Debt Rattle, August 6 2008: Pointed at the center of the sun

Enola Gay, you should have stayed at home yesterday
These games you play, they're gonna end in more than tears someday

Its 8:15, and that's the time that it's always been
We got your message on the radio, conditions normal and you're coming home

Enola Gay, is mother proud of Little Boy today?
This kiss you give, it's never ever gonna fade away
Orchestral Manoeuvres In The Dark

Ilargi: And so we find out -after the fact, and a potential $800 billion later- that the Treasury admits it never had the competency to handle Fannie and Freddie in the first place.

It held a "competitive bid process" for an adviser, and Morgan Stanley is the lucky winner. Looking at Morgan Stanley, you can’t help but wonder how bad a state the other competing bidders are in.

Also, the equally incompetent OFHEO is no more, but the new-and-improved regulator that replaces it, the Federal Housing Finance Agency, has the same director. Yeah, that should all go much better now, smooth sailing all the way down the hill. Think maybe they just gave it a new name, and left all the exact same clowns at the wheel?

Oh, and did you realize that Morgan Stanley has a huge self-interest in what happens with Fannie and Freddie? Morgan Stanley is in deep doodoo, like all of Wall Street, to a large extent because they hold enormous, and still mostly unrevealed, piles of asset backed securities such as those issued in large quantities by .. Fannie and Freddie.

A quick glance shows Morgan Stanley shares went from about $70 to $20 in one year, a loss of about 70%. The doodoo is so deep that just yesterday, they announced they are going to start unilaterally cutting home equity loans.

One expert comments: "It's evidence that they don't think the economy is going to recover quickly". Well, that is a nonsense explanation: it’s nothing but evidence that it’s Morgan Stanley itself that is not going to recover quickly, if at all.

Pulling the plug on equity loans for their mostly wealthy clients means one thing. and one only: Morgan Stanley now needs every single penny it can get its hands on.

It would seem that Morgan Stanley has more urgent matters to take care of than advising the Treasury on aiding the flotilla of sinking finance ships. Getting its own house in order and above the water line, for instance, would be a good start.

And besides, any company that manages to get itself in as much trouble as Morgan can hardly be considered the ideal candidate to provide counsel on how to get other firms out of the exact same kinds of trouble. After all, if it had the knowledge required to do so, we can presume it wouldn’t be where it is in the first place.

In my world, this is called incest. It’s illegal, frowned upon with heavy brow, and considered not done. In Lower Manhattan, there’s a different view, and a different culture.

The US economy is today kept -barely- alive by incest, moral hazard and creative accounting. It won't be much longer, it's heading for the center of the sun.



Treasury hires Morgan Stanley as adviser on Fannie and Freddie

The Treasury said on Tuesday it hired Morgan Stanley to advise it on whether housing finance giants Fannie Mae and Freddie Mac are adequately capitalized as the government tries to determine how it would use its new powers to support the two companies.

The Treasury said it has no immediate plans to provide support to Fannie Mae and Freddie Mac, the two largest U.S. providers of housing finance that together guarantee more than $5 trillion of mortgage assets, but wants to understand how it would use its new powers if needed. Sweeping housing rescue legislation enacted last week gave the Treasury temporary authority to make loans and provide equity to Fannie Mae and Freddie Mac to keep them viable providers of mortgage finance.

The move is aimed at shoring up investor confidence in the two government-sponsored enterprises at a time when their liquidity is needed to help end a crippling slide in the American housing market. The Treasury said Morgan Stanley won a competitive bid process to conduct a "sensitivity analysis" of the companies' financial profiles and provide an assessment of appropriate capital structures for the two firms.

The Treasury acknowledged that the move by Treasury Secretary Henry Paulson, a former chief of Goldman Sachs, to hire a Wall Street firm for advice on stabilizing markets is an unusual occurrence. But it said it had a responsibility to taxpayers and the financial system to analyze and understand its new powers.

The Treasury will pay Morgan Stanley's expenses of $95,000 under the contract, which runs until January 17, 2009, three days before the next U.S. president will be sworn into office. Morgan Stanley will receive no fees for the assignment. The Treasury said Morgan Stanley's advisory services will help it understand the new authorities, "should circumstances ever warrant their use.

"As we've said before, we have no plans to utilize the temporary authorities. That has not changed. This action should be interpreted as a prudent preparedness measure and nothing more." A Treasury spokeswoman said Morgan Stanley would not have access to Fannie's and Freddie's internal books in conducting its analyses. The Treasury will work with the GSEs' new regulator, the Federal Housing Finance Agency, on a range of issues, she added.

The head of the FHFA, James Lockhart, on Monday told Reuters that the regulator is mulling fresh capital standards for Fannie and Freddie. Capital adequacy levels are established to provide a cushion against possible losses on investments. In a separate statement, Morgan Stanley said it would support the Treasury's work to promote market stability and the availability of mortgage credit. It said the $95,000 would cover expenses only and would not include any fees for its work.

A Morgan Stanley spokeswoman said the company will use its usual procedures to prevent any conflicts between its banking and trading operations. Morgan Stanley will not underwrite securities for the two companies while it is advising Treasury, she said.

While Morgan Stanley's business trading in securities of Fannie Mae and Freddie Mac could give the appearance of a conflict of interest in its advisory role to the government, analysts said Treasury likely had little choice. "If you want that expertise, you've got to deal with someone in the business. I don't know how you get around it," said Bert Ely, a banking consultant in Alexandria, Virginia.

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Morgan Stanley Said to Freeze Home-Equity Credit Withdrawals

Morgan Stanley, the second-biggest U.S. securities firm, told thousands of clients this week that they won't be allowed to withdraw money on their home-equity credit lines, said a person familiar with the situation.

Most of the clients had properties that have lost value, according to the person, who declined to be identified because the information isn't public. The New York-based investment bank will review home-equity lines of credit, or HELOCs, monthly from now on, the person said yesterday.

Wall Street firms including Morgan Stanley are ratcheting back on risks after the collapse of the subprime mortgage market and ensuing credit contraction saddled banks and brokerages with almost $500 billion of writedowns and losses. Consumers fell behind on home-equity credit lines at the fastest pace in two decades in the first quarter, the American Bankers Association reported last month.

"Morgan Stanley periodically reassesses client property values and risk profiles," said Christine Pollak, a Morgan Stanley spokeswoman in Purchase, New York. "A segment of clients was recently notified of a change in the status of their home- equity line of credit, or HELOC, due to a change in the value of their property and/or their credit profile."

Pollak declined to specify the dollar amount of the frozen credit lines. The firm's global wealth management division, which doesn't disclose how many clients it serves, had 8,350 advisers managing $739 billion of customer assets at the end of May, according to its second-quarter earnings report.

"It's evidence that they don't think the economy is going to recover quickly," said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York who rates Morgan Stanley shares "outperform" and who owns some of the stock. "The fact that they're trying to get ahead of the problem is very good."

Morgan Stanley has already taken about $14.4 billion of losses related to leveraged loans and collateralized debt obligations. The clampdown on home-equity loans mirrors similar efforts by commercial banks, said David Hendler, an analyst at Credit Sights Inc. in New York. "All consumer lenders and home-equity lenders are reassessing the environment given the pressure on housing and the economy," Hendler said.

JPMorgan Chase & Co., the second-biggest U.S. bank by market value after Bank of America Corp., has notified 150,000 customers about changes in their home-equity lines of credit since March, said Christine Holevas, a Chicago-based spokeswoman.

In some cases the lines have been reduced and in other cases they've been suspended, depending on the change in home values, she said. The changes affect about 15 percent of JPMorgan's home- equity credit customers, Holevas said.
Bank of America and Washington Mutual Inc. are among the other lenders that have frozen home-equity credit lines this year.

