the summer fiscal package may not be enough to prevent a slide towards recession over coming months. It follows data showing an extra one million employees have been relegated from full-time to part-time jobs over the last year, a pattern that has disguised the true level of weakness in the labour market.

"We think the economy will contract outright in the second quarter," said Paul Ashworth, US economist at Capital Economics. The US Treasury has injected the equivalent of 4pc of GDP into the economy in the second quarter through one-off rebate checks. This stimulus is now fading from the picture.

The slowdown sweeping the world will knock away the export pillar that has helped keep US firms afloat through the crisis. Exports were up 9.2pc in the second quarter. "We're in a recession. It is going to widen, it's going to deepen," said Allen Sinai from Decision Economics. The Commerce Department said the economy had eked out growth of 1.9pc (annualised) in the second quarter, a far weaker figure than expected.

It sharply downgraded its estimates for growth all the way back to 2005, confirming long-held suspicions that the US government has persistently over-stated the strength of the US economy. It also revealed that growth had turned negative late last year.

Optimists say that the surprise jump in US jobless claims was due to an "outreach effort" by the US government to encourage the unemployed to sign up for benefits. They argue that a strong inventory build-up in the second quarter sets the stage for a rebound driven by restocking.

US Treasury Secretary Hank Paulson insisted yesterday that growth would last through the second half of the year. He said the property market would stabilise "in months rather than years", helped by the Treasury's rescue of mortgage giants Fannie Mae and Freddie Mac.

Bill Gross, head of the bond fund Pimco, said a staggering $5,000bn (£2,520bn) of US mortgage securities were now at risk. The "finance industry" will ultimately have to write off $1,000bn in losses - double current estimates - risking a downward spiral as a "negative feedback loop" in the credit system feeds on itself. Half in jest, Mr Gross suggests blowing up one million new homes with dynamite to clear the backlog of unsold property, and then "start all over again".

The Federal Reserves's "dynamic map" of the mortgage crisis shows that 19.4pc of all sub-prime loans in Florida and 14pc in California are in foreclosure. The dollar was pummelled in early trading as the latest blizzard of grim data flashed across traders' screens, not helped by a report from Standard & Poor's warning that US corporate defaults are now rising sharply as firms in trouble find it impossible to secure fresh credit or roll over debts.

S&P said the "distress ratio" of speculative-grade companies rocketed to 23.5pc in July, up from 13pc a month earlier. The complex ratio is regarded as a "precursor" to default. In total, 38 corporations that it rates have gone bankrupt this year with combined debts of $30bn. Combined defaults for the whole of last year were $4bn.

"The cost of funds for private companies has ballooned even as short-term rates and long bond yields have dropped," said Diane Vazza, S&P's managing director for credit. She said companies are carrying a more toxic mix of debt than ever before, and were defaulting at twice the rate of past downturns. Two thirds are now speculative-grade (junk), compared to just 40pc in the downturn of the early 1990s.

The dollar roared back later as a Reuters story sourced to a key insider at the European Central Bank suggested that the eurozone economy may contract in the second quarter, while inflation shows signs of peaking.

"People really sat up and took notice: it is the first time for months the ECB has begun to sound less hawkish," said Paul Mackel, currency strategist at HSBC. Martin van Vliet, senior economist at ING, said the likelihood of fresh rate rises in Europe are dwindling rapidly, despite the July spike in eurozone inflation to 4.1pc, the highest since the launch of the single currency.

"The risk of a sharp economic downturn or even a technical recession in the eurozone has become a worrying reality. By now, growth should be an alarming concern for the ECB," he said.

---

So who says the credit crunch won't run to a second birthday?

'Life changed on 9 August," says Northern Rock's former chief executive, Adam Applegarth, reflecting on the day last summer when his life and his bank fell apart. "That was when the markets froze."

No one will be celebrating the anniversary of the start of the credit crunch this week, and there are few prepared to claim we are even halfway into this global crisis. "There's no way of knowing when it's going to end," confesses Alex Potter, banking analyst at broker Collins Stewart.

Last week Sir James Crosby, the head of HBOS when its Halifax and Bank of Scotland divisions were leading British banks into the crunch, presented the Government with a report saying the housing market will remain in the mire until at least 2010. His old bank reported first-half profits down 72 per cent at £848m.

