Debt Rattle, September 13 2008: Hit List

Arthur Rothstein Boiled clothes 1939
Butler County, Missouri. Washing clothes at camp for evicted sharecroppers

Ilargi: The American financial system may yet manage to find a way to cut Lehman into pieces and sell them off. Selling it in one large chunk looks to be a receding option. Well, mind you, if the Fed and Treasury stick to their words, and don’t throw more of your money and credit into the pit.

I think they might just refuse to do it. Not because they have grown sudden scruples overnight, but because they have a pretty clear idea of what’s to come.

The world of finance, no matter how Lehman is sliced and diced, will change, and forever. It is now obvious that the best money and the biggest profits are available in bringing down companies, especially financials.

This is caused both by a fast weakening overall economy, and by the fact that all across the field, in every big player’s vault, there are insane amounts of paper that have not seen the light of day for a long time.

This paper will now rapidly turn into proverbial Achilles heels, and easy targets at that. If enough parties start betting against firms, there comes a point where the demand becomes irresistible to show the world what you really have, and what it’s worth. From there on in, it’s easy pickings.

This summer, there was a one-month ban on shorting 19 of the US’ main companies. Such a measure is controversial, and necessarily temporary. It’s also somewhat futile. There are reportedly $62 trillion in credit default swaps outstanding, and they are potentially at least as profitable as shorts when a company can be brought to its knees.

The first few weaker animals in the herd have been hunted down, but that has merely wetted the succesful predators’ appetite. They’ll keep on chasing down the rest; after all, they have to eat. Ironically, many of the hunted players undoubtedly hold CDS, in a cannibalistic ritual betting on the demise of their competitors, and for all we know perhaps on themselves as well.

The obvous next potential victims on the hit list are Merrill Lynch and AIG, but if they don’t fall fast enough, attention will shift to the hundreds of smaller banks that are sinking away in the quicksand of bad investments and disappearing credit availability.

A hit list full of easy pickings, a severely weakened herd, stumbling and heavily limping along. Fish in a barrel.

The chase will force many companies to come clean. And that won’t be a pretty sight. An upcoming new set of accounting rules will make it that much worse. Many of the hunted may try to bluff their way out of the situation ("we are well capitalized"), but very few will survive it.

Praying for a miracle increasingly becomes the final best hope for salvation. Like its political system, the US economy truly is a faith-based one.



U.S. Gives Banks Urgent Warning to Solve Crisis

As Lehman Brothers teetered Friday evening, Federal Reserve officials summoned the heads of major Wall Street firms to a meeting in Lower Manhattan and insisted they rescue the stricken investment bank and develop plans to stabilize the financial markets.

Timothy F. Geithner, the president of the New York Federal Reserve, called a 6 p.m. meeting so that bank officials could review their financial exposures to Lehman Brothers and work out contingency plans over the possibility that the government would need to orchestrate an orderly liquidation of the firm on Monday, according to people briefed on the meeting.

Flanked by Treasury Secretary Henry M. Paulson Jr. and Christopher Cox, the chairman of the Securities and Exchange Commission, he gathered the executives in person to impress on them the need to work together to resolve the current crisis.

Mr. Geithner told the participants that an industry solution was needed, no matter what, and that it was not about any individual bank, according to two people briefed on the meeting but who did not attend. They said he told them that if the industry failed to solve the problem their individual banks might be next.

A spokesman for the New York Federal Reserve Bank in New York confirmed the meeting but declined to provide details on the discussions.

The Wall Street executives included the following chief executives: Lloyd Blankfein of the Goldman Sachs Group, James Dimon of JPMorgan Chase, John Mack of Morgan Stanley, Vikram Pandit of Citigroup and John Thain of Merrill Lynch. Representatives from the Royal Bank of Scotland and the Bank of New York Mellon were also present. Lehman Brothers was noticeably absent from the talks.

The meeting was reminiscent of the circumstances that preceded the near-collapse 10 years go of Long Term Capital Management. At that time, William J. McDonough, then the president of the New York Fed, summoned the heads of big Wall Street banks to the Fed to stop the failure of L.T.C.M., a hedge fund firm that had made big bets on esoteric securities using borrowed money and which had already lost $4.5 billion.

The bankers ended up committing $3.65 billion to save L.T.C.M., though Bear Stearns, the hedge fund’s clearing broker, refused to contribute to the investment. Traders from the banks wound down the fund over time, averting what might have been big losses across the financial system.

But the fallout from a failure of Lehman Brothers could be even more severe, given the firm’s much larger size and its entanglements with trading partners around the globe. Policy makers fear its losses could ripple through the financial industry at a time when banks and securities firms are trying to overcome $500 billion in write-downs.

One observer briefed on the situation described the session as a “game of chicken” between the government and the heads of the major banks. Bank of America and two British firms, Barclays and HSBC, have expressed interest in bidding for Lehman Brothers, according to people briefed on the situation.

But they have indicated that their bids are contingent upon receiving support from the government, just as it did with the rescues of Bear Stearns, and the government-sponsored agencies, Fannie Mae and Freddie Mac. But Mr. Paulson and Mr. Geithner made it clear to the company, its potential suitors and to the meeting participants on Friday that the government has no plans to put taxpayer money on the line.

The government is deeply worried that its actions have created a moral hazard and the Federal Reserve does not want to reach deeper into its coffers. Instead, Mr. Paulson and Mr. Geithner insist that Wall Street needs to come up with an industry solution to try to stabilize Lehman Brothers and calm the markets.

Still, some of the other Wall Street banks, facing billions of dollars in losses themselves, have resisted this approach. They argue that Lehman Brothers overreached and brought its current troubles on itself. If there are no bidders for Lehman Brothers, these banks say they can collect their collateral and liquidate the troubled firm’s assets.

In this high-stake game, they may also be trying to call the government’s bluff, knowing that if push came to shove, it would provide financial support. Mr. Geithner, who led the session, firmly stood his ground. He told the banks that this was about fixing the system and preventing the crisis from worsening.

By the time Lehman’s shares went into a spiral this week, Fed and Treasury officials were convinced that Lehman posed far fewer real risks than Bear Stearns had back in March. The confidence by Washington officials stemmed from the fact that, after the Bear Stearns collapse, they obtained stronger regulatory powers that gave them the ability to peer into the activities and risk exposures of institutions on Wall Street.

