Butte, Montana. High school band parading up Montana street.
Update 8.55 PM EDT Ilargi: The last update for tonight, I thought you have to see this, just to see how companies value themselves, and how surreal that often is. Using Lehman’s valuations of similar subprime assets, AIG just lost $14 billion, or 18% of its entire value.
And then, on top of that, we can safely presume it has overvalued its CDOs as well, even as it claims a mark-to-market value (yeah, depends on the market?!), and it will lose another $20-30 billion on that. Mind you: AIG, as soon as tomorrow morning, is forced to sell into a hostile overcrowded market.
AIG looks destined to lose over $100 billion in "presumed" asset value in one day. Not on stock, but on assets and swaps valuation. Does not look good.
See you in the morning.
How to Prevent A.I.G. From Failing
But the moment it began trying to raise capital, A.I.G. had to open its books to potential investors who were likely to take a sharp pencil to the company’s portfolio values, analysts said. And with Lehman Brothers last week providing investors with a valuation for the same types of assets held by A.I.G., subprime and Alt-A mortgage securities, the investment bank’s marks can now be applied to the big insurer’s books.
As of the most recent quarter, for example, A.I.G. had $20 billion of subprime mortgages marked at 69 cents on the dollar and $24 billion in Alt-A securities valued at 67 cents on the dollar.
But Lehman officials on a conference call with investors last week said it was valuing similar subprime mortgage securities to those held by A.I.G. at 34 cents on the dollar; its mark on the Alt-A holdings was 39 cents. Those valuations suggest almost a $14 billion decline in A.I.G.’s holdings, after taxes, an amount representing 18 percent of the company’s book value.
Additional write-downs may also be required in A.I.G.’s collateralized debt obligations, which the company does mark to market because they are held in a short-term account known as available for sale. The company valued $42 billion in high-grade holdings at 75 cents on the dollar, while it marked another $16 billion in lower-rated obligations at 70 cents.
A.I.G. also said recently that it might have to post collateral to its swap counterparties, heightening concerns that the company would have to raise capital in tight markets. A.I.G. said in a filing with the Securities and Exchange Commission that if its own credit were downgraded one notch by Moody’s and Standard & Poor’s, its swap contracts would require it to post collateral of about $13 billion.
Update 7.55 PM EDT Ilargi: Yo, America, here's one more thing you get to pay for: banks saving each other. Nudge nudge pinkie winkie.
And just to prove to you that me heart's in the right place, and I'm really too sexy for my bar: oil prices are at their lowest level in 6 months. Told you so.......
Looks like a perfect night to get hammed and slammered! We'll have so much fun tomorrow...
Banks planning to create $50 billion lifeline for rivals
As the outlook for Lehman Brothers' future appeared to dim Sunday, U.S. and foreign banks joined forces to create a plan aimed at inoculating the global financial system against the investment bank's possible failure, a top investment banking official said.
Banks are in tense talks to create a pool of money worth up to $50 billion to lend troubled financial companies, the official said on condition of anonymity because the discussions were ongoing. And officials at the U.S. Treasury and the Federal Reserve are expected to say they are prepared to be more generous in the Fed's emergency lending program for commercial and investment banks .
The plan comes as top government officials and Wall Street executives hold marathon meetings to save Lehman Brothers. The meetings have failed to find a buyer for the troubled 158-year-old investment bank, raising worries that its likely collapse would disrupt global financial markets.
The official also said the U.S. Treasury Department and the Federal Reserve are pushing Bank of America Corp. to buy Merrill Lynch & Co, though talks are still preliminary. Expectations that Lehman would survive as a company dimmed Sunday afternoon after Barclays PLC withdrew its bid to buy the investment bank. Barclays and Bank of America Corp. were considered front-runners to buy Lehman.
Oil Falls to Six-Month Low as Refineries Escape Major Damage
Crude oil fell to a six-month low in New York and gasoline tumbled amid signs that refineries along the Gulf of Mexico coast will soon resume operations after escaping major damage from Hurricane Ike.
About 20 percent of the U.S.'s oil refining capacity was shut, limiting fuel deliveries and prompting the Department of Energy to release 309,000 barrels from its strategic reserves. New York Mercantile Exchange electronic trading opened early today to allow traders to respond to Ike.
"It looks like we've dodged another bullet," said Peter Beutel, president of energy consultant Cameron Hanover Inc. in New Canaan, Connecticut. "The refineries in the Houston area seem to have come out of the storm remarkably intact."
Crude oil for October delivery fell $1.43, or 1.4 percent, to $99.75 a barrel at 7:55 p.m. on the Nymex. Futures touched $98.46, the lowest since Feb. 26. Prices are up 25 percent from a year ago. Gasoline for October delivery fell 9.46 cents, or 3.4 percent, to $2.6750 a gallon in New York.