"Morgan Stanley customers are typically coming out of their wealth management side, so typically a high net worth customer," said Christopher Whalen, co-founder of Institutional Risk Analytics in Torrance, California. "This shows you they are under the same pressures as everybody else."

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The Fed Is Straddling The Economic Fence

The Federal Reserve's explanation of monetary policy yesterday struck the kind of cautious rhetorical balance more often associated with election-year politicking: simultaneous bids to assure both those who worry more about economic growth and those more spooked by inflation.

In keeping its benchmark interest rate at the 2% level set in April, the Federal Open Market Committee made the kind of slight linguistic alterations that Fed watchers like to study as closely as Kremlinologists once scrutinized who stood next to whom on May Day.

The FOMC still sees U.S. economic activity expanding but views softening labor markets and the persistent "considerable stress" in financial markets as potential threats. And FOMC members regard "tight credit conditions, the ongoing housing contraction, and elevated energy prices" to be just as burdensome on future economic growth as they did in June.

But the FOMC moved a key part of its June and April statements from the section about its policy leanings to the part where it describes its view of the economy: "Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth."

Meanwhile, descriptions of inflation more alarmingly expressed in the present tense in June merited less urgent syntax in yesterday's statement. "Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated," the Fed said.

And "the committee [still] expects inflation to moderate later this year and next year," even if "the inflation outlook remains highly uncertain." Thus, "although downside risks to growth remain, the upside risks to inflation are also of significant concern to the committee," the Fed said -- straddling the fence of conflicting economic worries as much as at any time in the recent past.

Fed Chairman Ben Bernanke and his colleagues -- only one of whom voted against yesterday's actions out of preference for an anti-inflationary increase in the cost of borrowed money -- aren't alone among the world's conflicted central bankers. Elevated energy and food prices have stoked inflation fears everywhere, but few economies are out of the credit-crunch woods or immune to contagion from American economic ills.

A German news report suggests official figures due out next week will show that country's economy contracted in the second quarter, as the Financial Times reports. A key reading of Japan's economic health fell in June, contributing to that government's pronouncement of a "worsening" view of the economy, as the Nikkei reports.

In the U.S., investors nonetheless took heart from the Fed's statement and sent the Dow Jones Industrial Average up more than 300 points in hope, as The Wall Street Journal puts it, that "the worst could be over for stocks." Of course, "this was hardly the first time since the bear market began in October that stocks have staged a strong rebound," the Journal notes.

And it adds that skeptical investors warned "this could be another false start," with a potential recession looming, housing prices continuing to fall and the financial system still in disarray.

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Freddie Mac loses $821 million on housing, credit markets

Freddie Mac, the second-biggest U.S. buyer of mortgages, reported Wednesday a second-quarter loss of $821 million, as the battered housing market and slumping credit conditions again pummeled the company's bottom line.

Reeling from the loss, McLean, Va.-based Freddie Mac is planning to slash its dividend to five cents a share or less for the third quarter, down from a previous payout of 25 cents a share. Freddie Mac's quarterly loss was the equivalent of $1.63 a share, compared to a profit of $729 million, or 96 cents a share, generated in the year-ago period. Quarterly revenue fell 28% to $1.69 billion.

The loss was much worse than had been expected by Wall Street analysts. On average, analysts surveyed by FactSet Research had been looking for Freddie to report a second-quarter loss of 38 cents a share. Freddie and Fannie have been under pressure in recent weeks as fears about their capital levels spooked investors and spurred Washington to action, enacting a backstop plan for the two huge companies, which own or guarantee about half of all U.S. mortgages.

Buddy Piszel, Freddie's chief financial officer, said the company is capitalized above regulatory requirements and has "open access" to the debt markets. However, in its filing with the Securities and Exchange Commission, Freddie Mac warned that it could suffer if its new federal regulator increases capital requirements, limits its mortgage purchases or boosts the company's affordable housing goals.

Analysts said that the company will need to continue to search for capital but that Wednesday's results shouldn't come as a surprise to policymakers. "I don't think this changes the situation in Washington at all," said Jaret Seiberg, a financial services analyst with the Stanford Washington Research Group. "Regulators clearly knew Freddie Mac's performance and how it's been doing."

The Treasury, Seiberg said, wouldn't need to step in and assist Freddie Mac unless the company is unable to raise short-term debt to finance its mortgage operations. As for Fannie, second-quarter financial results are scheduled for Friday morning.
Analysts, according to the consensus of a FactSet poll, are expecting the company to lose 91 cents a share in the second quarter. A year ago, Fannie earned 49 cents a share.

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Freddie Mac Posts Fourth Straight Loss, Cuts Dividend

Freddie Mac, the second-largest U.S. mortgage-finance company, posted a larger fourth-quarter loss than analysts estimated as delinquencies rose and cut its dividend to shore up capital.

The second-quarter net loss of $821 million, or $1.63 a share, compares with the 54-cent a share average loss estimate of nine analysts in a Bloomberg survey. The common-share dividend will be reduced to 5 cents from 25 cents, McLean, Virginia-based Freddie said today in a statement.

Freddie had credit-related expenses of $2.8 billion, double the first quarter, and wrote down the value of subprime and low- quality mortgage securities by $1 billion as the biggest housing slump since the Great Depression increased foreclosures. Freddie Chief Executive Officer Richard Syron is seeking to bolster capital and restore confidence after U.S. Treasury Secretary Henry Paulson was forced to step in with a rescue plan for Freddie and the larger Fannie Mae.

"Home prices have declined and have hurt them as has the decrease in home sales," said Credit Suisse Group's, Moshe Orenbuch, the top-ranked analyst covering the company. "What you need for this stuff to work its way through is for homes to get through the foreclosure process and be sold." Orenbuch, based in New York, has an "underperform" rating on Fannie and Freddie.

Freddie has plunged 76 percent this year in New York trading on concern the company may not have enough capital to overcome loan delinquencies on the $2.2 trillion of mortgages it owns and guarantees. Syron, 64, agreed to raise $5.5 billion in equity though failed to complete the sale as the stock slumped.

"We remain committed to raising $5.5 billion of new capital and will evaluate raising capital beyond this amount depending on our needs and as market conditions mandate," Syron said in today's statement. Freddie in November halved its dividend and sold $6 billion in preferred stock to offset writedowns and losses on mortgages it owns or guarantees.

Washington-based Fannie since December has raised about $14.4 billion in preferred and common stock. Freddie rose 52 cents, or 6.9 percent, to $8.04 in New York Stock Exchange composite trading yesterday and is down about 86 percent in the past year. Washington-based Fannie, scheduled to report earnings Aug. 8, climbed $1.77, or 15 percent, to $13.60. The stock has dropped 66 percent in the past year.

The second-quarter net loss is Freddie's fifth in the past six quarters. The company reported net income of $764 million, or $1.02 a share, in the year-earlier period. Fannie and Freddie own or guarantee 42 percent of the $12 trillion U.S. home loans outstanding.

Most of Freddie's losses stemmed from a surge in costs to cover foreclosures and losses on derivatives used to hedge credit and interest-rate risk. Foreclosures on properties owned by Freddie increased 20 percent in the quarter, the company said in the statement. Credit losses were 17.3 basis points over the average total mortgage portfolio, up from 11.6 basis points in the first quarter.

Freddie has projected credit losses of 12 basis points or $2.2 billion for this year and 14 basis points or $2.9 billion in 2009. Orenbuch said he expects Freddie's credit losses to rise to 20 basis points this year and 29 basis points in 2009. Freddie posted $4.6 billion in losses in the previous three quarters, while Fannie had $7.1 billion. Freddie's fair value was negative $5.6 billion at the end of the second quarter.

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Freddie Mac boss had been warned four years ago

Freddie Mac, the mortgage firm that had to be rescued by the US government last month, was warned as early as 2004 that dubious loans were compromising its financial health.