Fed officials, for example, are now embedded at each of the big Wall Street investment banks and have at least some capacity gauge the firms’ exposure to hedge funds and other big players, as well as their positions in financial derivatives and other opaque markets. Fed and Treasury officials have also been taking the daily pulse of executives and traders on Wall Street for months, and much of that discussion has been about Lehman.

Officials detected a rising number of defections by Lehman’s institutional customers to other firms, but nothing near the panic that caused Wall Street executives to bombard Mr. Paulson with dire warnings about a Bear Stearns collapse in March. Fed officials also saw few signs that fears about the future of the investment bank were spilling over to fears about its customers and trading partners.

And in practice, taxpayers could still end up on the hook for at least as much money as they were in the case of Bear Stearns. Lehman’s successor will still be able to borrow from the Fed’s new lending program for major investment banks, which the Fed created in response to the collapse of Bear Stearns in March.

If Lehman were to borrow money and then default on its loans, the Fed’s losses would reduce the amount of money it turns over to the Treasury. For political and economic reasons, both the Federal Reserve and the Treasury Department are loath to save financial institutions from their own folly.

But as the housing crisis has deepened, they have abandoned free-market orthodoxy, fearing that the collapse of institutions like Bear Stearns or either Fannie Mae or Freddie Mac could cripple the financial markets, and perhaps the economy itself. One of the biggest differences between the challenge facing Lehman and the one that faced Bear Stearns is the availability of the Fed’s emergency lending program for investment banks.

When confidence evaporated in Bear, with major hedge funds pulling their prime brokerage accounts, Bear’s financing ran out almost overnight, creating a panic situation. Lehman has had the power to plug any cash shortfalls by borrowing from the Fed, though it has not actually borrowed any money from the program since March.

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Merrill now in shorts' sights as Lehman crumbles

The crisis of confidence in Lehman Brothers has led to fallout throughout the financial sector -- especially for larger rival Merrill Lynch & Co Inc. The problem for Merrill is that short-sellers regard it as the next weakest investment bank after the crumbling Lehman and the crumbled Bear Stearns, which was sold at a firesale price in March.

"People are saying, 'Who's next on the list?'" said Matt McCormick, portfolio manager and banking analyst at Bahl & Gaynor in Cincinnati. The result in the market was clear. Merrill Lynch shares lost about a third of their value this week, while peers Citigroup and Morgan Stanley only lost 2 percent and 4 percent, respectively.

Like Lehman and Bear, Merrill has holdings of structured debt that are triggering write-downs and calling into question its overall capital position. Merrill Lynch has been one of the hardest hit firms over the course of the year-old credit crisis, posting well over $40 billion in write-downs and credit losses and selling valuable assets to raise capital.

In the second quarter, Chief Executive John Thain sold the bank's prized 20 percent stake in news company Bloomberg LLP and arranged to sell a banking administrator company to balance out $9.4 billion in losses and write-downs. Investors are bracing for more bad news in the third quarter, after Thain arranged to sell $30 billion in complex debt securities to a private equity firm in July, taking more than $5 billion in write-downs at the same time.

Merrill also provided financing to Dallas-based private equity firm Lone Star Funds and sold those securities at 22 cents on the dollar. While the Lone Star deal removed a large, toxic weight from Thain's shoulders, there are still problem assets on Merrill's books, according to analysts.

"There's concerns they still have commercial mortgage exposure and people feel that's worsening," said Albert Yu, portfolio manager and analyst at Clover Capital Management, which does not have a position in Merrill.

Looming large among investors' worries about Merrill are mortgage-backed securities and other structured debt held at two of its banking subsidiaries -- Merrill Lynch Bank USA and Merrill Lynch Bank & Trust Co. In the second quarter, structured debt held by these subsidiaries was responsible for losses of $1.7 billion. That could worsen in the third quarter as sales of these securities has set a low market price.

One hedge fund manager who is short Merrill said he sees these banks, which hold loans and deposits made through Merrill's network of financial brokers, needing more capital, which will have to be provided by the parent. "Merrill's in a box, but people don't realize it," he said.

According to the most recent data from the New York Stock Exchange, short interest in Merrill Lynch increased 5.31 percent, to 44.5 million on August 29, compared with 42.3 million on August 15. Over the same period, short interest on average across the NYSE slipped 0.5 percent. Merrill has a free float of 1.49 billion shares.

The difficulty for Merrill Lynch is that it has valuable assets that aren't reflected in its share price. According to a research report from Citigroup on Friday, Merrill's stake in investment manager BlackRock is worth about $9 a share and its wealth management franchise -- the largest by number of brokers and by assets -- is worth $16 per share. Citi analysts attributed an additional $15 per share to the bank's institutional business.

"Merrill Lynch has some very valuable assets, but the same is true of most Wall Street companies," said John Stein, co-founder of FSI Group in Cincinnati, which doesn't own Merrill Lynch shares. "Shorts have made a lot of money of late, and one thing about Wall Street is when something works, they tend to keep doing it," he added.

As Merrill shares decline, it makes raising any further equity more expensive, noted Stein. "It may force a strategic decision on to Merrill," he said, noting Lehman was prompted to raise capital following Bear Stearns' takeover, but it came too late to the idea of a strategic partnership. "I think what's going on with Lehman will likely force Merrill to look for partners sooner rather than later."

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Investors Turn Gaze to A.I.G.

Investors skittish about further losses in the financial industry have pounced on the American International Group, the beleaguered insurance company that has reported some of the biggest losses in the spreading credit crisis.

With Lehman Brothers running out of options this week, investors fear that A.I.G. will face billions in additional losses because it has effectively guaranteed complex financial instruments tied to home loans whose values have plummeted. If so, it too could need to raise capital, which Freddie Mac, Fannie Mae and Lehman have demonstrated can be a vexing problem in the current market environment.

The company’s chief executive, Robert B. Willumstad, is expected to unveil a master plan Sept. 25 to turn the company around, but investors are increasingly impatient. Lehman also had promised to deliver a plan in a couple of weeks, but was forced to make an announcement this week in what proved to be an unsuccessful attempt to reassure investors. On Friday, A.I.G.’s stock closed down 30.83 percent, or $5.41 to $12.14.

A.I.G. stock had lost nearly a fifth of its value Tuesday as investors watching the Lehman drama focused on others that might have to raise money. Since Mr. Willumstad took over in June, succeeding Martin J. Sullivan amid mounting losses, the stock has fallen nearly 50 percent.