CME Group Inc., the world's biggest futures exchange, began Nymex electronic trading of energy contracts at 10 a.m. New York time today.Oil in New York has fallen 33 percent from a record $147.27 a barrel on July 11 as high prices and slowing global economic growth reduce demand for fuels. Sales at U.S. retailers dropped in August for a second straight month and July inventories at American businesses increased the most in four years, Commerce Department reports showed last week.
"Growing fears about the economy are trumping any fears about the damage caused by Hurricane Ike," said John Kilduff, senior vice president of risk management at MF Global Inc. in New York. "The broader issue is the weakness of the financial system. Given the Lehman and WaMu watch, cash looks better than any speculative investment."
Barclays Plc, the U.K.'s third-biggest bank, pulled out of talks to buy Lehman Brothers Holdings Inc. today as the U.S. government raced to find a solution for the faltering investment bank. Washington Mutual Inc. plummeted in New York trading last week on speculation about its financial health.
Update 7.15 PM EDT Ilargi: Well, dear readers, I don’t know if you have followed the events this Sunday afternoon, but it might be a good idea to start doing so. Lehman is dead, and Merrill Lynch is given up in an arranged marriage. This will influence, down the line, every bank and government, wherever you are.
I predicted the Lehman situation kind of head-on, or rather, my sixth sense (my itch) or whatever you call it did. From here on in it gets more complicated though. The fall-out on Wall Street tomorrow morning is unpredictable for all parties. There will be all sorts of monsters forcibly dragged from closets, and there is no telling how many there are, how big, or how costly.
We have entered uncharted terrain. We might well see a historic Honey-I-shrunk-the-stock-exchange event. Very possible. Somehow I hope not.
One thing is for sure: Lehman failing takes trillions of dollars out of the world economy.
Bank of America plans $200 billion 'merger' with Merrill Lynch
Bank of America (BoA) has turned its attention to a possible $200bn (£111bn) merger with Merrill Lynch after pulling out of talks to save Lehman Brothers.
BoA, America's largest bank with a market value of $154bn (£85.9bn), is in early-stage merger discussions with Merrill about creating a financial conglomerate which, if the two were to combine, would become the world's biggest bank. BoA is believed to be willing to pay between $25-30 a share for Merrill, valuing the bank, whose shares closed at $17.05 on Friday night, in the region of $38-46bn.
The talks could also act as a trigger for other interested parties to enter the fray, with Merrill rivals Goldman Sachs and Morgan Stanley both likely to be interested in at least some of its assets.
It is understood that discussions surrounding the possible merger of BoA and Merrill began as a result of the weekend's conversations led by 100 regulators and senior bankers at the Federal Reserve Bank of New York's headquarters in downtown Manhattan.
BoA began negotiations with Merrill on Sunday morning, not long after it indicated it no longer had any interest in purchasing Lehman's assets.
The combination would be a smart move for Merrill chairman John Thain, who has looked on at the pain inflicted on Lehman over the weekend in horror, and is only too aware that after Lehman, Merrill is the smallest of the large brokerages on Wall Street.
Merrill has not been without its problems, having written off in the region of $50bn of mortgage-related assets and leveraged loans since the start of the credit crisis 13 months ago. On Friday, investors continued to sell-off Merrill's shares, which lost more than a third of their value last week on fears over its capital levels.
The two banks would make a sound strategic fit, combining BoA's strength in retail markets with Merrill's strengths in investment banking and private client broking. BoA chairman Ken Lewis has long been interested in providing the bank with some form of investment banking presence, but attempts to do organically have not always been successful.
In October 2007, Mr Lewis said he had' "all the fun" he could stand in investment banking after profits in that division fell by 93pc amid sub-prime related write-downs. But he is thought to have coveted Merrill from a far for some time, aware of the compelling offering that combining the two banks could make.
If the deal were to go ahead, it would mark the second major transaction BoA has undertaken during the credit crisis, having stepped in to rescue troubled mortgage lender Countrywide last year.
Wall Street's Wild Weekend
Merrill Lynch, one of those that considered being part of a consortium to rescue Lehman, is itself said to be in talks to merge with Bank of America, for as much as $45 billion, or up to $30 a share. Merrill has been caught, like Lehman, with huge exposures to mortgages and mortgage securities, though it has aggressively moved to unload those from its books in recent weeks.
A deal would help it escape the fate of Lehman, which is teetering on the brink now that Barclays has walked away from buying all or part of it. Bank of America was also in the running to buy all or part of Lehman and apparently decided Merrill was better prey. Meanwhile, American International Group is expected to announce a sweeping reorganization Monday, with plans to sell off an array of assets and businesses.
The developments come as traders furiously try to net out derivatives trades involving Lehman so they won't be caught exposed to a trading maelstrom when the U.S. markets open on Monday. The International Swaps and Derivatives Association was holding a "netting trading session" Sunday afternoon. "The purpose of this session is to reduce risk associated with a potential Lehman Brothers Holdings Inc. bankruptcy filing," the trade group said, adding that trades conducted during this period "are contingent on a bankruptcy filing on or before 11:59 p.m. New York time."