In the United States – where sub-prime mortgage lending is blamed for the squeeze that has made banks around the world reluctant to lend to each other – Merrill Lynch announced new writedowns and the injection of $8.5bn (£4.3bn) through the sale of new shares, with the takers being the sovereign wealth funds that have been bailing out financial institutions in the West.

Banks are now estimated to have written off almost £250bn assets since last August. And the problems are spreading, with evidence that what began as a financial sector crisis is developing into a business slump. Both Woolworths and Next reported falling sales last week.

With asset prices – from property to shares – on the slide and inflation rising, the current crunch is being compared to the 1970s. But then, Britain had a secondary banking crisis and the big institutions formed a lifeboat to rescue those overstretched secondary firms. This time the major banks are in trouble, with no larger organisations to turn to for help.

In Britain, Royal Bank of Scotland, Barclays, HBOS and Bradford & Bingley have all raised new capital, while Alliance & Leicester has sought the comfort of a new Spanish parent. While the primary banks had the balance sheet strength to rescue smaller lenders 30 years ago, only governments can keep the big banks afloat now.

The state has taken over Northern Rock directly, and through the Bank of England it is injecting £50bn or more into other mortgage lenders to refinance existing home loans, with calls last week for a similar sum to provide funds for new property purchases.

But foreign government agencies, particularly those with reserves boosted by high oil prices, are using the crisis to buy into Western banks. Merrill Lynch's share issue last week will go to sovereign wealth funds in Kuwait and Singapore.

Qatar took a 7.7 per cent stake in Barclays' recent £4.5bn refinancing, with Singapore and China buying smaller holdings, and Citigroup turned to Abu Dhabi for new capital. Banks are also seeking asset sales to free capital and generate cash – like Royal Bank of Scotland's disposal of its joint-venture stake to Tesco last week, the sale of its train-leasing division and attempts to find buyers for its insurance subsidiaries.

Mamoun Tazi, banking analyst at MF Global, is sanguine that when credit markets do unfreeze, sovereign funds will be holding big tranches of Western banks' shares. "If they weren't there, we'd be in a worse position. They've decided to come and help and ultimately they will reap the rewards of their investment."

Even though they have raised more than £20bn, City analysts aren't convinced Britain's banks have sufficient capital. But after the debacles of Bradford & Bingley's fund raising – which had to be repriced and revised twice – and with 92 per cent of shareholders rejecting HBOS's £4bn rights issue, they believe the sector has slammed the door on such issues and locked itself out.

"After the size of HBOS's failure, the price of underwriting an issue will be impossible for others," says Mr Potter at Collins Stewart. "There will now be pressure from central banks to take the big red pencil to dividends."

Mr Potter adds that, usually, a credit crunch follows a recession. "This time we've had the crunch first," he says. But if the economy grinds to a halt or goes into reverse, that will add to the banks' problems as customers – both corporate and personal – default on loans.

"I think we're on the way into recession and we'll see mortgage losses greater than in the early 1990s," he warns. For banks that have so far written down the value of financial instruments, that will mean a new round of provisions on their direct lending.

Paul Dales, UK economist at consultancy Capital Economics, is also preparing for recession, admitting: "It's more likely than not. Consumers are going to get hit hard by a combination of the housing market downturn and inflation. "We see growth falling from 2 per cent this year to flat next year and companies will see their profits fall sharply and won't be able to borrow."

As the financial crisis becomes a business crisis, Mr Dales predicts that unemployment will increase from 1.6 million people to 2.5 million. And while falling house prices do not hit pockets, lost jobs do. "Unemployment is a lagging indicator and will take some time," he adds, adding weight to fears that the anniversary of the credit crunch may not mark the halfway point.

The weakness of the US housing sector should have given warning that financial markets were unstable early last year. But it was only on 9 August, after the French bank BNP Paribas suspended three of its funds with exposure to American sub-prime losses, that banks stopped lending to each other. They were unsure about the quality of the complex instruments they had traded between themselves.

The liquidity crisis pushed up interest rates and forced lenders to seek help from central banks. Among them was Mr Applegarth's Northern Rock, and when its problems raising wholesale finance became known, they were exacerbated by a public run on the bank to withdraw private savings.