Stocks rallied broadly at the end of trading on Thursday, with investors relieved that a deal for Lehman and perhaps even one for Washington Mutual, the troubled savings and loan, appeared to be in the works. A.I.G. shares gained 5 cents to close at $17.55.

Red ink has been flowing at A.I.G. It reported a loss of $5.3 billion for the second quarter, after a $7.8 billion loss in the previous quarter. The main problem is sophisticated contracts, called credit default swaps, that A.I.G.’s financial products unit sold to investors.

The contracts allow buyers to bet on the creditworthiness of debt obligations backed by mortgages. As home values have fallen, the values of those underlying mortgages have declined. A.I.G. has had to reduce the value of the swaps on its books. Mr. Willumstad declined to comment on A.I.G.’s stock price Thursday, but a company spokesman, Nicholas J. Ashooh, said market pressure would not speed up the new business plan.

“In the meantime, there’s a lot of work going on to determine the best future course for A.I.G.,” Mr. Ashooh said. “The focus is on doing what’s right for the shareholders and the future of A.I.G.” A sliver of good news came Thursday when A.I.G. announced a $115 million settlement of a lawsuit filed by shareholders on behalf of the company.

A.I.G. is to receive $85 million in insurance payments covering its directors and officers, and $29.5 million from four former officers. The former officers were accused of breaching fiduciary duties by redirecting insurance business that generated hundreds of millions of dollars in commissions to another company they controlled.

Simultaneously, Maurice R. Greenberg, A.I.G.’s former chief executive and one of the former officers, began the first of what is expected to be three grueling days of depositions in a civil lawsuit brought against him by the office of the New York attorney general, Andrew M. Cuomo. The lawsuit accuses Mr. Greenberg of devising transactions to make A.I.G.’s financial condition look stronger.

A.I.G.’s board removed Mr. Greenberg in 2005, after regulators served A.I.G. with subpoenas. He was succeeded by Mr. Sullivan, a former co-chief operating officer of A.I.G., who oversaw the restatement of the company’s financial results covering a five-year period. But calm did not return; instead, the mortgage crisis ensnared the company.

Perhaps the most pressing concern for investors now is the exposure to falling home values. Although A.I.G. has sharply written down the value of its contracts, it has warned investors that more write-downs, into the billions of dollars, are possible. To maintain its overall financial strength as its assets are falling in value, the company may have to raise new capital. Shareholders could find the value of their existing shares diluted if A.I.G. issued new shares.

This month, an analyst at Citigroup Global Markets, Joshua Shanker, issued a report saying that while new shares “could be extremely dilutive,” he did not think that selling stock would be the company’s only option for raising capital. A.I.G. could sell off certain operations, for instance, or shrink its insurance business in unprofitable markets.

A.I.G. outlined some of its risks in a securities filing with its second-quarter results. If one of the major credit rating agencies were to downgrade A.I.G.’s debt, the company could be forced to post additional collateral on contracts, the company said. If just one agency downgrades A.I.G. debt by a notch, it could set off a collateral call of $10.5 billion, and if Moody’s and Standard & Poor’s downgraded the company together, A.I.G. could be required to post $13.3 billion.

A downgrade could also give counterparties on A.I.G.’s financial contracts the right to end the arrangements early, which the company has said could cost $4 billion to $5 billion. A.I.G. has said it does not expect all its counterparties to exercise this right.

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Lehman's Lost Weekend

Lehman Brothers Holdings is likely spending its final hours as an independent company, but while its future seems assuredly bleak, the manner of its exit is holding investors in thrall.

A week after the U.S. Treasury took financial responsibility for its former mortgage progeny Fannie Mae and Freddie Mac and half a year after the Federal Reserve engineered the rescue of rival brokerage Bear Stearns, the question roiling the markets is whether Washington will put taxpayer money at risk to guarantee a deal.

The alternative would be to let Lehman swim or sink on its own, the latter outcome carrying the risk of a global financial crisis if the firm couldn't settle its debts and set off a cascade of defaults. The problem with the government bailing out Lehman, aside from the cost to taxpayers, is that it would send a message that free-trading America is willing to shelter its financial industry from the costs of poor decisions.

Two private-sector suitors have emerged, but if a deal cannot be signed before the markets open in Asia on Monday, there could be negative consequences as investors sell shares in and withdraw money from banks and brokerage houses in fear of a meltdown.

According to Fitch ratings service on Friday, Lehman is inches away from a downgrade if it doesn’t make a deal. "All three rating agencies have them on rating watch negative," Fitch analyst Eileen Fahey said. "In the absence of any deal, there will be downgrade."

On Friday, Ladenburg Thalmann analyst Dick Bove said in a note to investors that a match between Dick Fuld's Lehman and Ken Lewis' Bank of America would be a "natural fit." Lehman Brothers Holdings has been desperate for a suitor as its losses mount and its future solvency is called into question.

British bank Barclay's was also reported as a likely buyer because of the size of its balance sheet. Barclay's added a similar 3.0%, or 73 cents, to close at $25.18 in New York. Both Barclay's and Bank of America are primary dealers, meaning they have special access to the U.S. Federal Reserve.

Sen. Richard Shelby, the top Republican on the Senate Banking Committee, said on television on Friday that the Fed and the U.S. Treasury were trying to work out a deal for Lehman that involved no government money. The government has been reluctant to intervene after the Bear Stearns bailout. "I think they're going to have to draw a line at some point," Rose Grant, managing director of Eastern Investment Advisors in Boston said of Washington regulators. "This could be the point."

Sanford C. Berstein analyst Brad Hintz was skeptical when he spoke of the matter on television on Friday. He thinks it is going to take quite a long time to do the due diligence on Lehman's large balance sheet and that many potential buyers wouldn't be willing to step in unless the government agreed to shoulder the first chunk of any new losses.

Bove contended that Lehman would benefit by gaining access to Bank of America's 68,000 commercial customers to sell capital markets products. Also, Lehman's fixed-income business would "meaningfully increase" if it were tied to the country's largest credit card and mortgage company.

Additionally, Lewis would get access to a top-notch bond trading operation and immediately become a player in stock underwriting. Bank of America would also get Neuberger Berman, Lehman's respected asset-management operation. As Wall Street continues to worry about the state of Lehman, the dollar was being driven down by the news, reversing recent gains.