Hopes for a complete sale of Lehman faded Sunday as the negotiations among top Wall Street bankers and regulators gathered at the Federal Reserve Bank of New York pressed on. Barclays was seen as the stronger contender to take over a part of Lehman, but backed out. "In essence we were asked to look at the transaction--it would have been very attractive, but we're pretty strict about M&A, and if it doesn't meet our criteria, it doesn't do it for us, and in the case it didn't," a source said. "In this transaction we would have needed to guarantee the trading operations at Lehman. We just felt that we couldn't take on that sort of open-ended deal."
A plan for other Wall Street firms to inject capital into a proposed $85 billion-asset "bad bank" also stalled, in part because the federal government refused to chip in money, as it had with the seizure of Fannie Mae and Freddie Mac one week ago and as it did in the rescue of Bear Stearns in March. Not many firms would be able or willing to participate in capitalizing the bad bank without federal backing. Wall Street is still reeling from exposure to the mortgage markets, and many banks are struggling to raise capital for themselves, let alone a rival in need.
Bankers are also keenly aware of the difficulties facing each others' firms and other financial companies that have exposure to the mortgage markets. American International Group and Washington Mutual, like Lehman, were hammered in stock trading last week on concerns they would unearth more toxic assets that they need to write-down.
Ilargi: If today doesn't bring a deal for Lehman, the reason will be that the 100+ people involved in the negotiations are simply not focused on the matter at hand.
Everyone is trying to figure out, with their teams of lawyers and accountants, what it would mean if Lehman goes down and files for bankruptcy protection. Few of the market makers have counted on that happening, at least not in this -early- stage of the Unwind game.
They are supposed to work together to find a solution, but while they talk their thoughts wander inexorably towards the survival of their own firms and jobs and shares and homes and yachts and lifestyles and choir boys and mistresses and reputations. Not an ideal environment to do big business in.
Nobody really wants Lehman. An early proposal to split off a "bad bank" branch containing $85 billion in "souring" assets, including $30 billion in commercial real estate silly paper, had the effect of a category 12 hurricane warning: women and children first.
They all know that if that's what's known, there's more to come: they only need to look at their own -hidden- books. That's exactly why they refuse to lend to each other, after all.
It didn't help that the bad bank proposal almost certainly died when Lehman shares crushed through the basement floor. Any buyer will have to take it all, or get into bed with other peers that they fear for the same reasons.
It's not 100% impossible to get a deal done, but there's no way it'll look pretty, or live long enough to have any chance of ever making it to kindergarten.
Look, Lehman will never return to profitability. So the Lords of the Street might as well move on. Only, they can't.
Lehman is so intertwined and entangled and tentacled into the sphere of international finance that it's not enough for the happy few to have their accountants tell them what their own exposure to the latest dead bank talking is. They would have to know those numbers for everyone they do business with. Only, they can't get them.
Sure, one or the other of the movers and -shaky- shakers may offer two calves, a sheep and a hardly-ever-used rosy-cheeked kitchen maid for the lot, but accepting that would just be too risky. If on Monday morning that is set as the value for all of Lehman, then the value of their own firms will need to be re-calibrated along the same dark math. Not good: there goes the yacht.
And even if and when they manage to get their focus off their own sordid fates for a second, it's not to Lehman and the negotiations at hand that their aching brains turn.
It's to Merrill Lynch's missing hind legs, to the balance sheet shattering option-ARM portfolio's at Washington Mutual and Wachovia, to the Freddie and Fannie preferred shares holdings at hundreds of regional US banks and pension funds, and to the $20 billion in assets that AIG will need to try to sell in a market flooded with assets, and against the background of Ike-only-knows how many billions of dollars in flood-insurance claims coming its way.
Nouriel Roubini thinks that a Lehman demise will ravage all other large US investment banks as early as tomorrow morning. He may be right, but then again, why go after Morgan Stanley and Goldman Sachs while there are still so many smaller but much easier-to-catch fish left in the barrel of abundance? They can be picked off one by one; the big fish can be left for later.
There's only one barrel. It’s not as if they’re going anywhere.
Update 4.15 PM EDT Ilargi: Tony Soprano has nothing on these guys:
In plain terms:
Goldman Sachs, re: Hank Paulson, wanted to execute Lehman. That is now done. The price they have paid for it, set in the alleged Save-A-Lehman talks, is that Merrill will be around for a while longer.
Anyone want to take a bet on how much we will ever find out about the amounts of money, off-market, try the derivatives trade, that was slushed from Lehman to Merrill holdings since Friday night by the in-the-know crowd? Merrill close at $17, BoA offers a $10 profit per share.