If the start of the crunch can be dated to that day 12 months ago, there will be no single time when it ends. No all-clear will be sounded to indicate the crisis is over. Some sectors of the economy will have escaped the squeeze while others continue to be crushed. For some businesses, the effects of the crunch will last for years; others will not survive to see the recovery.

For Mr Dales, the signal that the crunch is ending will be the rates at which banks lend to each other returning to historic levels. The rate is still 80 basis points above the overnight cost of money – better than last autumn's 150 points but well above pre-crunch levels of just 15.

Mr Potter says: "We need to see asset prices stabilise and the reopening of the securitisation markets for banks. But even then it's going to take time to feed through to the consumer." Mr Tazi believes ministers must kickstart the economy to prevent a long slump.

"We're in the middle of a downturn," he says. "How quickly we get out depends on whether the Government puts in place a package to stimulate the economy and cut interest rates."

Ministers and the Bank of England have been criticised for dithering during the first year of the credit crunch. As we enter what could be the second of several years, the pressure is for decisive action with the hope that recession will curb inflation while lower interest rates curb the recession.

---

Some Real Talk on Housing

Another month, another round of negative housing data, and the pattern has become so repetitive that it's hard to think of anything original to say about it. However in the wake of last month's round of "housing bottom" predictions and in recognition of the current round, let's briefly discuss what a bottom to the housing market will actually look like.

The first thing to recognize is that the housing market is merely correcting itself after a period where it was inflated into a bubble by a combination of poor lending standards/practices, over-speculation, over-leveraged and/or under qualified buyers, etc. Now that these "bad actors" have been removed from the market, prices are declining back to where they would be if the housing bubble hadn't occurred.

Once we understand that the housing market is going through a post-bubble correction, we can see that we shouldn't be looking for a bottom as much we should be looking for pricing stability. We also know that pricing stability cannot happen until the housing market has given up nearly all the gains of the housing boom era.

At the moment (per Marketwatch) it appears that we've only turned back the clock to 2004, and have bit of a ways to go before anyone can make any credible claims of housing having reached a bottom.

The other factor to consider is inventory because the housing boom saw a surge in the number of homes being built, and the demand for these homes didn't come from a population surge, it came from speculators, people looking to upgrade, and people who weren't really qualified to be in the housing market. As these people leave the market (or are forced out), the number of vacant homes is steadily increasing. Consider the chart:

As of the end of Q1 the number of vacant homes had nearly doubled from its historical norm of around 1.5% to around 2.9%, a figure doesn't factor in foreclosures or empty homes that have been pulled from the market.

This means that that the actual number of empty homes is higher than the above number indicates, especially in the current era of foreclosures and the pending completions of housing projects that were started during the boom.

Now I've always suspected that many housing development projects were being primarily built in response to demand from the speculators who accounted for 25-33% of homes purchased during the boom. If I'm right it means that there isn't enough real demand from people who are actually buying a home to live in to fill up all the new developments.

Additionally, let's not forget that the housing market is unique in that you don't necessarily need new inventory to have a fluid housing market because people buying or often selling (and vice-versa) giving you a musical chairs effect, in other words not all housing sales have an impact on available inventory. These two factors will make combine to make filling up the excess inventory somewhat difficult.

In order to put the level of vacant homes in perspective in terms of what it will take to return to historical averages, consider this passage from the WSJ:

To get this vacancy rate back to something like normal, about one million homes would have to find new owners. With mortgage rates climbing, that could take awhile, short of a ban on new-home construction.

Better yet there would need to be enough people who don't currently own homes (and are financially read to buy) to go out and buy every home currently going through foreclosure, homes that were pulled off the market and to fill up recently (or soon to be) completed housing development projects, then you would need an additional 1 million non-home-owning individuals to come along and purchase homes that are currently empty.

Considering everything that needs to fall into place for the vacancy problem to be resolved, it stands to reason that it's going to take a while for the number of vacant homes to return to historical levels. Unfortunately the vacancy problem is the real issue that needs to be fixed for housing prices to stabilize, because it could serve to put downwards pressure on housing prices even after we give up all of the housing boom era gains.

As you can see it's going to take a lot of things coming together for housing market to stabilize, because not only do we need to shed the pricing gains of 2002-2006, we also need to resolve the inventory problem as well.