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Barclays Bank in talks over bargain basement deal for Lehman Brothers

Barclays Bank is in talks about a potential takeover of Lehman Brothers as the authorities in the United States seek a rescue of the stricken Wall Street investment bank, The Times has learnt.

While Henry Paulson, the US Treasury Secretary, masterminds the rescue talks this weekend, Wall Street endured one of its worst days in recent memory as fears of a wider crisis spread across the financial community. Shares in AIG slumped 31 per cent as traders panicked about the future of the world’s largest insurer. The group said that it had hired JPMorgan Chase to help it to raise new capital and it is expected to reveal asset sales on Monday to bolster its balance sheet.

At the same time, Washington Mutual stock slipped 3.5 per cent to $2.73 as the bank’s new chief executive sought ways of steering the largest American savings and loan group through its crisis after it projected a new writedown and was downgraded to junk status by Moody’s, the credit rating agency.


Although John Varley, the chief executive of Barclays, and Bob Diamond, the chief executive of the investment banking division, have stated that they do not favour large-scale mergers, the prospect of securing Lehman businesses on favourable terms has piqued their interest. A number of other parties are also interested, including a consortium of Bank of America, JC Flowers, the private equity group, and China Investment Corporation, the sovereign wealth fund.

One possibility would be for JC Flowers to take on Lehman’s distressed real estate assets while the investment banking and asset management businesses could be sold to Bank of America or Barclays. Barclays believes that Lehman’s investment bank is an attractive asset and is understood to be interested should the price be sufficiently low.

Mr Paulson and Ben Bernanke, the Chairman of the US Federal Reserve, are racing to find a buyer and secure a sale of Lehman Brothers by tomorrow evening, so that the future of the Wall Street bank will be clear by the time that the Tokyo stock markets open on Monday. It is believed that Mr Paulson will narrow the field to one or two parties and will spend today and tomorrow pushing a serious suitor to complete the transaction.

It is also believed that Mr Paulson and Mr Bernanke are not willing to offer the kind of rescue funds to secure a sale as they did when Bear Stearns was sold to JPMorgan Chase in February. In that deal, Washington agreed to absorb as much as $29 billion in potential losses.

Washington’s reluctance to bankroll a rescue deal of Lehman Brothers triggered another steep fall in the bank’s share price yesterday, which dropped 14 per cent to $3.65. The bank is valued at about $2.5 billion in New York, even though its fund management business is estimated to be worth about $10 billion alone. The bank controls assets of about $600 billion.

The future of Lehman Brothers, the most heavily exposed to toxic mortgage-backed bonds of all the Wall Street banks, has become increasingly precarious over the past week. Shares in the bank halved at the beginning of the week, prompting Richard Fuld, chairman and chief executive of Lehman Brothers, to bring forward details of the bank’s third-quarter results.

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Barclays and Lehman: the rescue that shouldn’t be

That Barclays is contemplating rescuing Lehman Brothers takes the breath away. The British bank remains weak, even after tapping shareholders for £4.5 billion this summer. There are still worries among some shareholders that it is taking an overoptimistic view of some of its own assets. Only a month ago it insisted that organic growth, not big acquisitions, was the way ahead.

That it should seriously consider throwing in its lot with an even weaker merger partner is surprising, especially when market confidence is as fragile as it was in March, when Bear Stearns collapsed. Even if the price were buttons, Barclays would probably still have to issue fresh equity to strengthen its capital ratios and to pay Lehman shareholders.

There are some gems in Lehman, such as the equity capital markets division and the fund management offshoot. A deal could boost Barclays’ standing in investment banking in general and on Wall Street in particular. But there would be big risks in buying the investment banking business even if shorn of its huge holdings of toxic, illiquid assets.

And it seems unlikely that Barclays, which has a highly successful fund management unit, would want to add Lehman’s business, worth an estimated $10 billion. In less doubt would be the reaction of UK regulators. Does the FSA really have the stomach to become lead regulator for a British-owned Lehman?

Does the Bank of England, which regards banks as undercapitalised, want Lehman-inspired jitters crossing the Atlantic? The message from bruised shareholders to John Varley, the chief executive, is likely to be, by all means indulge in window-shopping, but please don’t enter the store.

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Hank to the rescue

If Hank Paulson had not already lost all his hair, he would surely be tearing it out right now. America’s treasury secretary must have thought saving Fannie Mae and Freddie Mac, the government-sponsored housing enterprises, would restore confidence to the financial system.

But the stockmarket rally lasted just one day, before investors switched their worries to Lehman Brothers, a struggling investment bank. Mr Paulson should get some credit for his rescue. The businesses had to be propped up to avoid chaos in the housing market; Fannie and Freddie have been providing around 80% of American mortgages this year.

By taking the lead, the Treasury took the pressure off the Federal Reserve. Quite rightly, the “conservatorship” structure has ensured that the chief executives went and the shareholders suffered. Inevitably, bondholders (which include foreign central banks) have been protected; the government had promised as much and a debtor nation could not afford to antagonise its lenders.

In our view, the pair should have been nationalised back in July, and the new scheme should have had a clearer plan to shrink or break up Fannie and Freddie, so that they never again hold the taxpayer hostage (though not right now, because of the ailing housing market). Cuts will not occur until 2010—a reprieve that leaves the door open for Congress to put its clunking foot through.

In the past Democrats have blocked plans to restrain the two agencies. Then there is the new fund that will buy mortgage-backed securities in order to support the market. The first purchase will be just $5 billion, but it is a worryingly open-ended commitment.

Once begun, purchases will be hard to stop; the government will be tempted to send good money after bad. This sets a disturbing precedent: if the government can buy mortgages, why not credit-card or car loans? And if it can spend billions rescuing Fannie and Freddie, why not General Motors or Ford?

Stockmarkets at first welcomed the deal. The meltdown of Fannie and Freddie would almost certainly have led to financial chaos. By lowering the funding costs of the two agencies, the rescue should also bring down mortgage rates for hard-pressed householders.

Although the plan has forestalled Armageddon in the American housing market, it is no cure-all. There are some signs of stability, but too many homes are for sale and defaults are rising fast. More than 9% of all single-family homeowners with mortgages are now a month in arrears or facing foreclosure. House prices may well fall further.

In any case, the credit crunch is no longer just about American housing. In Britain, Spain and Ireland house prices are falling. Defaults are rising across a range of debt classes from commercial property through corporate bonds to consumer loans. With unemployment rising in America and economic weakness ever more pronounced in Europe and Japan, economists are arguing about what counts as a recession.