Bank of America in Talks to Buy Merrill Lynch
Bank of America is in advanced talks to buy Merrill Lynch for at least $38.25 billion in stock, people briefed on the negotiations said on Sunday, as a means to preserve that investment bank while Lehman Brothers looks likely to collapse.
The move suggests a desperate effort at triage on Wall Street, as Bank of America works to shore up the likely next victim of the credit crunch. A deal, valued at between $25 a share to $30 a share, could be announced as soon as Sunday night, these people said. Merrill shares closed at $17.05 on Friday.
Bank of America, the nation’s second largest bank by asset size, had been mulling buying Lehman, perhaps in a consortium with other financial players. But with financial aid from the government looking unlikely, Bank of America has moved on to Merrill, these people said.
As Lehman began to totter in recent weeks, investors feared that Merrill would be the next victim of the credit squeeze. Shares in Merrill, which has already reported tens of billions of dollars in losses, have plunged more than 68 percent over the past year.
Update 4.15 PM EDT Ilargi: I think this one may be down the drain...
Extremely rare event: Derivative traders open session to reduce Lehman risk
A rare emergency trading session has been opened Sunday afternoon between Wall Street dealers who have carried out transactions with Lehman Brothers that may be put at risk if the investment bank files for bankruptcy, the International Swaps and Derivatives Association said.
U.S. regulators and bankers were making last-ditch efforts on Sunday to prevent toxic assets from ailing Lehman Brothers spilling into global markets and rupturing investor faith in the international financial system. "This is an extremely, and I stress extremely, rare event. It also speaks to the more general notion that, in today's highly disrupted financial markets, the unthinkable is thinkable," said Mohamed El-Erian, the chief executive of Pimco, the world's biggest bond fund, based in Newport Beach, California.
The session will run from 2 p.m. to 4 p.m. New York time (1800 to 2000 GMT) and will involve credit, equity, rates, foreign exchange and commodity derivatives, ISDA said in a statement. ISDA confirms a "netting trading session" was taking place for OTC derivatives. Market sources said the special session was initiated by the Federal Reserve.
The aim is to reduce risk associated with a potential bankruptcy filing by Lehman Brothers Holdings Inc.
"Trades are contingent on a bankruptcy filing at or before 11.59 p.m. New York time Sunday (0359 GMT)," said the statement. "If there is no filing, the trades cease to exist." Britain's Barclays Plc , which had appeared to be the frontrunner to take over Lehman -- excluding its bad mortgage-related assets -- pulled out of the bidding early in the afternoon, according to a person familiar with the matter.
That raised the risk of a Lehman bankruptcy. The special session "is a way to offset the risk between the remaining large banks and insurance companies and fund managers prior to the markets opening in Asia," said Mark Grant, managing director of structured finance at Southwest Securities, based in Dallas.
Hank Paulson begs banks to deliver Lehman rescue
Barclays is considering a direct plea from Hank Paulson, the US Treasury Secretary, to assemble a cut-price rescue bid for Lehman Brothers, the investment bank which has become the latest victim of the global financial crisis.
Paulson, the former head of Goldman Sachs, has urged Barclays and a number of other large financial institutions to intervene in the Lehman crisis, which is threatening the future of one of Wall Street's most venerated businesses. US officials are concerned that the collapse of Lehman will prompt a fresh contagion among investors worried about the security of institutions such as Merrill Lynch and AIG, the insurance group.
Last night, a team of senior Barclays executives, including Bob Diamond and Jerry del Missier, the chief executive and co-president of Barclays Capital respectively, were locked in talks aimed at finding an appropriate structure for a takeover of Lehman. However, people close to the British bank were uncertain last night whether a deal would be achievable, particularly at such short notice.
Barclays executives are keen that they have access to financial assistance from the US government which would allow Lehman's non-performing assets to be held in a so-called 'bad bank' vehicle with no risk to Barclays shareholders. Paulson's public insistence that taxpayer funds will not be used to bail out Lehman, as they were earlier this year to facilitate the bailout of Bear Stearns by JP Morgan Chase, makes such help unlikely.
"We have been asked [by Paulson] to look at this, and it would be remiss of us not to, but looking is not the same as doing," a person close to Barclays said last night. Barclays is facing competition to buy Lehman from Bank of America, and it remains possible that another bidder will emerge today, with Nomura, the Japanese brokerage, Goldman or others named as potential buyers.
Lehman would be valuable to both Barclays and its US rival, either strengthening the British bank's standing on Wall Street or giving Bank of America an enhanced presence in Europe and Asia, regions where its investment banking business is weak.
At an emergency meeting at the New York Federal Reserve on Friday night, Lehman was told by some of those present that it needed to find a solution to its capital crisis before Asian stock markets open tomorrow morning, about midnight tonight in Britain.