Freddie's former chief risk officer, David Andrukonis, told the New York Times that he sent chief executive Richard Syron a memo in mid-2004 showing Freddie's underwriting standards were slipping and potential liabilities were widening.

He says he warned Syron at a meeting that the number of bad loans "would likely pose an enormous financial and reputational risk to the company and the country". But, according to Andrukonis, the response was blithe: "He said we couldn't afford to say no to anyone."

Freddie and its sister firm, Fannie Mae, play a crucial role in the US financial system by guaranteeing nearly half of the country's mortgage debt. A crisis of confidence erupted last month when it became clear they faced losses far higher than initially feared in the meltdown in US sub-prime home loans.

Shares in Freddie have fallen by 77% since the beginning of the year. In first-quarter figures due today, analysts expect Freddie to reveal up to $2bn (£1bn) in credit-related costs. Syron, a former Federal Reserve policy adviser who joined Freddie five years ago, responded to Andrukonis's accusations with a measured acceptance of responsibility.

"If I had better foresight, maybe I could have improved things a bit," he said. "But frankly, if I had perfect foresight, I would never have taken this job."

Executives at Freddie say they were under pressure from Congress to buy loans from low income families in order to facilitate broader access to home ownership. Legislation was rushed through last month that allows the US government to buy shares in Freddie and Fannie and to extend them credit to prevent them from going bust.

The nonpartisan congressional budget office estimated this could require $25bn of taxpayers' money. Syron, 64, is due to stand down as chief executive once a successor can be found. Reports suggest that one candidate under consideration is the former Bear Stearns chief executive Alan Schwartz.

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Credit-Card Bonds Fight A Tougher Debt Market

Investors are growing wary of bonds backed by credit-card payments, jamming up another debt market and making it tougher for Americans to tap what has been one of the easiest places to get credit.

Rising defaults on credit-card payments, coupled with a bleaker economic outlook, are spooking investors in the market where this debt is packaged and sold. In July, issuance of credit-card asset-backed securities fell to $4.4 billion from $5.26 billion in June, according to J.P. Morgan Securities Inc. July's total was down 56% from the $10.08 billion issued in March.

Investors who aren't too leery to buy are demanding higher returns on securities tied to credit-card loans. On Friday, a $1 billion offering of packaged credit-card loans from American Express Co. sold at 0.82 percentage point over a benchmark commonly used to price such deals. That was 0.04 percentage point more expensive than a similar credit-card deal from Bank of America Corp. that priced July 29.

"Deal flows have slowed considerably, and deals are taking longer to market," Chris Flanagan, head of global structured-finance research at J.P. Morgan Securities, said in a research note Monday. Tepid demand in the asset-backed market, a primary source of funding for credit-card issuers, hurts in two ways.

It raises the borrowing costs for these companies, translating into higher rates for consumers. It also forces the companies to keep more loans on their balance sheets, thus locking up funds they could have extended to credit-card users.

Citigroup Inc. reported a second-quarter loss on securities made up of pools of credit-card loans, also indicating growing wariness among investors in a corner of the asset-backed market that had so far proved resilient.

The firm, the fourth-largest issuer by credit-card volume, had a loss of $176 million packaging card loans into securities, compared with a gain of $243 million a year earlier, according to an Aug. 1 quarterly filing with the Securities and Exchange Commission.

Citigroup attributed the loss to higher funding costs as investors demanded higher returns to buy these securities.
Citigroup also marked down in value a portion of these investments that it held. Of the nearly $202 billion of credit-card loans it manages, Citigroup has bundled $111 billion of them into securities to sell to investors.

Citigroup was the second-largest issuer of asset-backed securities of consumer loans last year (J.P. Morgan Chase & Co. was first), mostly credit-card debt, according to Dealogic data. The credit-card issuer is also vulnerable because it has a large exposure to so-called private-label credit cards -- those affiliated with a particular retailer -- with a $55.2 billion portfolio. These cards typically have higher loss rates than general-purpose cards, say analysts.

In the second quarter, delinquencies on Citigroup's total credit-card portfolio was up nearly 12% from the end of last year to about $4.27 billion. Delinquencies on the securitized portion of that portfolio had a 16% rise during the same stretch.

As credit-card issuers suffer, they are likely to pull back the reins even harder on consumers. Many Americans, including those using plastic to get by month to month, may soon find it harder or more expensive to tap credit for everyday purchases such as gasoline and groceries.

"Another shoe is dropping for the U.S. consumer," says Christian Menegatti, lead analyst at RGEMonitor.com, an economic consulting and research firm. "Credit cards are the last resort for the consumer who can no longer use the value of his home to sustain spending."

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FirstFed Grapples With Payment-Option Mortgages

Like many mortgage lenders, FirstFed Financial Corp. is struggling with rising losses. The bank posted a loss of nearly $70 million in the first quarter -- reversing years of profit. Forty percent of its borrowers became at least 30 days delinquent after the payments on their adjustable-rate mortgages were recast.

The number of foreclosed homes held by the bank doubled in the second quarter from the first quarter. But FirstFed isn't another bank grappling with the fallout from subprime mortgages that went to less-creditworthy borrowers. In fact, FirstFed was ranked last year as one of the top five banks in the nation by a trade publication, partly because it appeared to have pared back on risky mortgage loans.

Yet this year, the Los Angeles bank is on the front lines of what could be the next big mortgage debacle: payment option mortgages. These loans went mainly to people with good credit, but they are likely to experience defaults that are nearly as high as -- in some cases higher than -- those for subprime.

Barclays Capital estimates that as many as 45% of option ARMs, as they are often called, originated in 2006 and 2007 could wind up in default. Another analysis, by UBS AG, suggests that defaults on option ARMs originated in 2006 could be as high as 48%, slightly higher than its estimate for defaults on subprime loans. Both studies looked at loans that were packaged into securities.

Option ARMs typically carry a low introductory rate and give borrowers multiple payment choices, including a minimum payment that may not even cover the interest due. Borrowers who make the minimum payment on a regular basis -- as many do -- can see their loan balance rise, known as negative amortization.

Monthly payments can increase by 60% or more once borrowers begin making payments of principal and full interest. That typically happens after five years or earlier if the amount owed reaches a preset amount, typically 110% to 125% of the original loan balance.

FirstFed's experience highlights the challenges lenders face as option ARMs recast. That is happening earlier at FirstFed than at some other banks because it set a 110% cap on many of its option ARMs, while many other lenders have higher caps.

FirstFed is a relatively small lender, with just $7.2 billion in assets. Babette Heimbuch, FirstFed's chief executive, says that option ARMs were "a very good loan for the borrower and the bank" for more than 20 years. But that changed, she said, when investment-banking firms entered the industry and set lower lending standards, which FirstFed and others followed.

For most of the product's history, Ms. Heimbuch says, the introductory rate on an option ARM was one to two percentage points below the actual interest rate on the loan. As long as interest rates were flat or falling, the minimum payment was enough to cover the interest due, making the option ARM equivalent to an interest-only loan in the early years of the mortgage.

But around 2003, as home prices accelerated, lenders began pushing mortgages that made payments more affordable. As competition increased, lenders dropped the introductory rate on option ARMs to 1% or even lower and made more loans to borrowers who didn't fully document their income or assets. FirstFed was initially reluctant to follow the crowd.

But as mortgage brokers took their business to other lenders with easier terms, FirstFed's mortgage originations declined to $366 million in the second quarter of 2003, from $389 million a quarter earlier. At the same time, its existing borrowers refinanced into new loans at other banks that offered easier terms. "The fear was that at the rate loans were paying off we were going to have to close the company down," says FirstFed President James Giraldin.