The credit crunch had its origins in finance. But the banking industry and the economy are now locked in a kind of negative symbiosis, where bad news in one induces pain in the other. Defaults cause bankers to restrict the availability of credit, which causes more defaults. And so the malaise spreads.

The next test of the system is already here. Banks have spent the past year shoring up their balance sheets but, after some big losses, investors have lost their appetite for more share issues. Shares in Lehman Brothers have plunged as the investment bank tried, without success, to find an outside investor, leading the company to bring forward its results and its own emergency plan.

If that fails, will the government be forced, as with Bear Stearns, to engineer a takeover by a rival? It might be good, in theory, to let an investment bank fail “to encourage the others” and to buff America’s tarnished reputation as a champion of free markets. But having gone to such lengths to boost confidence in the financial system, the authorities will be reluctant to take that risk.

It does not help that financial products are now so complex that it is very hard to make even an educated guess about the real value of a bank. The world economy may well muddle through, as it has so often in the past. Growth in much of the developing world is still strong. And the recent fall in commodity prices, although partly sparked by economic fears, should be a boon.

But the rescue of Fannie and Freddie and the travails at Lehman are merely the latest in a long series of tests that the authorities will have to face over the next year or so. With Fannie and Freddie, they eventually passed the test. They may have to act more quickly and decisively next time.

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Could Lehman's Failure Cause a Systemic Meltdown?

What are the risks of a systemic crash if Lehman Brothers is allowed to fail? As Sudeep Reddy says, Lehman is just as big and interconnected as Bear Stearns was:

Mr. Bernanke, testifying before Congress in July, outlined his three reasons for stepping in with Bear Stearns: One was the size of the firm and its implications for broader financial markets. Another was that financial infrastructure was not strong enough to protect against a failure in derivatives markets. The third was "extremely fragile" financial conditions. Supporting the case for Fed action with Lehman: Most of those issues aren't resolved today.

Yet the situation with Lehman is clearly not a re-run of Bear. Why not? That's harder to answer. The main reason is that the Lehman unravelling has taken so long that everybody pretty much expects it to fail, at this point -- and in the markets, if something is expected (a/k/a priced in), there's generally little likelihood much chaos when it actually happens.

On the other hand, I suspect that although a bank failure might be priced in to the LEH share price, the same expectations have yet to percolate fully through the rest of the financial system. It's easy for a stock market investor to anticipate a Lehman collapse: you just sell the shares.

But what if you're a widget manufacturer in Iowa whose treasurer has been doing a lot of business with Lehman's derivative desk? Those positions are much harder to unwind. If you're expecting a big payment next month on the interest-rate swap which Lehman wrote for you, what are you meant to do?

I would hope and expect that the New York Fed will somehow manage to backstop most of Lehman's obligations to its counterparties, but given that nobody knows anything, it's impossible to say for sure. There should be some way to keep the pure trading book functioning smoothly even if people who lent money directly to Lehman are forced to take a haircut.

But it would be much easier for a big commercial bank to take over the entire Lehman Brothers operation -- Bank of America seems to be the most likely contender, according to the WSJ. Remember that when BofA took over Countrywide, it was careful not to guarantee Countrywide's debt. It might be able to do something similar with Lehman: buy the bank, absorb its employees and traders, but then allow the subsidiary to default if it turns out to be insolvent.

That might be a desirable outcome from the point of view of the New York Fed, but I can't see Ken Lewis being particularly keen on taking the reputation risk associated with such a move: No banker wants to default on his obligations, ever. It'll be interesting to see whether Tim Geithner comes up with a clever way of twisting his arm.

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New York City economy could take hit as Lehman falters

New York City's economy will likely suffer should Lehman Brothers lay off more staff as the credit crisis unfolds.

Banks and brokerages have long anchored the city's economy, in much the same way car-makers previously powered Detroit. The global credit crunch now in its 13th month has already spawned deficits in both the city and state budgets.

"I am very concerned about the situation at Lehman Brothers," said Democratic City Comptroller William Thompson. "The way in which it is resolved will affect its impact on New York City's economy and tax revenues," he added.

The credit crisis has taken a toll on the global financial industry, triggering hundreds of billions of dollars of losses, resulting in lower tax revenues for the city. Lehman shares fell to nearly a 14-year low on Friday amid fears the investment bank might not find a buyer as it seeks to raise desperately needed capital.

Lehman, which had some 26,000 workers around the world at the end of August, has shed more than 2,000 since the end of February. Experts also said Wall Street's latest downward cycle could easily drag on.
"My sense is we're probably getting close to halfway, just a little bit over that, but the dominoes keep falling," said Ross DeVol, director of regional economics, for the Santa Monica, California-based Milken Institute.

Financial workers exert much influence on the city, with each of their positions creating as many four other jobs, because they are so highly paid, the nonpartisan think tank's Devol explained. On average, financial workers earned $157,000 a year last year, around three times the national average of $53,000, he said.

The comparison is even more stark when just the salaries of bankers and brokers are examined. These individuals received an average of $340,312 in 2006, according to the state labor department.

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Testing times for the swaps market

The seizure of Fannie Mae and Freddie Mac is a big moment for the housing market. But it will also be a test for the dauntingly large market for credit-default swaps (CDSs).

Placing the mortgage agencies into “conservatorship” counts as bankruptcy, and thus triggers the settling of contracts on these derivatives, which are used to hedge, and speculate on, the risk that a company defaults.

The value of swaps linked to the agencies’ $1.5 trillion of bonds is unknown, as CDSs are private. One estimate puts it at $500 billion, which would be the biggest “credit event” yet in a market worth a notional $62 trillion.

It is a strange sort of default. Because of Treasury backing, the bulk of Fannie’s and Freddie’s debt (though not their preferred shares) will settle at par or close to it. That means some buyers of CDSs, who were betting on default, may paradoxically end up worse off. They will have earned mark-to-market gains as spreads on the agencies’ swaps widened (ie, the risk of default grew). Now they will have to give them up.

Equally, many protection sellers will reap gains. But not all: some have already booked as income premiums from the buyers for the life of the outstanding contracts—usually five years. They will now receive only a part of this.

Auctions to close out the swaps will be held in October by the International Swaps and Derivatives Association, a trade group. Complexity abounds but most dealers think the market can cope. If so, its credibility will receive a boost.