The summit was attended by Wall Street bosses including John Mack, chief executive of Morgan Stanley, John Thain, his counterpart at Merrill Lynch, Jamie Dimon, head of JP Morgan Chase, and Lloyd Blankfein, chief executive of Goldman Sachs. Representatives from Royal Bank of Scotland, which has a large US banking business, and US government officials, including Paulson, and Tim Geithner, head of the New York Federal Reserve, were also there. It is not clear whether anyone from Barclays attended.
A further meeting was held yesterday and another is expected to be staged today in an effort to secure a deal that will salvage Lehman's future. The Fed meetings have revived memories of the crisis which engulfed Long Term Capital Management, the hedge fund, in 1998, when Wall Street firms were asked to make contributions to save it from collapse.
Lehman's situation is different, in that the US authorities do not generally view its collapse as an event which would pose a broader systemic risk. Efforts to secure capital infusions are now more complicated because of the deep scars on the balance sheets of many investment banks.
Last week, as its share price continued to slide despite the government rescue of Fannie Mae and Freddie Mac, the US mortgage giants, Lehman unveiled plans to separate its core investment bank from the 'toxic' real estate assets which have triggered concerns for its financial health.
The slump in Lehman's share price last week - the bank has lost more than 90 per cent of its market value this year - was mirrored by sharp declines at Merrill and AIG. AIG had been planning to update the market about its strategy towards the end of the month, but is now likely to do so as early as tomorrow, potentially raising billions of dollars through a stock issue and asset sales.
Lehman had been hoping to secure a capital injection of about $6bn (£3.6bn) from Korea Development Bank, a state-backed lender in South Korea. Talks with KDB ended unsuccessfully last week with Dick Fuld, Lehman's chief executive, holding out for a price higher than the Koreans were prepared to offer. Other discussions with potential investors, including sovereign funds in the Middle East, and Citic Securities of China, have also stalled.
Fuld was this weekend seeking offers for Neuberger Berman, Lehman's asset management arm, which is valued at up to $8bn but may fetch considerably less because the bank is seen as a forced seller. The bank has received offers for the business from private equity firms including Bain Capital and Clayton Dubilier & Rice.
Fed's options limited if Lehman talks fail
If intense weekend talks fail to turn up a buyer for investment bank Lehman Brothers, the Federal Reserve's options for calming markets will be down to words, interest rates, or appeals to Congress to extend its powers.
One option is to do nothing at all and some analysts think that may be the best one, even if it proves to be the straw that breaks Lehman's burdened back. "A reasonable argument can be made that a failure, while painful, would not cause systemic damage," said economist Mark Zandi of Economy.com in West Chester, Pennsylvania. "I think the Fed really can't do much in this case and probably shouldn't."
Since it orchestrated the sale of Bear Stearns to JPMorgan , complete with a $29 billion promise to absorb losses, the U.S. central bank has faced criticism from among its own members and outside that it may have overstepped its bounds.
Letting Lehman fail could help the Fed restore some credibility among those who say its willingness to bail out Wall Street time and again has set a dangerous precedent, one that may be encouraging would-be Lehman buyers to wait and see whether more government cash is coming.
"It would reflect badly on the Fed if they have to bail out Lehman," said Anil Kashyap, an economics professor at the University of Chicago's Graduate School of Business. "It's been six months since Bear Stearns. Everybody knew that Lehman was shaky. They've had six months to think about this and if their best answer is to throw more taxpayer money at them, there is going to be a lot of criticism."
U.S. Treasury Secretary Henry Paulson let it be known on Friday that he "adamantly" opposed using taxpayer funds to help rescue Lehman and the Fed similarly signaled it didn't want to do so. That has persuaded many analysts that Lehman may be the test-case, where officials decide a rescue stands or falls on its own merits and not rely upon guarantees of taxpayer help.
"I think the Fed will seriously consider letting Lehman find a buyer or file for bankruptcy protection," said Raghuram Rajan, former chief economist at the International Monetary Fund who teaches at University of Chicago's business school. "The Fed and the Treasury want to take a stand against the notion they stand behind all large financial firms. Lehman may be where they make the stand."
Since the credit crisis mushroomed in August 2007, the Fed has poured cash into frozen financial markets, created lending facilities to tide over firms in need of emergency funding, and lowered its federal funds rate by 3.25 percentage points.
None of that saved Lehman Brothers from its current predicament. The few remaining measures that are available to the Fed may not be very effective in settling markets either if Lehman cannot find a buyer. The central bank would undoubtedly offer assurances that it stood ready to provide liquidity to financial markets but that is not the issue afflicting markets.
"We have tons of liquidity, but the problem is that some of the financial pipelines in credit markets are clogged and velocity has slowed down," said Sung Won Sohn, an economics professor at California State University. That also argues against an emergency cut in the Fed's trend-setting federal funds rate, a move Sohn said would be "highly undesirable" since it would incorrectly aim to boost liquidity.
Zandi said that, if the Fed fears systemic risk from a failure of Lehman, then rather than try to boost liquidity federal officials should consider "a big, bold step" to address insolvency such as setting up an institution to help dispose the assets of failed institutions.