Rather than shut its doors, FirstFed joined the crowd and business boomed. But as the Federal Reserve boosted short-term rates, the gap between the introductory rate, used to set the minimum payment, and actual rates swelled to as many as 7.5 percentage points. That meant that borrowers making the minimum payment weren't covering even the interest due.

FirstFed started to pull back in mid-2005 and, as a result, didn't see a big jump in delinquencies until loans began recasting in the second half of 2007. Others lenders are seeing borrowers fall behind even before recasts.
Now, as loans are recasting, FirstFed is scrambling to modify the loans of borrowers who can't afford the higher payments.

As of the end of June, nonperforming assets climbed to 8.2% of total assets, compared with 0.85% a year earlier. Instead of waiting for borrowers to fall behind, the company sends borrowers letters as their loan balances swell, offering them a chance to modify their mortgages. From January through June, the company had modified 705 loans totaling $345 million.

There have been unexpected hurdles. Many borrowers took out home-equity loans with other lenders after getting an option ARM from FirstFed. These borrowers account for 25% of FirstFed's mortgage loans but represented nearly 50% of its delinquencies in the third quarter of 2007, the company says. It is harder to modify the terms of these loans because FirstFed often needs the approval of the holder of the home-equity loan.

In addition, many borrowers submitted loan applications that overstated their financial condition, making it more likely that they won't be able to afford even a modified loan. FirstFed figured that some borrowers had fudged their incomes and tried to protect itself with tighter credit standards. "But we were shocked by the magnitude of the lies," Ms. Heimbuch says. "You expect a 20% fudge. You don't expect 500%."to absorb the losses.

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Uninsured Depositors May Be 'Iceberg' for US Economy

Uninsured depositors, including company payrolls, are the next "potential iceberg" for the U.S. economy, said Larry Lindsey, CEO and president of The Lindsey Group economic advisory firm.

"All you need is one case where the uninusured depositors, the big deposits, don't get covered, and you have the potential that they start to run," he said. "To run an economy, to have a function that works, you've got to have a place where people can keep their money safely ... Unfortunately, the way the Congress has structured it now, that's not the case."

The futility of Congress' bailout bill for mortgage lenders Fannie Mae and Freddie Mac, which includes no reforms to put limits on the companies and prohibits risk-based pricing, also a presents problem for the economy, Lindsey said.

It does nothing to protect Fannie and Freddie's securitization function, a "vital" part of the economy. It does, however, continue their role as hedge funds, a benefit only to shareholders, Lindsey said. "You'll notice that since the plan passed, mortgage rates have actually risen in the country," he said. "That's because we have a less competitive market."

Lindsey suggested the government should do a de facto nationalization of the two companies to eliminate their role as hedge funds. This would eliminate the government-backed shared monopoly created by the bill, he said.

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Citi Talks With Regulators May Bring Billions in Auction Rate Securities Buybacks

Citigroup Inc. is in negotiations with state and federal regulators to resolve allegations of wrongdoing in the auction-rate-securities market that could result in its buying back several billion dollars of the illiquid securities from investors and paying a sizable fine, according to people familiar with the matter.

New York Attorney General Andrew Cuomo last week threatened to sue Citigroup for alleged fraud in the marketing and sales of auction-rate securities. Mr. Cuomo's office has said the firm wrongly told customers the securities were safe, liquid and cash-equivalent. It added that the firm failed to tell investors that, from August 2007 until earlier this year, the market was kept afloat primarily because the bank placed bids in auctions for the securities.

Citigroup has been in talks this week with representatives from Mr. Cuomo's office, other state securities regulators and the Securities and Exchange Commission, according to people familiar with the matter. Spokespeople for Mr. Cuomo's office and the SEC declined to comment.

If Citigroup reaches an agreement with regulators, which as of late Tuesday wasn't certain, the firm could be forced to spend more than $5 billion to buy out individuals, charities and other investors whose cash is tied up in the frozen auction-rate-securities market, according to people familiar with the negotiations. It also could include a fine of as much as $100 million, according to these people.

Citigroup has been hit by many other issues in the past few quarters. The firm has taken a total of $40 billion in write-downs tied to complex mortgage-linked securities and loans, among other things. An agreement could also pave the way for settlements between regulators and other financial institutions in auction-rate-securities probes.

UBS AG and Merrill Lynch & Co. have been charged with civil fraud and other firms are under investigation by government agencies. UBS and Merrill have said they are fighting the charges, which were brought by Mr. Cuomo's office and the Massachusetts securities regulator.

Investors currently hold more than $200 billion in auction-rate securities that can't easily be sold. Auction-rate securities, typically issued by municipalities, student-loan companies and charities, are long-term securities with short-term features. The interest rates reset at weekly or monthly auctions run by Wall Street firms.

The market, which once topped $330 billion, began to struggle last year as the credit crisis spread. Wall Street firms worked for several months to support the market. Then in February, they stopped supporting the auctions and the market froze, leaving investors with largely illiquid securities.

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Ambac, Using an Accounting Change, Posts Net Income

Ambac Financial Group Inc., the bond insurer that lost 92 percent of its stock market value in the past year, posted second-quarter net income after using an accounting change to record a $5.2 billion gain related to its debt securities.

Net income rose to $823.1 million, or $2.80 a share, from $173 million, or $1.67, a year earlier, New York-based Ambac said in a statement today. Excluding gains and other changes in the value of securities it holds and insures, Ambac had a loss of $1.53 a share, compared with an average estimate for a loss of 61 cents from five analysts surveyed by Bloomberg.

Claims on collateralized debt obligations -- responsible for $492 billion in credit losses and asset writedowns at financial firms worldwide -- will rise to $1.1 billion at Ambac, taking likely impairments to more than $3 billion, the company said.

Ambac, MBIA Inc. and three other bond insurers have posted record losses and were stripped of their AAA status after expanding from guarantees on municipal bonds to securities tied to mortgages that are now going delinquent at the highest rate since 1985.

"We won't know for sometime whether Ambac is going to be one of the long-term survivors," said Rob Haines, an analyst with CreditSights Inc. in New York. Without the use of the accounting rule that allowed Ambac to book the gain, "the numbers look weak," Haines said.

"The tumultuous credit markets continue to negatively impact the estimated impairment value of a few of our CDOs," Interim Chief Executive Officer Michael Callen, 68, said in the statement. Ambac, once the second-largest bond insurer, reported a $1.7 billion net loss in the first quarter after a $3.3 billion loss in the fourth quarter of 2007.

A rise in the risk premiums on Ambac's own debt in the second quarter lowered the value of bond guarantees, which was allowed to be reflected as a gain under new accounting rules, resulting in the quarterly profit. Ambac and other financial companies are taking advantage of the accounting standard change -- intended by rulemakers to expand so-called mark-to-market accounting -- to report gains when market prices for their liabilities fall.

The rule was enacted for some companies last year after Merrill Lynch & Co., Morgan Stanley, Goldman Sachs Group Inc. and Citigroup argued to the Financial Accounting Standards Board that it wasn't fair to make them mark their assets to market value if they couldn't do the same for liabilities. The paper profits have helped offset more than $160 billion of writedowns taken by U.S. financial-services companies in the past year as of June 1.

Ambac and MBIA have been losing new business to Hamilton, Bermuda-based Assured Guaranty Ltd. and New York-based Financial Security Assurance Holdings Ltd. Ambac and MBIA had a combined market share of 3.2 percent in the first half of the year, down from 42.2 percent in the same period of 2007.

Ambac's credit enhancement production, a measure of new business, fell 95 percent in the second quarter to $19 million.
Wisconsin regulators are expected to approve Ambac's plan to create a new AAA rated municipal-bond insurer, the company said today. The business, which wouldn't underwrite the structured finance securities that led to Ambac's losses, "starts fresh with a clean balance sheet," Callen said in the statement.