Any analyst who isn't discussing a bottom coming to housing in terms of clearing through the vacancy issue and returning prices back to 2002 levels should be ignored, because they're not actually discussing what needs to happen for housing prices to stabilize.

---

The Credit Problem

A long wave of credit stimulation has been allowed to obscure the underlying problem of capital accumulation in the United States. We are paying a price, but not solving the problem.

The political class simply cannot be trusted to provide solutions. They are too interested in retaining power for the sake of power. They do not have the guts to say what needs to be said for fear of alienating some group of supporters. They do not have the integrity to stand on principle and advocate unpopular but necessary policies.

They are too beholden to special interest groups to do what is right for the country rather than what is right for their campaign contributors. It is high time that politicians were held responsible for the damage done by policies intended to benefit the few at the expense of the many.

In this election year, the greatest concern for most Americans is the economy and there is good reason for that. Unemployment, foreclosures and prices are all rising. The stock market, home prices and the dollar are all falling. Economic growth is still positive but well below potential. Americans are rightly worried.

In a recent market commentary, Bill Gross called credit the mother's milk of capitalism. That sentiment, echoed by our politicians and policy makers, is the source of our problems. It is not credit but capital that is the lifeblood of capitalism and the US doesn't accumulate enough capital to support the growth to which we've become accustomed.

The savings rate has ticked somewhat higher over the last few months, but for years we've saved too little and spent too much. The difference to date has been provided by foreigners such as the Chinese who now own over $1 trillion of US debt and Middle Easterners who own even more.

In their efforts to revive the credit markets, the Federal Reserve and their political enablers may have averted an economic crisis in the short term, but the long term implications have yet to be reckoned. Bear Stearns, Fannie Mae and Freddie Mac, deemed too big to fail, were given access to the public purse rather than face the consequences of excessive leverage.

The cure for excessive private indebtedness has been deemed to be more public indebtedness. Private actors will reap the benefits if these transactions turn out profitable while the public will pay the price if they don't.

Large financial institutions were encouraged to take on too much leverage and take too many risks by a Federal Reserve that held interest rates at artificially low levels for far too long. Rather than allow these companies to suffer the consequences of their actions our leaders are working overtime to ensure they continue to take imprudent risks in the future.

The Fed has allowed overleveraged institutions to borrow funds at attractive rates with dubious collateral. Savers are punished with low interest rates while speculative actors are encouraged to find new avenues for their speculation. Oil prices would seem to indicate they've found a new outlet for their speculative impulses.

Likewise the individuals who borrowed too much to buy homes they couldn't afford. I feel for the people who face foreclosure but why should those of us who were prudent be forced to bail out those who weren't? The recently passed housing bill will allow both lenders and borrowers to forgo the consequences of their actions.

And again, if everything works out the lenders and borrowers will benefit while failure is assigned to the taxpayer. It would be better for the foreclosures to proceed and former homeowners to become renters again. The real estate market would face a further increase in inventory but prices could finally fall to market clearing levels. That would make housing affordable for those who have saved and acted prudently.

Over the last 50 years (at least) but especially the last 30, every economic problem has been buried under another layer of credit and government intervention. The Federal Reserve and Congress have worked together to promote an economic environment where failure is deemed a threat to the "system" and all economic ills are "solved" by reducing the cost of credit.

The result is plain for all to see. The US has moved from creditor to debtor nation. Debtors are bailed out through the tax code while savers are consigned to a prison of low interest rates. It is no surprise that we must import capital to cover our debts when we encourage debt and discourage saving.

The long term problems facing our economy will not be solved painlessly. Nor will they be solved by providing more of the same policies that got us to this point. While the Federal Reserve sits at the center of our problems the institution itself is not at fault.

They have been given an impossible dual mission to maintain economic growth and to limit inflation. Having control only over the money supply, it is beyond the capabilities of the Fed to create growth. Inflation and credit expansion do not add anything to the amount of resources available or the capital stock. The Fed cannot create universal prosperity by creating more money.

Inflation consumes precious capital by misdirecting resources into non economic investments. If you have any doubts about that, think of all the empty houses sitting around the country which attracted so much investment over the last decade. The capital devoted to housing was diverted from more productive uses and is now being destroyed as banks are forced to write off the bad loans.