The model is the Resolution Trust Corp that was used to help sell assets of failed savings and loans in the 1990s and then was disbanded. Doing so might help break a developing cycle in which investors hold off on bidding because they anticipate that the U.S. government will eventually step in with some form of taxpayer-financed help to close a deal.
The Fed could also go to Congress to ask it to speed up its grant of authority for the central bank to pay interest on reserves it holds for banks. Lawmakers gave the Fed permission in 2006 to pay interest but set 2011 as the effective date. But again that move would largely be aimed at broadening its powers to provide liquidity to financial markets.
If the Fed had such authority, it could flood the banking system with excess cash without fear the overnight federal funds rate -- its main economic policy lever -- would plunge in a manner that could set off inflation. Banks must meet set reserve requirements, but since they receive no interest on those reserves, they have an incentive to lend out any excess cash in the open market, pressuring interest rates lower.
If the Fed could pay interest on reserves, it could put a floor under benchmark rates. Zandi said a more useful immediate move by Fed policymakers, who meet Tuesday to plot interest-rate strategy, would be underline its sensitivity to financial market stress and signal that its next likely interest-rate move will be to lower them, which might bring some calm to markets.
Sentiment swings as financials ride rollercoaster
Uncertainty about the health of the global financial sector dominated market sentiment this week as an initial wave of euphoria over the bail-out of Fannie Mae and Freddie Mac quickly gave way to fears that Lehman Brothers would be the next casualty.
Equity and credit markets suffered wild swings, while the dollar continued to attract buyers and commodities sank as an uncertain outlook for global growth triggered a wave of risk aversion. US crude briefly dropped below the psychological $100 a barrel level yesterday, despite the threat of hurricane damage to oil installations on the Texas Gulf coast and this week's decision by Opec to raise output.
But the decline for oil prices this week was overshadowed by financial sector concerns as investors awaited developments on Lehman Brothers. Concerns mounted going into the weekend that the investment bank may fail to find a buyer because of the US government's apparent reluctance to provide financial backing.
Lehman shares tumbled some 77 per cent over the week, prompting weakness across the US financial sector, although the broader equity picture was more mixed. By midday yesterday, the S&P 500 was showing a gain of 0.5 per cent over the five-day period, although European investors appeared far more confident and drove the FTSE Eurofirst 300 index up 3.3 per cent. The Nikkei 225 Average in Tokyo ended the week flat.
Lehman's credit default swaps widened sharply, but credit markets as a whole appeared to be far less alarmed than they were in the run up to the collapse of Bear Stearns in March. There was far more of a sense of risk aversion towards emerging market assets. The MSCI EM equity index touched its lowest level since November 2006 as the Russian RTS index sank 8.7 per cent and the Shanghai Composite lost 5.6 per cent.
The spread of emerging market sovereign debt over US Treasuries hit its widest level for more than three years, while in currencies the South African rand fell about 3 per cent over the week and the Brazilian real 5.6 per cent, even as Brazil's central bank raised interest rates by a hefty 75 basis points to 13.75 per cent - the highest for nearly two years.
According to Merrill Lynch's latest global FX and debt investor survey, investors have moved to underweight emerging market currencies for the first time since 2002, with exposure to the US dollar at its highest level since July 1999. "The catalyst for recent EM currency weakness has rotated from rising inflation and the attendant monetary policy challenges to slowing growth," said Steve Malyon, currency strategist at Scotia Capital.
"With industrialised countries taking in roughly half of the emerging world's exports - according to IMF statistics - it was only a matter of time before concerns over an EM slowdown had a currency market impact." Risk aversion was also evident elsewhere in the currency markets as the yen benefited from a continued unwinding of carry trades, in which investors sell low-yielders such as the Japanese unit to fund purchases of riskier, high-yielding assets.
The yen reached a two-year high against the euro and gained ground against traditional carry beneficiaries such as the Australian and New Zealand dollars - particularly after a bigger- than-expected 50bp interest rate cut by the Reserve Bank of New Zealand. But the yen slipped against the dollar as concerns about the prospects for economic growth outside the US continued to drive the greenback higher virtually across the board.
"So far we have negative GDP prints for New Zealand, Canada, Japan and Germany," said David Bloom, global head of FX strategy at HSBC. "It is obvious that other economies are deteriorating fast. The US dollar is benefiting from the misery of others." The euro sank below $1.40 to its lowest against the dollar for 12 months, while sterling hit a 2?-year low. However, the US currency gave back some of its gains after weak US retail sales data yesterday.
Government bonds had a choppy week as investors took their cue from movements in equity markets. The big stock rally on Monday drove the yield on the two-year US Treasury to 2.52 per cent, the highest for a month, but by midday yesterday it was back to 2.24 per cent, flat on the week. "With investors now assigning around a one-third probability to a 25bp [US] rate cut by year-end, two-year yields are barely above the Fed funds rate," noted John Higgins at Capital Economics.