Callen said later on a conference call with investors that the new business, called Connie Lee, would have a separate board and is likely to be embraced by the municipal-bond market.

MBIA, once the largest insurer of bonds, is scheduled to report results on Aug. 8. The Armonk, New York-based company had a net loss of $2.4 billion in the first quarter. Ambac shares have more than doubled since July 28 as Ambac and other bond insurers said they're seeking to cancel guarantees on more than $100 billion of CDOs backed by mortgage securities.

Ambac said last week it will pay New York-based Citigroup Inc. $850 million to tear up a guarantee contract on a $1.4 billion CDO to minimize future losses. In addition to reversing $150 million in losses, the $850 million payment may improve Ambac's capital position and its standing with credit-rating companies.

"The benefit to Ambac will come from reduced risk and improved rating agency capital cushions," Gary Ramson, an analyst with Fox-Pitt Kelton, said in a report this month. Chief Risk Officer David Wallis said on the call that Ambac is "very active" in working on more CDO commutations.

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More Losses Expected for Fannie and Freddie

As the one-year anniversary of the housing and credit crunch approaches, investors in Fannie Mae and Freddie Mac have nothing to celebrate. They won’t see an end to the losses at these mortgage finance giants until after next year.

Moreover, a report from the regulator of the two mortgage finance giants gives embarrassing new detail on how Fannie and Freddie were mindlessly gunning the securitization engines well after the housing bubble had burst and Wall Street backed off.
Freddie Mac will report its second-quarter financial results Wednesday. Fannie Mae will release its results on Friday.

Freddie Mac’s shares are down 88% this year, while Fannie’s shares have dropped 83%. More losses and writedowns for the two are likely on the way. The Office of Housing Enterprise and Oversight says in a new report that the two combined own about $217 bn in securities minted by Wall Street firms that are backed by the shakiest home mortgages dating to 2004 and 2005, the height of the housing bubble.

The mortgages here are subprime and Alt-A loans, just a notch above subprime. To the extent that Wall Street firms book fair value losses on this pool, “Fannie Mae and Freddie Mac may have to do so as well,” OFHEO says. As delinquencies and defaults on subprime loans continue, and increasingly even prime loans bellyflop, Fannie and Freddie will continue to book losses into 2009, says Credit Suisse. Some analysts say they may lose an additional $24 bn or more.

This should alarm both taxpayers and investors across the country. Elected officials enacted a $300 bn housing bailout bill that gives these two carte blanche without any statutory limits on their colossal $5.3 tn book of business (Lehman Bros says the two have another $3.3 tn in hedges, among other items, off the balance sheet).

The two have reported more than $11 bn in pre-tax losses over the last three quarters and have a history of accounting misdeeds (on a fair value basis, Fannie incurred a loss of $13.3 bn, Freddie, $24.7 bn, OFHEO says). The housing rescue now lets the government inject tens of billions of taxpayer dollars into these two publicly traded companies, who clearly have failed in their fiduciary responsibilities.

The government can now use tax dollars to buy unlimited equity stakes in the companies and their bonds if needed. The thinking is, the Treasury will simply mint more debt and use that resulting capital to inject more liquidity into Fannie and Freddie, despite their history of accounting misdeeds, losses, misstatements and repeated dilutive equity raises that prove that these two companies do not know what they are doing. Also, the two can now borrow at the Federal Reserve.

Fear is now rampant that if the rescue doesn’t work, the US government must spend more than what the Congress said it would cost to bolster Fannie and Freddie, $25 bn, a sum it cooked up in order to sell the $300 bn housing bailout bill. Remember, the government’s estimate of the cost to taxpayers for the S&L crisis rose from an initial $50 bn to more than $124.6 bn (not inflation adjusted).

More importantly, Congress spitballed that $25 bn number even though just this past month it sent in bureaucrats from the Federal Reserve and the Office of the Comptroller of the Currency to go find out what the heck is really sitting on Fannie and Freddie’s books, as it clearly doesn’t believe the management at these two levered up examples of crony capitalism.

The fear is, too, that the government may have to swallow these two obesities, causing the US dollar to plunge in anticipation of the need to mint more dollars, creating more inflation (not to mention the $99 tn in unfunded liabilities at Social Security and Medicare, according to Fed stats).

In effect, US taxpayers have been loaded into the backseat of Congress’s spaceship pointed directly at the center of the sun.

Because the market believes the US government has given Fannie and Freddie an “implicit guarantee”of their debt, for years both have used that backing to execute a sweet carry trade, where they can borrow money much more cheaply than banks and then turn around and use that money to buy things such as higher-yielding mortgage-backed securities from lenders, in turn injecting liquidity into the lending system to make more loans.

The two also sell guarantees against defaults on loans for a fee. For years, Wall Street believed their obligations were “nearly as good as Treasurys themselves,” notes Dennis Gartman of The Gartman Letter. Indeed, their securities traded as if the government backed them, and US government debt traded as if the government did not back them.

Fannie Mae was born in 1938 as part of FDR’s New Deal to get the country out of the Great Depression and provide home ownership. Back then, millions of Americans were struggling to buy homes, and also faced foreclosures, as banks weren’t lending and mortgage money had dried up.  

For years Fannie sat on the government’s books, helping to expand the real estate industry. In 1968, the LBJ administration, worried about the effect of the Vietnam War on the federal budget, moved Fannie Mae off the government’s books, and Fannie became a publicly traded company. 

When the savings-and-loan industry wanted its own mortgage financing creature to play with beginning in 1968, Congress obliged and in 1970 Freddie Mac was born. The two quasi-socialist mortgage finance giants then became to the US economy what off-balance sheet vehicles were to Enron, Gartman says.

When Freddie Mac and Fannie Mae were limited in the dollar amount of mortgages they could buy and securitize, to $417,000, in the ‘90s, Wall Street stepped in to securitize these loans. Wall Street then manufactured all sorts of subprime paper, paid the credit ratings agencies to get rosy ratings, and then sold this drunken daisy chain of paper to all sorts of unwitting investors from here to the Arctic Circle, now sitting as landfill in portfolios run by pension funds, hedge funds and local governments.

Wall Street firms then kept a sizable slug of this bad paper off their balance sheets to keep financial results rosy, and then wrote themselves sweet bonus checks off the goosed-up numbers. So Wall Street, with the help of Fannie and Freddie, shot these risky loans into the ether, thus breaking the bond between the overseer, meaning the lender, and the borrower.

Why care about monitoring a borrower who has no skin in the game with a zero-down mortgage when you’ve entirely offloaded that loan as a security? As far back as 1987 the Financial Accounting Standards Board warned there was no adequate way to value these derivatives, and now Frankenstein derivatives are sluicing financial poison through the system.  

Then Fannie and Freddie itself started buying Wall Street’s mortgage backed securities, securities backed by zombie loans given by banks such as Countrywide Financial (CFC), which already had pointed its conveyor belt of bad loans at Wall Street.
When the credit markets seized up in 2007, Wall Street stopped doing much of these securitization deals as its recycling machine for these cut and paste jobs had sand thrown in its gears.

But as Wall Street stepped back, check out how Fannie and Freddie stepped in big time. OFHEO says in its recent report that while the volume of single-family mortgatges securitized in 2007 fell by 8% to $1.9 tn, as the number of single family mortgages originated declined, “Fannie Mae’s and Freddie Mac’s combined share of MBS [mortgage-backed securities] issuance rose substantially to 61.6% from 46.7% in 2006.”

Indeed, OFHEO says Fannie and Freddie “increased their MBS issuance by nearly one-third in 2007 as competition” from Wall Street “virtually ceased in the second half of the year,” though OFHEO says the two started to curtail their purchases of securities backed by shoddy loans. Too little too late.
 