The villains in this story are the inhabitants of our political institutions. They seek to buy our votes with our own money and when they find that is not enough, they turn to the Federal Reserve and the banking system to create more.

Rather than raise taxes to pay for the goodies they promise or the wars they deem necessary, they depend on debt and inflation. They do not create jobs, but destroy them. They do not create equality but exacerbate the divide between the haves and have nots and manipulate the divide to accrue more power.

They do not create capital but rather destroy it. They are not special but mere mortals susceptible to the same failings as all men. They are self interested actors acting on a stage of their own design in a play written for their own benefit.  

It seems evident that the housing bubble that is the source of the current economic malaise was caused by Federal Reserve policy. Does it not seem perverse to turn to the same institution for a remedy? How can they be expected to prescribe a remedy when they obviously don't understand the malady?

It would seem more logical to proscribe the manipulation of interest rates for any purpose other than to achieve price stability. While a gold standard or some other real asset backed currency would be preferable and less susceptible to political manipulation, setting a single goal for the Fed is preferable to the current situation.

Higher interest rates are obviously needed to reduce the inflation evident to everyone except the government statisticians. Higher interest rates would also encourage saving and discourage further debt accumulation.

It also seems evident that the government budget deficit is a result of excessive spending rather than a lack of taxation. Tax revenue has been remarkably stable as a percentage of GDP for many years, ranging between 18% and 21% regardless of tax rates. Right now it stands at 19%.

Furthermore, other countries, such as Hong Kong, are able to collect nearly the exact same percentage of revenue with much lower tax rates. Hong Kong has income tax rates, personal and corporate, of less than 20% and generates a budget surplus while spending over 15% of GDP on government services.

Hong Kong also doesn't tax capital gains or dividends. We do not need higher taxes to generate the revenue needed for essential government services. We do need to decide what is essential. In particular, it is illogical to raise taxes on capital when the basic problem we face is a lack of capital. If anything, taxes on capital should be further reduced to encourage accumulation of the capital needed to fund our growth.

As for income taxes, it is time for Americans to assess the wisdom of taxing the very thing we wish to generate. If it is logical to tax cigarettes to discourage smoking, what is the logic for taxing income? A consumption tax coupled with repeal of the income tax would realign incentives toward a more rational economy based on thrift and savings rather than conspicuous consumption.

Because we keep re-electing the same politicians, we have no one to blame but ourselves. It is time to get angry.

---

Ilargi: Religious publications chime in. They saw it all coming. Of course.

Brace for More Bank Failures

If you are uneasy about the failure of IndyMac Bancorp in July, the second-largest financial institution to close in U.S. history, prepare yourself. The crisis is about to get a whole lot uglier.

Government-sponsored Fannie Mae and Freddie Mac, holders of half the nation’s mortgages, just went down too. It is becoming clear that before all is said and done, the financial wipeout will be bigger than anything America has ever experienced.

It didn’t take much to set off a run on Pasadena-headquartered IndyMac. In a scene resembling the storied collapse of British bank Northern Rock last year, customers lined up by the hundreds and stood in line for hours to try and pull out what money was available before the doors closed. The corporate motto of America’s seventh-largest savings and loan—“Raise Your Expectations”—didn’t do much to comfort depositors, who withdrew $1.3 billion over 11 days.

As a result, the Federal Deposit Insurance Corporation has its hands full. On July 11, the FDIC seized IndyMac and began covering the insured accounts. However, as some hapless savers found out, if anyone had more than $100,000 in an account, the rest is frozen and it may take years before it is recovered—if ever.

The most alarming thing about the IndyMac collapse wasn’t how fast it occurred or even how big it was. The real shocker was that the FDIC didn’t see the failure coming. As of March 31, the FDIC had identified and placed 90 institutions, with assets totaling $26.3 billion, on its “problem list,” but IndyMac was not one of them.

When IndyMac failed, it had assets supposedly valued at $32 billion—more than the grand total of all the companies on FDIC watch. To say it caught regulators off guard is an understatement.

Another reason this is so alarming is that by the time the FDIC is done cleaning up IndyMac, analysts suggest it may cost up to $8 billion—and that’s if the housing market doesn’t keep deteriorating, which it will. Since the FDIC has just over $52 billion in assets, IndyMac burned approximately 15 percent of its cash.