However, the yield on the three-month US Treasury bill - widely seen as the world's most liquid asset - was down 22bp at 1.48 per cent, reflecting the broad sense of uncertainty among investors. In Europe, the 10-year Bund yield rose 14bp to 4.17 per cent while the 10-year Japanese government bond yield rose 9bp to 1.53 per cent.
Battered insurer AIG’s $20 billion asset sale
AIG, the world’s largest insurer, is planning a $20 billion (£11 billion) asset sell-off as it fights to correct a record slump in its share price and braces for the impact of Hurricane Ike. Details of the plans could come as early as tomorrow. On Friday the insurer appointed investment bank JP Morgan to work on a rescue plan after its shares fell a record 31% in a single day.
Assets under the hammer include Transatlantic Holdings, its New York-listed reinsurance group. Swiss Re and Munich Re, two giants of the European reinsurance business, are understood to be potential buyers. Other assets on the block are AIG’s consumer finance, reinsurance and plane-leasing units, according to analysts at Citigroup.
AIG shares have been pummelled by worries over a possible credit downgrade and the continued chaos on Wall Street. The shares plunged 46% last week. AIG said: “We are working with a number of firms on a variety of options.” It could not comment on whether the firm would be making further announcements tomorrow.
The move comes as AIG and other insurers brace themselves for the cost of Hurricane Ike in the Caribbean. Thousands of homes have been destroyed and 2.9m people left without power by the storm that is ravaging southeast Texas. Authorities have no idea how many people have perished in the storm.
AIG shares have slumped as the cost of insuring its debt has risen and concerns have grown that the company may be the next big American financial firm to run short of cash. Last weekend the US government stepped in to bail out Fannie Mae and Freddie Mac, the American mortgage giants.
Washington Mutual, America’s largest savings and loans company - the equivalent of a building society in the UK – is also struggling under a collapsing share price. AIG has been hit hard by credit crunch because its derivatives unit sold guarantees on securities tied to the American mortgage market.
British Airways CEO: 30 more airlines will go bust this year
Up to 30 more airlines will go bankrupt before Christmas, the chief executive of British Airways warned yesterday, as the biggest rescue of stranded passengers in travel industry history began.
Willie Walsh said the scenes of chaos in which 85,000 passengers have been stranded at locations around the world after the collapse of XL, Britain's third largest holiday company, would become a familiar sight as the travel industry struggled with soaring fuel costs and the effects of a global economic downturn.
"We are in the worst trading environment the industry has ever seen", said Mr Walsh. "We have already seen 30 or so airlines go bust this year and it would be fair to expect a similar number of casualties worldwide over the next three to four months." Mr Walsh also announced up to 1,400 redundancies at his own airline yesterday.
Travel industry experts said smaller airlines and tour operators were most at risk and warned passengers to book in a way that ensured they got their money back if an airline went bankrupt. Joseph Thomas, a travel and leisure analyst at Investec, the City stockbroker, said: "XL will not be the last: there have been a number of similar issues recently of smaller tour operators hitting financial difficulties."
John Strickland, an aviation consultant with JLS Consulting, added: "There are carriers in the UK that are not cash-rich like BA or Ryanair and who have not been able to hedge their oil costs. I think there will be other failures in coming months."
The travel sector is particularly vulnerable at this time of year because operators have to begin paying suppliers, such as hoteliers just as the number of bookings begins to dwindle. This year, however, is especially difficult because the UK's economic slowdown has begun to damage sales.
At the same time, the costs of airlines and other travel companies remain high, primarily because of the hugely inflated price of jet fuel, which has doubled in a year. Britain's biggest tour operators, TUI Travel and Thomas Cook, have already announced they are cutting by about 8 per cent the number of holidays on offer next summer to avoid being caught out by falling demand.
Most leading airlines, including national carriers such as BA and budget airlines such as Ryanair, have also announced reductions in capacity, particularly during the winter months. But smaller players may have insufficient resources to survive. XL is understood to have had large borrowings, which left it especially vulnerable to a rise in costs.
Kenny Ezard, of Airline Business magazine, said she was sure other airlines would go bust, following Zoom, Silverjet and XL. "It's an ever-growing list," she said. "It will be the ones that don't have strong balance sheets, probably the start-ups. There will also be a lot more consolidation, which is already happening in Europe."
Some bookmakers are now taking bets on which airline or tour operator will be the next to go bankrupt, though transport analysts are reluctant publicly to name those considered most vulnerable for fear of sparking a panic that would seal their fate.
Gert Zonneveld, a transport analyst, said: "Companies that have gone under in the UK have tended to be younger, smaller companies; the larger companies have a lot more cash and are well established and it takes a long time to achieve that."