The episode might also be a badly needed catalyst for change. The auctions will involve “cash settlement”, rather than a physical exchange of the underlying bonds, which is needed because the value of swaps far exceeds the face value of those bonds.

Regulators have also been urging dealers to tighten up trade processing and to move to centralised clearing, especially since the demise of Bear Stearns, with its vast derivatives exposure, laid bare a huge “counterparty” risk—that it might not be able to honour contracts it had written.

The launch this week of a service to cut the level of capital at risk by batching trades in a process called “compression” is another encouraging sign that the market can heal itself. The quicker it does so, the better. The woes of Lehman Brothers, like Bear a big CDS counterparty, hint at even bigger tests to come.

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EU Policymakers Worried About Shaky Financial Markets

European Union policy makers see no end in sight to the credit crisis, but believe their banking systems remain sound. At a two-day meeting on the French Riviera, the bloc's finance ministers and central bankers mulled the impact of Lehman Brothers Holdings Inc.'s difficulties and questioned whether their own regulatory regime could prevent the collapse of such a large firm.

But they did little to address the fragmented nature of E.U. bank supervision, which falls to member nations despite the fact that a growing number of institutions operate across the bloc. To be sure, policy makers were nervously watching developments in the U.S., where the Federal Reserve Bank of New York and the U.S. Treasury are guiding efforts to shore up confidence in Lehman, which will likely involve finding a buyer for the firm or its parts.

German Finance Minister Peer Steinbrueck said he hopes a resolution for Lehman Brothers is found before the end of the weekend. "We're hearing that the U.S. authorities are trying to find a solution by Monday and before Asian markets open," he said.

European central banks have been preparing for the worst. Bundesbank President Axel Weber said the German central bank has been in contact with German lenders and is aware of their individual exposures to Lehman Brothers. Weber said that if Lehman Brothers can be kept in business or sold, "the impact should be limited." But he noted that global financial markets are being shaken by a new round of tensions.

E.U. policy makers should have little cause for feeling complacent, having been briefed on the scale of the problems faced by banks around the world by Mario Draghi, the governor of the Bank of Italy who is also chairman of the Financial Stability Forum, which brings together central bankers and regulators from the Group of Seven and other leading economies.

He told them that U.S., European and other banks will have to raise $350 billion in new capital if they are to put the losses they have suffered as a result of the credit crisis behind them. But he added that some may not be able to find the investment they need. He estimated that banks have suffered losses of almost $500 billion as a result of the financial turmoil that began last year with rising defaults on U.S. subprime mortgages.

He also estimated that banks have raised $350 billion in new capital to date, but said further losses will occur, requiring more capital and likely triggering consolidation in the sector. "We're in a phase where new losses may surface in the banking sector, and banks are facing these times with weaker balance sheets," Draghi said,

The policymakers did take one small step towards improving cooperation in banking supervision, agreeing to create a single reporting system for financial companies by 2012. "Transparency is improving," French Finance Minister Christine Lagarde said. " It is vital to enhance work on the valuation of assets, in particular where the current market is illiquid."

E.U. finance ministers in June asked the bloc's banks to disclose the risks they face during the current credit crunch. Lagarde said 80% of E.U. banks so far have complied, giving regulators a better sense of threats to the financial system.

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Best- and Worst-Case Scenarios

O.K., we've finally wrapped our minds around the impossible: On Sunday, Sept. 7, in the name of preventing a financial meltdown, the conservative Bush Administration announced that it was seizing control of two of the nation's biggest and highest-rated (until recently) financial institutions, the mortgage giants Fannie Mae and Freddie Mac.

In short, pigs can fly, and hell really can freeze over. So maybe it's time to expand our sense of the possible and ask what other shockers are in store. Will the 13-month-old credit crunch get even worse and drag down the entire global economy? Or are punch-drunk Americans due for an even bigger shock, namely some good news for a change?

The financial markets are grappling with just those issues—and gyrating between euphoria and panic. Stocks climbed on Sept. 8, the first trading day after Treasury Secretary Henry M. Paulson Jr. announced that he was placing Fannie and Freddie under federal conservatorship. The Standard & Poor's 500-stock index rose 2%.

But the next day, fears that venerable investment bank Lehman Brothers might go under dragged the S&P 500 down 3.4%. In highly uncertain times like these, scenario-spinning can be an excellent tool for making sense of conflicting data. It won't guide you straight to the right answer, but it will get you thinking about the right questions to ask.

For a best case, imagine a virtuous circle of events that starts with a favorable market reaction to Paulson's putsch. Paulson promised to replenish the companies' capital by purchasing up to $100 billion in senior preferred shares in each, as needed, to make sure they retain a positive net worth.

He also set up a secured lending facility that they can draw on if their private funding sources get too costly. And he said Treasury itself will try to make mortgage loans more available and affordable by buying Fannie and Freddie mortgage-backed securities, starting with a token $5 billion but possibly going far higher.

Paulson's move made a big impression in foreign markets, which have been nervously eyeing the condition of American banks. On Sept. 10, at a conference in Germany titled "Banks in Upheaval," Deutsche Bank CEO Josef Ackermann argued that "we are in a period of stabilization in credit markets and in stock markets, although they still remain nervous." Ackermann added: "We believe that what we see is the beginning of the end of the crisis."

At the very least, Paulson's unprecedented move defuses one ticking time bomb. It decreases the chance that either Fannie or Freddie will default on its debts or credit guarantees, which was the doomsday scenario for global financial markets. Together, the two companies have about $1.7 trillion in outstanding corporate debt. In addition, they have guaranteed repayment on $3.7 trillion worth of mortgage-backed securities they've issued.

Those securities are held by risk-averse investors such as banks, pension funds, and central banks around the world. Asian central bankers, in particular, had pressed the Treasury Dept. for action in the weeks before the takeover. Technically, Treasury is not guaranteeing the twins' obligations, but the chance that it would tolerate a default has dropped from small to near zero.

As investors get comfortable with Treasury's terms, the hope is they will settle for lower yields on the mortgage-backed securities Fannie and Freddie package and insure. Indeed, yields on the companies' mortgage-backed securities fell the day after the announcement by about 0.4 percentage points.