Beyond the 90 already identified, how many more banks that regulators have no clue about are ready to go down? The Royal Bank of Canada estimated that over 300 U.S. banks will not survive the next few years. But even this estimate may be on the light side. And some of the financial institutions in question absolutely dwarf IndyMac.

Nobody knows which will be the next, but there are a lot of candidates. Rumors, backed up by cascading share prices, abound. Will it be investment giant Lehman Brothers? As of July 11, share prices had dropped 83.3 percent from their peak. Will it be Washington Mutual, the nation’s largest savings and loan? By early July, its stock was worth less than 10 percent of its former value. How about Newport Beach, California-based Downy Financial Corp., or Los Angeles’ FirstFed Financial?

For that matter, what is the solvency outlook for the FDIC? How many more banks can it afford to cover? Who will be insuring people’s bank deposits when the FDIC is overwhelmed? But it is not only the FDIC whose solvency is being questioned. It is also the federal government’s.

The weekend after IndyMac bank fell apart, the U.S. government, in conjunction with the Federal Reserve, announced that it would be bailing out mortgage giants Fannie Mae and Freddie Mac. The twin government-sponsored lenders got in way over their heads, and now their bloated debt loads are threatening to take not only the whole U.S. housing market, but other banks and the economy in general down with them.

Fannie and Freddie own or guarantee a mind-boggling $5.2 trillion worth of U.S. home mortgages. That is approaching half of all the mortgages in the United States. Backing up that $5.2 trillion in loans is a paltry $95 billion in capital; the rest is borrowed money! With home prices falling and mortgage delinquencies rising, the companies were balancing on the edge of insolvency; thus the government stepped in.

That $5.2 trillion is greater than the gross domestic product of both Germany and Japan, and is almost 40 percent of America’s gdp. How two government-backed lenders were able to borrow so much money defies reason. And now that the government has decided to bail them out, it means those liabilities are now the government’s—and that means yours, and mine too. $5.2 trillion will double the federal government’s public debt burden.

With conditions deteriorating—and at least 2.5 million more homes in danger of going into foreclosure across the country—the bill from Fannie and Freddie’s largesse is sure to end up in Taxpayer Eddie and Taxpayer Suzie’s mailbox. The July 12 Wall Street Journal called the bailout a “nightmare scenario.”

For probably the first time in at least 40 years, America’s AAA credit rating is being questioned. And because America is so dependent on borrowing, a downward revision could be a deathblow for the whole economy. If America’s good credit rating goes, it will set off a chain reaction. Interest rates will jump; the bond market will get massacred; the government debt burden will soar; the dollar will plummet; and foreign capital flight will decimate the U.S.

But with all the debt swamping America, a ratings downgrade is probably inevitable. America’s foreign creditors are realizing that America will never be able to pay its huge debts. And as bad as all that sounds, it could get worse. If the U.S. resorts to printing money to pay the bills (and that is the only option short of massive service and welfare cuts and tax increases), then all bets are off. The end result: a currency value headed south as quickly as that of Zimbabwe.

In June, investment bank Morgan Stanley warned that a “catastrophic event” in world currency markets is imminent. The same month, the Royal Bank of Scotland warned investors to prepare for a full-fledged crash in global stock and credit markets over the following three months, and banking group Barclays advised clients to batten down the hatches for a worldwide financial storm.

The list of those issuing warnings is now growing: the International Monetary Fund, the Bank for International Settlements, global analysts leap/2020, etc. The banking sector is the heart and core of America’s economy. It contains the pillars supporting the entire Anglo-Saxon economic model. Its smaller pillars are already snapping like twigs, and the big pillars are cracking under the strain.

The whole thing is about to go, and repairs at this point can only be temporary quick fixes.

---

America's Smartest Banker

"If you look to the right, you can see New York City," says Ronald Hermance Jr., CEO of Hudson City Bancorp, as he points out the fourth-floor window of the company's boxy headquarters in unglamorous Paramus, N.J.

I had to venture through traffic to this distinctly nonimperial corporate redoubt 17 miles west of the George Washington Bridge—it's just past a union building and across the street from a garden supply center—in my quest to find a sensible banker in the New York area.