Now teetering atop Fannie’s and Freddie’s painfully razor thin $54 bn in net worth is a pyramid of $5.3 tn in debt that is nearly half the size of the US gross domestic product. The two have much higher leverage ratios than banks or hedge funds, but lower borrowing costs due to their implicit government backing. The two whittled down their capital cushions after they gunned their lobbying engines on Capitol Hill, showering elected officials with money.

JPMorgan Chase or Bank of America, for example, have almost as much bank-level capital as these two “combined supporting one fifth of the commitments,” says the research website The Institutional Risk Analyst, published by Lord, Whalen LLC. So the fear is that, as mortgages belly flop right and left and an increasing number of homes go into foreclosure, the two are insolvent. Former Fed official William Poole has said as much of Freddie Mac.

But instead of reining in their colossal, outsized portfolios which has caused such danger to taxpayers, the new housing rescue legislation went in the opposite direction. It would increase the statutory limit on the national debt by $800 bn, to $10.6 tn, as the two would now get to buy and back jumbo loans worth $625,000.

And as economist Edward Yardeni points out (his reports are a must-read), both “have been scrambling to plug all the holes in their huge mortgage portfolios.” Citing the Wall Street Journal, Yardeni notes that at the end of last year, the two “started guaranteeing payments on loans that back mortgage securities held by others to delay recognizing losses on some delinquent loans.”

Yardeni adds that “earlier this year, in their most shocking (desperate) tactic to reduce losses, Fan and Fred started making loans of up to $15,000 to people who have fallen behind on their mortgage payments.”

Here are the stink bombs, potholes and steam pipes bursting in these two reckless publicly traded companies:

• Both have a total of a microscopic–did you see it, did you catch it?–$54bn in net worth, generally assets minus liabilities (don’t listen to the $81 bn figure tossed around for their total capital, that’s a pro forma fake number that doesn’t include certain losses).
  
• Teetering atop that razor thin wedge is a pyramid of $5.3 tn in debt.
  
• One stink bomb is the total of $260 bn in securitized assets backed by subprime and Alt-A loans, loans which sit in between subprime and prime. Those sums dwarf their capital positions.
  
• Freddie has $156.8 bn in level three assets, those illiquid securities it can’t get a pricetag on because no one wants them now. Remember, under US accounting rules, it gets to assign its own values to these assets, they could be worth more, they could be worth less.
  
• Fannie has $56.1 bn in level three assets, or about a seventh of its fair valued assets.  
  
• Fannie and Freddie have combined debts of $1.59 tn, borrowings they made merely to operate their businesses. Again, that’s against just $54 bn in total net worth. Their guaranteed liabilities were 29 times their net worth at the end of the first quarter.
  
• They each have $2.25 bn pipelines into the Treasury, which the government now wants to expand.
  
• Forty years ago, when they went public, Fannie had debt of about $15 bn.

Do the math against Fannie’s $804 bn in liabilities today, and the pipelines should be about $120 bn each. Still believe that $25 bn figure Congress is selling you?

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Britain's biggest pension schemes turn surplus into $81 billion black hole

The UK's largest pension schemes have plunged £41 billion into the red as a result of the credit crunch and stock market losses, a report says today.

Retirement plan funding for FTSE100 companies showed the deficit in mid-July compared to a £12 billion surplus a year earlier, according to figures from consultancy firm Lane Clark & Peacock (LCP). Leading pension experts said the re-emergence of a sizeable black hole marked a nail in the coffin for generous schemes and predicted the end of final salary pensions in the private sector.

LCP's 2008 Accounting for Pensions report puts the swing into the red down to a combination of equity market volatility, rises in expected inflation and the credit crunch. As a result, funding levels have seen their largest slump since the introduction of modern accounting methods in 2002. Bob Scott, partner at LCP, said: "UK pension schemes of FTSE 100 companies enjoyed a brief period of surplus until early in 2008.

"Some companies chose to spend their surpluses on various forms of de-risking activity including buy-out, purchasing financial swaps and reducing their exposure to equities. "Events of the last year demonstrate the importance of assessing and managing pension risks and being prepared to take opportunities when they present themselves."

Research shows that at a time when British businesses are feeling the pinch, contributions to schemes have fallen, from £13.4 billion to £13.1 billion over the year. Separate figures released yesterday by consultancy firm Mercer found that for FTSE 350 companies, the pensions deficit stood at £47 billion at the end of June compared to a £14 billion surplus in March.

Ros Altmann, pensions consultant and former Downing Street adviser, said the growing black hole would result in companies shutting more generous final salary schemes. She said: "It is inevitable that employers will keep on closing schemes to both new and existing members, especially in the face of so much uncertainty around funding and costs.

"This is the final chapter. Final salary pensions promise will soon be a thing of the past for private sector workers. "Public employees will become the pension elite for a while, but cost pressures will burden future taxpayers too much and, in years to come, we as a nation will face greater problems with funding public sector pensions than the private sector is struggling with to fund its historic pension promises now."

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Five reasons to hate Wall Street

After reading an interview in the New York Times with Merrill Lynch & Co. CEO John Thain, I began to wonder whether Wall Street, as it currently exists, needs to change. What's wrong with Wall Street? Here are five things:

• Rewards employees, not shareholders - It pays as much as 76% of its revenues to the people who work there (e.g., in 2006 Merrill paid $17 billion in compensation and its revenue totaled $22.4 billion). That pay is linked to revenue, not how much money their deals make for customers. This encourages them to close big deals fast rather than paying attention to quality.
  
• Puts its own interests ahead of its clients' - One need look no further than how firms pushed their toxic Auction Rate Securities (ARS) off their books and into the accounts of individual investors.
  
• Absorbs talent that could solve more important problems - That money sucks up the world's brightest minds. Those MIT PhDs could have been inventing ways to lessen our dependence on oil and gas instead of Collateralized Debt Obligations (CDOs).
  
• Too highly leveraged - It can't make money without borrowing $31 for every dollar of capital it holds. This is great when bets go the right way but it wipes out capital quickly when they lose.
  
• Gets taxpayers to bailout its mistakes - And when it loses money, it cries to Washington for a bailout. For instance, the Fed used $29 billion of taxpayer money to bail out Bear Stearns for its poor management.

Thain made a very unpopular decision -- to take $31 billion worth of those CDOs off Merrill's books at 22 cents on the dollar. That price tumbles to 5 cents when you consider that Merrill financed 75% of the deal. I have not heard any reports that the Merrill bankers who took those CDOs onto Merrill's books ended up paying back their bonuses. So who exactly is paying the price for Merrill's mistakes?

Wall Street operates on information asymmetry -- that's an academic term which means that the sellers know more than the buyers. And the buyers use that superior knowledge to their negotiating advantage. The miracle is that Wall Street gets people to pay brokers so they can profit from the information asymmetry between the brokers and their customers.

When brokers at Merrill told its wealth management customers that the ARS Merrill was eager to dump from its books was a good investment, it was using that information asymmetry to benefit Merrill at the expense of its customers.

The Boston Globe reports that Merrill's ARS trading desk threatened to fire analysts who wrote research reports that pointed out ARS risks to investors. The result? The Globe reports "Merrill sold $95 million in [ARS] to 165 [Massachusetts] investors in January and February, even as executives knew the market could fail."

And wealth management is the core business that Thain hopes investors will now focus on. As the Times says, "He believes Merrill is well positioned for the coming years because several of its businesses, like wealth management, do not depend on borrowing - or leverage, as the industry calls it."

But convincing people to let Merrill manage their money depends on trust. And after the ARS scam, how will Merrill rebuild that trust? The same might be said for much of Wall Street. So perhaps it would be useful to let Wall Street fend for itself instead of accepting the idea that we can't afford to let it fail.

If I make a bad investment, I don't come crying to the government to bail me out. Why should it be any different for the masters of the universe? So maybe Wall Street should change.