National average rates on 30-year, fixed-rate mortgages fell by an equal amount between the Friday before the announcement and the Wednesday after, to about 5.7%, according to daily surveys by Bankrate. Unclogging Fannie and Freddie's pipeline could finally make effective the easy-money policies of the Federal Reserve, which has cut the federal funds rate by 3.25 percentage points since the start of the crisis, to a stimulative 2%.

If mortgage rates keep moving lower, it should help some people refinance to avoid foreclosure while spurring sales by lowering the financial hurdle for people to buy homes. "I think this is a correct move. I think it will stabilize housing," says David Kelly, chief market strategist for JPMorgan Funds.

Stabilizing the housing market would be a confidence booster for the entire economy and the financial system. John Paulson of Paulson & Co., a $35 billion hedge fund that made a killing in 2007 betting against the U.S. subprime sector, told clients in a conference call days before the Treasury announcement that he's finally ready to make some tactical investments in financial firms that have gotten especially cheap, even though he thinks prices in the overall sector still have further to fall as foreclosures mount. His toe-dipping was first reported by the Financial Times.

If the housing market stopped sinking, or even rose, consumers might also spend more liberally, which would then boost employment and induce even more spending—the classic virtuous circle. One optimist, James W. Paulsen (not to be confused with Henry or John), chief investment officer of Minneapolis-based Wells Capital Management, notes that the 94% of the economy that's not housing or autos has grown over 5% over the past year, while the 6% consisting of housing and autos has shrunk 20%.

The implication, says Paulsen: "A quicker-than-expected turnaround is possible, since it would not require a broad-based recovery, but rather only a cessation of the collapse in two industries." Signs of health in the U.S. economy would reduce the risk of a panicky pullout by foreign investors, ensuring that inflowing capital would help finance spending by American households and businesses. In fact, the dollar rose after the Treasury announcement, adding to a gain of 10% against six major currencies since mid-July.

So we're golden, right? Well, maybe not. In the vicious-circle scenario, Treasury's intervention ends up being a replay of Japan's ill-fated effort to prop up crippled banks in the 1990s. Increasing the availability of credit delays—but does not prevent—the full price decline needed to clear out the daunting overhang of nearly 4.7 million unsold existing homes as of July.

As the lender of last resort, the government throws good money after bad, first on housing and then on airlines, automakers, and other supplicants. All this against an undeniable backdrop of rising federal deficits: The Congressional Budget Office predicted this month that the federal budget deficit would remain above $400 billion annually from 2008 through 2010, up from about $160 billion in 2007.

In the nightmare scenario, the descent into quasi-socialism balloons the national debt and wrecks foreign investors' faith in the economy. That's the vision sketched out by ultra-bears like Peter Schiff, president of Euro Pacific Capital, a brokerage in Darien, Conn. Schiff is passionate on the topic: "The dollar is going to go through the floor, interest rates are going to spike up, and we're going to have a complete financial meltdown. It's going to be the worst-case scenario."

A different school of pessimists says the housing market actually does need a big adrenaline shot from the government. But they say it's unlikely to get one from either a McCain or an Obama Administration because the risk to taxpayers from a much bigger commitment to housing would be deemed too great.

The only real beneficiaries of the takeover are the holders of Fannie and Freddie securities, who are bailed out of their bad investment choices, says Robert I. Kessler, CEO of Kessler Cos., a Denver investment firm. Says Kessler: "It's a great thing for the big banks. I don't see any benefit whatsoever to consumers."

Specifically, the Fan-Fred takeover does nothing to help homeowners who can't refinance a home loan because their property is assessed for less than they owe. It also may not be enough to draw in buyers, who are focused more on the risk of declining home values than on the upside of a slightly lower mortgage rate. "I've sat in open houses, and you just can't get people to make an offer," says Edward Cudahy Spalding, a real estate broker in Fort Lauderdale. "You've got to reinflate values in the housing market. I don't know how you do that."

Without more relief for homeowners and consumers, the housing-led recession is likely to deepen. In this vicious-circle scenario, the housing slump depresses consumer spending, leading to job cuts and thus forcing even more foreclosures and bigger spending reductions—in other words, the mirror image of the virtuous circle. Vulnerable sectors include finance; nonresidential construction, which tends to follow homebuilding downward with a lag; and retail, which has so far lost only a modest number of jobs nationally relative to the size of the sector.

Away from Wall Street, the mood is glum. Douglas S. Bartlett, owner of Bartlett Manufacturing, a maker of printed-circuit boards in Cary, Ill., says competition from China has forced him to cut employment nearly two-thirds since 2000, to 87. He hasn't felt any reprieve from the dollar's recent depreciation against China's currency.

Says Bartlett: "Fortunately for us, there's been enough of our competitors going out of business that we're able to pick up their work." In Sacramento, restaurateur Ali Mackani was forced to shut down his fashionable Restaurant 55 Degrees shortly after Labor Day because of slower-than-expected commercial and residential development in the area, which he had been counting on to produce customers.

Today's business failures ripple across the economy, triggering more failures. And when the financial system is crippled by losses, the hoped-for V-shaped recovery can flatten out into a wide-bottomed U, says Dan North, chief economist of Euler Hermes ACI, a North American unit of Germany's Allianz Group (AZ) that insures accounts receivable. North says that because of business failures, the number of insurance claims processed by his company was up 80% in the first six months of 2008 compared with a year earlier.

It's easy to imagine either scenario unfolding, good or bad. And really, that's the whole point. Blind conviction has not served us well. On the one hand, the credit crunch has embarrassed optimists, like Federal Housing Finance Agency Director James B. Lockhart III, who averred on Mar. 19 that Fannie and Freddie "will continue to be safe and sound" and called the idea of a bailout "nonsense."

In his new book, The Subprime Solution, Yale University economist Robert J. Shiller says regulators suffered from an "inability to believe that there could ever be a housing crisis of the proportions we are seeing today." On the other hand, it would be equally wrong to assume the worst and get into a defensive crouch, as some investors have done.

Prices of some derivative securities are so low that they seem to factor in a complete collapse of the U.S. economy. And yet investors who smell a profit opportunity in those assets are holding back because they worry their prices could go even lower before rebounding.

Ricardo Caballero, a Massachusetts Institute of Technology economist, wrote in the Bank of France's Financial Stability Review in February that "in today's market, uncertainty has led every player to make decisions based on imagined worst-case scenarios." What to do? Whether you're inclined toward the virtuous circle or the vicious one, hedge your bets. Because as the Fan/Fred takeover shows, just about anything can happen.