Despite the proximity to Manhattan, Hermance and his 140-year-old bank have never been part of the fast-money Wall Street scene. And thanks to its geographic and cultural distance, this bridge-and-tunnel bank has thrived amid the mortgage debacle.

Hudson City in late July reported that second-quarter profits were up 52.3 percent. In the 2008 first half, mortgage originations rose 50 percent from 2007. And yet its balance sheet is pristine. "Only 328 out of 79,929 loans are nonperforming at the end of the second quarter," he said. (But who's counting?) Last Thursday, Hudson City sported a market capitalization of $9.46 billion, twice the size of the Blackstone Group.

But Hermance could walk unnoticed through power lunch hotspots like the Four Seasons. "I'll let everybody else go to the Hamptons," he says in the flat accent of an upstate New Yorker. (He's from Batavia.) When I first spoke to Hermance, he was vacationing on a lake near Buffalo.

Hudson City banks the old-fashioned way: It takes deposits and makes mortgages to people who buy homes in which they plan to live. And then it hangs on to them. No subprime, no securitization. Hudson City's bankers are steady daters in a wham-bam-thank-you-ma'am era.

"We don't have Wall Street bundle up the mortgages and sell them to someone in Norway," Hermance says. "We're going to live with those loans." As a result, Hudson City maintains higher standards. Throughout the boom, it eschewed computer models and required borrowers to make down payments of at least 20 percent. (The typical mortgage in its portfolio has a 39 percent down payment.)

Just as on the singles scene, maintaining high standards in lending means turning down a fair number of dates. But Hudson City builds loyalty by lavishing attention on Realtors and mortgage brokers. "Out of the 44 banks I work with, Hudson City is the one I really and truly love," says Michael Daversa, president of Atlantic National Mortgage in Westport, Conn., which has done $100 million in business with Hudson City in the past eight months.

Boring? Maybe. But Hudson City, which went public in 1999, hasn't had to beg for money from Mideast oil potentates. Instead, its impressive growth has been fueled by the deposits of prosperous New Jersey burghers. The average Hudson City branch has about $138 million in deposits, almost twice the average for FDIC-insured banks. Hudson City's idea of swinging has been to venture tentatively beyond New Jersey.

In 2005, it moved into Long Island and Staten Island, where the demographics (read: income levels) were similar to those of Northern New Jersey. Now Hudson City is spreading from Sopranos territory to John Cheever country—Westchester County in New York and Fairfield County in Connecticut, both of which are thick with affluent households.

Hudson City's 123 branches are concentrated in nine of the nation's 50 wealthiest counties. It just opened one in snooty Darien, Conn. The strategy, which led Hudson City's stock to bump along during the height of the boom, has proved a genius long-term move.

A one-year chart of Hudson City's stock compared with the KBW Bank Stock Index looks like the mouth of a Nile crocodile about to swallow a warthog. The stellar performance of Hudson City's stock, which is up nearly 50 percent since last July, has turned the 61-year-old banker—whose first CNBC appearance in 2005 on the B-list 6 a.m. hour was pre?empted for the Saddam Hussein trial—into a media darling.

CNBC's motormouth James Cramer has dubbed Hermance a modern-day George Bailey. And while it has been a wonderful life of late for Hermance (last year he was paid a total of $8.45 million, and his shares in the bank are worth about $114 million, according to Hudson City's 2007 proxy), comparisons between the balding, mustachioed banker and Jimmy Stewart only go so far.

Hudson City has avoided crossing the river into Manhattan. "They don't want to get involved in the condominium marketplace," says Melissa Cohn, president of Manhattan Mortgage. And yet Hudson City is very much tethered to the fortunes of Wall Street, the contracting job-engine of the bank's expanding service area.

Even though local government officials have warned about impending declines in Wall Street bonuses, Hermance isn't concerned. "The analyst from Bear Stearns who followed us got a new job the week after Bear went down," he says.

So how is it that Hermance kept his head when all the geniuses with higher pay and fancier pedigrees lost theirs? The tri-state metro area's only smart banker shrugs. We all approach life's fundamental choices from a unique angle. "It's like my grandfather used to say," he says. "If everybody thought the same way, they would have married your grandmother."

---