Either its capital and business mix becomes regulated by independent regulators. Or it cuts itself off completely from the public so that investors don't have to pay for its mistakes. It's definitely time for a change.

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Morgan Stanley issues alert on Spanish banks

Morgan Stanley, the investment bank, has issued a major alert on the health of Spanish banks, warning that a replay of the ERM crisis in the early 1990s could wipe out the capital base of weak lenders exposed to the property crash.

"A momentous economic slowdown is now under way. We believe the deterioration in Spain is just in the beginning stages. The bulk of the pain will be suffered in 2009," said the report, by Eva Hernandez and Carlos Caceres. "The probability of a crisis scenario similar to the early 1990s is increasing.

If the ERM (Exchange Rate Mechanism) scenario were to become reality the main concern would not be earnings, but capital," it said. "We estimate that a non-performing loan ratio of 10pc to 15pc for developers' loans would fully erase earnings in 2009 and would represent between 20pc to 30pc of the current tangible capital base of Banco Popular, Sabadell and Banesto," they said.

The grim report comes amid a fresh flurry of horrendous data from Spain. The ICO consumer confidence index has plunged to a record low of 46.3. Lay-offs continued to surge in July as the building industry - 13pc of Spain's workforce - stepped up its job purge. Unemployment has risen by 457,000 over the last year, pushing the rate to 10.4pc. "These figures are very disturbing", said employment chief Maravillas Rojo.

Finance minister Pedro Solbes told El Pais that the outlook had darkened dramatically over recent weeks as the global oil shock and rising interest rates combined with Spain's home-grown housing crisis.

"The economic situation is worse than we all predicted. We thought it would happen slowly but instead it has hit fast," he said. Mr Solbes admitted that the property boom had degenerated into a "bubble" but said there was little the government could reasonably do about it.

"What was the state supposed to do? Stop people building houses? That wouldn't be reasonable. Tell the banks who they can lend money too? We couldn't do that either. We warned that building 800,000 homes a year was not sustainable: and that granting mortgages for 40 years was folly, but there are certain things the government cannot prohibit," he said.

The root cause of the bubble was the extremely lax monetary policy imported by Spain after it joined Europe's monetary union. Interest rates were slashed on EMU entry, and then fell to 2pc until late 2005 - far below Spain's inflation rate. However, Mr Solbes has been reluctant to link the crisis to Spain's euro membership. As Europe's economics commissioner at the launch of the euro, his career is inextricably tied up with the whole EMU experiment.

For now, smaller Spanish banks are getting by on funding from the European Central Bank, in many cases issuing mortgage bonds with the express purpose of using them to secure loans from Frankfurt. ECB loans have tripled to €47bn over the last year, causing rumblings of concern among regulators. The ECB is not allowed to prop up banks with long-term funding under EU treaty law.

Morgan Stanley said there was 40pc chance of a "bear scenario" leading to a 0.5pc contraction of the Spanish economy next year, with a mounting risk of an even more extreme case that replicates the ERM crisis (or worse) and leads to a 1.4pc contraction in 2009.

The report said construction investment made up 18pc of GDP last year, much of it funded by foreign investors. The concern is that a "sudden reversal of capital inflows" could leave the economy unable to finance its current account deficit, now 10pc of GDP - the world's second biggest after the US in absolute terms. The corporate sector has debts equal to 130pc of GDP. This too requires foreign funding.

Morgan Stanley said it had become concerned about the banks after the €5.1bn (£4bn) collapse of Martinsa-Fadesa, the country's biggest builder. Loans to developers make up 26.1pc of total lending for Sabadell, 21.9pc for Banesto, and 19.4pc for Popular.

This leaves them highly vulnerable to an ERM-style bust that could push non-performing loans for developers to 14pc. "Such a scenario cannot be disregarded, in our view," it said, adding that the developers may face an even more drastic challenge than they did in the early 1990s.

The "extreme bear" case would lead to further dramatic falls in bank shares: Banco Popular (-61pc), Sabadell (-56pc), Bankinter (-51pc), Banesto (-42pc), and BBVA (-35pc). The report based its estimates on a stress test that replicates what happened in Britain in the early 1990s, as well as Spain's own travails during that period. It said BBVA enjoys a solid client base and is likely to be a "winner" once the storm passes.

The condition of Spain's lenders is a source of intense controversy, and the Spanish officials bridle at claims by foreign critics that there is any problem. The banks certainly dodged the US sub-prime debacle, thanks to restrictions by Bank of Spain on the use of off-books investment vehicles.

Home equity withdrawals and "piggy back loans" are rare. Mortgages were mostly limited to 80pc of house prices, at least in theory. The great unknown is whether those price estimates bear much resemblance to reality. Ramon Lobo, a former bank auditor, said valuations were routinely inflated by as much as 25pc, allowing the sub-prime-style abuses through the back door.

The Bank of Spain denounced the use of inflated appraisals in 2006. If the practice was as widespread as feared, the default rate on €320bn of Spanish mortgage paper sold to investors worldwide could prove higher than expected. Spanish house sales fell 34pc in May from a year earlier, and mortgages were down 40pc.

The consultancy Facilismio said yesterday that prices had fallen 6.7pc in July from a year earlier, but anecdotal reports suggest a much steeper drop. With gallows humour, Spanish journalists have begun using the term "Costa del Crash". The UK estate agent Savills said Britons are having to accept price cuts of 20pc to 30pc if they need to sell their villas in a hurry.

The vultures are starting to circle around the hapless Mr Solbes. Critics are calling for his head, accusing him of covering up the true scale of the downturn before the re-election of the Socialists in March. This seems unfair. Mr Solbes continued to dismiss warnings of a crisis as "enormously exaggerated" long afterwards. He appears to be genuinely astounded by what has occurred.

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The woman who called Wall Street's meltdown

Whitney's rise to prominence began last October when she dropped jaws from New York to London with her audacious (yet spot on) prediction that Citigroup would be forced to cut its dividend to prop up its leaky balance sheet.

She followed that call with forecasts of more losses and write-downs at the likes of Bank of America, Lehman Brothers, and UBS, as well as some insightful tangents on how the implosion of the bond insurers would threaten banks' bottom lines. Sometimes she seems steps ahead of management.

On a Merrill Lynch conference call in mid-July, she asked CEO John Thain why the company wasn't unloading damaged assets and boosting capital. Thain demurred, but less than two weeks later, Merrill did just that. It agreed to sell more than $30 billion of CDOs (collateralized debt obligations) for 22 cents on the dollar and sold stock to raise $8.5 billion in fresh capital.

Whereas her peers keep searching for some sort of light at the end of the tunnel, Whitney thinks the tunnel is about to collapse. Bank stock investors will get crushed if they jump back in now, she contends, because the banks are facing much, much bigger credit losses than what they've reported so far.

Moreover, Whitney is convinced that the economy is about to sink into an "early 1980s-style" recession that will devastate the 10% of the population that became overextended during the housing boom. "It feels like I'm at the epicenter of the biggest financial crisis in history," says Whitney.

This isn't ego talking. "She definitely moves markets," says Gus Scacco, an institutional fund manager for AG Asset Management. An executive with a top hedge fund goes so far as to compare Whitney's influence to that of former Goldman Sachs chief strategist Abby Joseph Cohen in the late 1990s. "It's gotten to the point," the executive says, "where Meredith can't opine or write anymore without moving stocks."

Whitney's insights haven't always translated into lucrative investment picks. Based on the performance of her buy and sell recommendations relative to her industry peer group - what analyst tracker Starmine refers to as an analyst's "industry excess return" - Whitney's stock picking ranked 1,205th out of 1,919 equity analysts last year and 919th out of 1,917 through the first half of 2008.