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Housing after Fannie and Freddie

Hank Paulson has earned himself a place in the record books as the Republican treasury secretary who engineered the biggest nationalisation in modern American history. It may be called a “conservatorship”, but the seizure of Fannie Mae and Freddie Mac is, in effect, a government takeover.

Whether this boldness improves the outlook for America’s economy depends on the answer to two big questions. First, will government control of Fannie and Freddie help solve America’s housing mess? Second, would stability in the housing market be enough to turn around the economy?

The answer to the first question is a qualified yes. It is hard to overstate Fannie’s and Freddie’s importance in the housing market, both as holders or guarantors of half of America’s mortgages, and as lenders who have stepped in as private finance has collapsed.

Over the past year they increased their lending by about $600 billion, or 12%, and this year they have financed four out of five mortgages. Without this cushion America’s housing bust would be far worse.

The conservatorship places restrictions on how fast Fannie and Freddie’s loan book can expand but not on the pace at which they can extend guarantees. After 2009 it demands that their portfolios shrink, but in the short term Mr Paulson’s takeover is meant to make mortgage finance flow more freely and cheaply. What is more, the Treasury said it would buy mortgage-backed securities. The impact on borrowing costs was swift.

On September 10th the average rate on a 30-year mortgage was 5.79%, almost half a percentage point below the average rate of 6.25% the previous week. In effect, Mr Paulson engineered the equivalent of a half-point cut in interest rates targeted at the mortgage market.

If it lasts, easier access to cheaper finance ought to help boost housing demand, particularly since the plunge in house prices has improved many measures of housing affordability. According to the S&P/Case-Shiller national index, America’s house prices have fallen by 15% in the past year.

The vast overhang of unsold homes (more than 11 months-worth of supply at July’s pace of sales) coupled with accelerating foreclosures (which rose at their fastest pace in three decades between March and June) means that prices still have further to fall. But lower financing costs and stronger demand will help staunch the decline.

What about the broader economy? Since mortgage losses are at the heart of banks’ financial woes, softening the housing bust would help. Shoring up Fannie and Freddie will also compensate for tighter credit elsewhere. But the takeover will not avert the deleveraging that has hardly started.

In a paper presented at the Brookings Institution, Jan Hatzius of Goldman Sachs predicts that house prices will fall by a further 10% and that overall mortgage-related losses will eventually reach $636 billion. Even with Fannie and Freddie continuing to lend, he reckons the credit crunch will knock 1.8 percentage points off GDP growth.

Moreover, the economic picture was growing more gloomy even as the Treasury was plotting its takeover. Consumers’ troubles are mounting as the boost from fiscal stimulus fades and the labour market worsens. The jobless rate soared to 6.1% in August; with falling asset prices and tighter credit making it harder for consumers to borrow, lost paychecks will have a more immediate impact on their consumption.

Falling oil prices may bring some relief at the petrol pump, but gauges of chain-stores’ sales suggest that consumer spending is flagging. Under such circumstances, the government is right to take bold steps. But even interventions on the scale of Mr Paulson’s may not be enough to raise people’s sagging spirits.

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Florida's Big Insurance Problem

When Hurricane Ike took a left on Sept. 8, heading away from Florida, locals breathed a sigh of relief. Not only are their homes on the line with each burst of violent weather but their pocketbooks are increasingly at risk, too. Over the past four years, Florida taxpayers' vulnerability to a major weather catastrophe has grown.

The quasi-governmental company that was conceived as an insurer of last resort, Citizens Property Insurance, has become Florida's top underwriter of homeowners' insurance. Citizens now has more than $433 billion of property exposure on its books, and Florida has exacerbated that risk by getting into the reinsurance business as well. "It's a disaster," says Brian P. Sullivan, editor of Property Insurance Report. "This is not something the public should be dabbling with."

Florida's concentration of risk in the hands of taxpayers is an example of the potential risks of having states supplement private-sector insurance. While Florida is particularly exposed to hurricanes, states including Texas and Louisiana also have increasingly popular state-sponsored insurance funds. And there's talk in Washington of adding wind coverage to the federal flood insurance program.

The appeal for homeowners: reasonably priced policies that offer relief from rising rates. But critics say that, in Florida at least, the state-sponsored player has inadequate reserves to cover future losses if a big storm hits, and that private companies find it tough to compete. "If the market behaved more rationally, prices would likely go up," says Ross Buchmueller, chief executive of PURE Risk Management, which writes only high-end homeowners' insurance in Florida.

On the surface, Citizens looks like an attractive option. The insurer is projecting a $4 billion surplus at the end of this year, says spokesman John Kuczwanski. But risk modelers project a rise in hurricanes, which could lead to heavy losses. According to the pro-industry Florida Insurance Council, if a category 4 or 5 storm hit Miami, it could cost $50 billion in repairs. Hurricane Katrina cost insurers $44.9 billion nationwide, according to insurance credit-rating agency A.M. Best.

Insurers typically try to spread the risk of such major calamities by buying reinsurance. Florida has instead taken on $28 billion worth of reinsurance risk itself, and its reinsurance pool would have to issue bonds for anything over $7.8 billion in losses. (The state's entire 2007-08 budget is $70 billion.) Given the credit market's volatility, taxpayers could face a huge bill. In July the state agreed to pay $224 million to Berkshire Hathaway just for the right to borrow $4 billion if insurance fund losses exceed $16 billion before May 15, 2009.

Citizens was never meant to grow to this size. It now has 1 million policies in force and accounts for 28% of all written premiums for homeowners' insurance—more than double its nearest rival, State Farm Insurance. Formed as a backstop in 2002, the company took off after three major hurricanes in 2004 and 2005.

Faced with state-imposed limits on raising rates to cover their risks, insurers began to pull out of Florida. Allstate Insurance has reduced its presence by two-thirds since 2004, writing 500,000 fewer homeowners' policies. State Farm, meanwhile, is appealing for a 47% rate increase and stopped writing new policies in Florida in February.

Earlier this year it also canceled coverage on all homes within a mile of the coastline. "We are very concerned about the financial condition of State Farm Florida," says spokesman Chris Neal. "Even in nonhurricane years, we have continued to lose money." As Citizens grows, how much liability could taxpayers face? With foreclosures rising and reconstruction costs high, it seems that Florida's next big hurricane could leave a wake of financial destruction.

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