That said, evaluating Whitney solely on the timing of her buys and sells misses the point. It's not just that she's bearish on the entire banking industry. What makes Whitney so interesting is the brutality of her arguments and the evidence she summons in making them.

Whitney warned last year - and continues to warn today - that the "incestuous" relationship between the banks and the credit-rating agencies during the real estate bubble will have a long-lasting impact on banks' ability to recover. With Moody's and Standard & Poor's now trying to make up for past wrongs, the pace of downgrades on mortgage securities shows no sign of slowing:

There were $85 billion in mortgage securities downgraded in the third quarter of 2007, $237 billion in the fourth quarter, $739 billion in the first quarter of this year, and $841 billion in the second quarter of 2008.

This is a problem, because every time their portfolios are hit by significant credit downgrades, banks are forced to improve their capital ratios. Often that means issuing reams of new stock, which leads to serious dilution, something shareholders at Citi, Merrill Lynch, and Washington Mutual can unhappily attest to.

"You're going to have this stealth pressure on bank balance sheets until you start to see the ratio of downgrades to upgrades change," says Whitney. "It's something people don't talk about."

Obviously the financial companies she covers aren't thrilled with all the dire talk. Whitney got an earful from Wachovia, she says, when she downgraded the stock to "underperform" in July. Investors aren't always thrilled either. She says she's received one death threat and hundreds of abusive e-mails and phone calls.

But at least now there's a grudging respect for her work. "What do you do when your biggest tormentor keeps being right?" one ex-Citigroup executive asks when queried about Whitney. "You got to give it to her - she figured it out."
Despite her unremitting bearishness, Whitney has probably never had better access to bank management.

This is a bit surprising, given that being a renegade bank analyst used to be a one-way ticket to the unemployment line. (Just ask industry vets like Michael Mayo.) Nevertheless, Whitney has been landing one-on-one meetings with the likes of Bank of America CEO Ken Lewis, Merrill Lynch CFO Nelson Chai, and American Express CEO Kenneth Chenault.

Of course, a cynic might counter that it's hardly shocking that a bunch of middle-aged male bank executives would spare time for a glamorous analyst with a megawatt personality and a jock-celebrity husband. "She always had more personality than anyone else," offers former Commerce Bancorp CEO Vernon Hill.

But this explanation for Whitney's influence and access is belied by her following among money managers who treat her latest research reports like gospel. "What I like is, she's got conviction," says Scacco. "She was early, she was right, and she wasn't shy about saying it."

The most recent conference call Whitney hosted for Oppenheimer's institutional clients drew as many callers - about 500 - as Exxon Mobil typically gets on its quarterly earnings calls. Plus, as warm and engaging as Whitney can be in person, she's an utter killjoy when the conversation turns to banking and the economy.

"What's ahead is much more severe than what we've seen so far," she warns a standing-room-only crowd of money managers at a May lunch meeting. Once she gets rolling, Whitney morphs into a kind of dark sage - the anti-Abby Joseph Cohen, if you will - whose doom-and-gloom views capture the prevailing mood of today's market about as perfectly as Cohen's unapologetic bullishness caught the exuberance of the late 1990s.

When one shell-shocked lunchgoer presses Whitney for a glimmer of hope, she has none to offer. Asked by another money manager whether she has any doubts, Whitney concedes only one: "While my loss estimates are much more severe than those of my peers, my biggest concern is that they're way too low."

That was May. By mid-July, bank stocks were down another 20%. Today, of the 14 financial stocks she covers, she rates five underperform and the rest market perform.

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Freddie and Fannie's Healthy Cousin.

The Federal Reserve's extraordinary efforts to help investment banks have effectively put the taxpayer on the hook for enormous potential losses.

If borrowers can't make good on their debts, we could end up paying tens or hundreds of billions to cover losses tied to Bear Stearns, mortgage-backed securities at other banks, and the Fannie Mae and Freddie Mac debacle. But the actual amount of credit extended so far through these public-rescue efforts pales in comparison with the credit that has quietly been extended to banks in the past year—another lifeline that taxpayers could end up paying dearly for. Here's the story:

Last summer, as the subprime rot spread throughout the credit market, the process through which banks make loans to borrowers and then package and sell them to investors came to a screeching halt. For the past 12 months, an obscure agency created by President Herbert Hoover during the Great Depression has come to the rescue of the banking industry. It is called the Federal Home Loan Banks.

Like Fannie Mae and Freddie Mac, the FHLB is a government-sponsored enterprise. But it differs from the wounded giants in some significant ways. Instead of being owned by public shareholders, as Fannie and Freddie are, the 12 independent regional FHLBs are owned by their 8,100 members. Banks large and small, representing about 80 percent of the nation's financial institutions, own shares in the FHLB and share in the profits.

The FHLB has a simple business model. Basically, it funnels cash from Wall Street to banks on Main Street. Member banks present mortgages they've issued—high-quality ones, not junky subprime ones—as collateral to the FHLB and borrow money so they can have more cash to lend.

To finance its activity, the FHLB sells debt to big investors in the capital markets. As with Fannie and Freddie, the FHLB benefits from a unique status. The FHLB doesn't pay federal income tax, and it borrows "at rates just slightly higher than Treasury bonds," thanks in part to the high ratings of its debt.

While the FHLB takes pains to note that "Federal Home Loan Bank debt is not guaranteed by, nor is it the obligation of, the U.S. government," there's an assumption afoot in the marketplace that were the FHLB to encounter serious trouble, the government would step in. In return for this special treatment, the FHLB provides some vital public services.

Twenty percent of its net earnings are used to help cover interest on debt issued by the Resolution Funding Corp., which paid for the Savings & Loan bailout. The FHLB also channels one-tenth of its profits to affordable-housing loans and grants.
During the mortgage boom, FHLB quietly did its job and avoided many of Fannie and Freddie's excesses. A year ago, loans to member banks accounted for only 62 percent of total assets.

The rest was held in safe investments like the government bonds and bonds issued by Fannie Mae and Freddie Mac. Subprime holdings were minimal. And since commercial banks were able to raise capital from Wall Street to make any kinds of loans they wanted, they didn't have all that much need for the FHLB's services. As the chart below shows, the number of loans extended to member banks rose modestly in the boom years, up 7 percent in 2005 and only 3 percent in 2006.

As of June 30, 2007, the FHLB had $640 billion in loans outstanding to members. But last year the mortgage house of cards began to collapse. And as Wall Street's securitization machine, which had enabled banks to raise cash with alacrity, broke down, banks staged their own run on the FHLB.

In its 2007 third-quarter report, the FHLB noted that "in light of the extraordinary events affecting the credit markets during the third quarter," loans to members soared by 28.6 percent from the first quarter, to $824 billion—an increase of $184 billion. Since then, as the broken-down Wall Street mortgage securitization machine was sold for scrap, FHLB loans to member banks continued to rise: to $875 billion at the end of 2007 and to $914 billion at the end of this June.

In the past 12 months, FHLB loans to its members have risen by 43 percent, representing an additional $274 billion in real credit provided by the system to its member banks. That sum dwarfs the actual amount of credit extended to investment banks by the Fed—or by the government to Fannie and Freddie.

Does the increase in FHLB's balance sheet mean taxpayers may be on the hook for another trillion dollars in mortgage debt? It's unlikely. FHLB has a much better track record than Fannie and Freddie. Because it maintains high standards, it has never suffered a credit loss on a loan extended to a member. It doesn't spend hundreds of millions of dollars each year on executive compensation or lobbying, as Fannie and Freddie did.

And it didn't lower standards or shift into riskier markets as a way of increasing market share, as Fannie and Freddie did. Seventy-six years after it was created by a president whose administration was hostile to government intervention in markets, the FHLB stands as an enduring and (so far) effective example of socialism among capitalists.

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