Alitalia, the Italian national airline, could be the next high-profile victim of the downturn, having been given one more day by the Italian government yesterday to come to an agreement with trades unions. Ministers said that if the unions did not sign up to a rescue plan for the ailing airline its assets would be liquidated.
British Airways said its programme of redundancies, which are – for now – voluntary rather than compulsory, was the final stage of a restructuring plan launched in 2005. A spokesman for BA said it had intended to complete the restructuring by next March but was now bringing forward the final phase.
Staff have been told that anyone who applies for redundancy will be offered a severance package, though the airline has not set a formal target for the number of people it wants to shed. "The airline industry faces exceptionally difficult circumstances," BA's spokesman said. "We'll see what response we get from these managers."
The airline has already unveiled a series of measures designed to counter a crippling rise in its jet fuel bills, which are expected to total £3bn this year, 50 per cent more than in 2007. Last month, it revealed profits during the first three months of the year were 88 per cent lower than in the same period last year and warned price increases and cuts to capacity were inevitable.
Lehman's Options Narrow, With Forced Breakup Possible
The outlines of plans to determine the fate of Lehman Brothers Holdings Inc. emerged today even as it became increasingly clear that a clean sale of the entire firm to a big bank would be too difficult to execute.
A sense of optimism that a rescue could be arranged today dimmed as a growing sense of gloom descended on Wall Street. Executives from top banks in the U.S. and Europe huddled with federal regulators in an attempt to come up with plans to either buy pieces of Lehman or prepare for an orderly winding down of the firm in a manner that would minimize the collateral damage for the ailing global financial system.
Under one plan, either Barclays PLC or Bank of America Corp. would buy Lehman's "good assets", such as its equities business, people familiar with the matter say. Lehman's more toxic, real-estate assets would be ring-fenced into a "bad" bank that would contain about $85 billion in souring assets.
Other Wall Street firms would try to inject some capital into the bad bank to keep it afloat for a period of time so that a flood of bad assets don't deluge the market, damaging the value of similar assets held by other banks and insurers. The banks are also looking for the government to somehow financially backstop the bad bank.
The problem, though, is getting enough banks to back that plan. While teams of bankers are working through structures, it's clear that only a handful of banks are in a position to provide enough funding. Many banks are inclined to preserve capital ahead of third-quarter and year-end cash preservation moves. Also, banks aren't keen to see a big rival such as Barclays or Bank of America walk away with valuable assets by only paying a pittance.
As of Saturday afternoon, Barclays, the U.K.'s third-largest bank in terms of market value, appeared to have more interest in pulling off a deal for Lehman's good assets. At about 3 p.m. on Saturday, Barclays President Robert E. Diamond Jr. was seen entering the New York Fed's employee entrance on Maiden Lane, carrying a briefcase.
Bank of America, an obvious buyer, appeared to be cooling toward a deal, people familiar with the matter. Of course, some of this could be the posturing that happens in any auction. Neither Barclays nor Bank of America wants to buy all of Lehman without some government assistance, and so far the government has been reluctant to do so.
In a meeting at the Federal Reserve Bank of New York in lower Manhattan, some participants also were discussing insurer American International Group Inc. and thrift-holding company Washington Mutual Inc. While those two financial firms aren't the focus of the emergency meeting, participants also are weighing the potential implications of their problems.
One person leaving the building said at least 100 people were gathered inside trying to settle the fate of Lehman, which has been staggered by its exposure to soured real-estate-related assets. By 5:15 pm, some Wall Street executives started to leave the New York Fed one at a time, getting in their cars inside a garage so they can't have their photos snapped.
Outside the Fed's downtown headquarters, a fleet of black towncars waited for bankers who were inside. At one point, the towncars blocked the narrow streets around the building, causing a traffic jam that had to be broken up by the Fed's uniformed guards. Meanwhile, bankers and Fed staffers milled around outside, smoking cigarettes and talking on their cell phones about subjects like counterparty risk.
"Everybody is hoping there will be a Wall Street solution to deal with Lehman's toxic assets," said one senior executive at a major bank. "It is a cheaper alternative than having everything unravel." With it unclear whether the gap between the federal government and potential buyers can be bridged, a second group at the New York Fed is focusing on the possibility that there might be no alternative to liquidating Lehman and winding down its operations in an orderly fashion.
On Saturday afternoon, the credit-trading heads of major investment banks gathered at the meeting to discuss how to deal with their exposures to Lehman in the intertwined credit-default-swap market. The lack of a central clearinghouse in this market means that dealers, hedge funds and others are directly facing each other in insurance-like contracts that are tied to trillions of dollars in debt instruments.
Credit derivative traders at some firms were asked to come to work over the weekend to help quantify their exposures to Lehman and compile lists of outstanding contracts they have with the investment bank. One person familiar with the matter said large dealers are trying to decide if they should show each other all their credit default swap trades with Lehman. Disclosing their positions could enable dealers to offset their positions with each other wherever possible.
For example, if one dealer has bought a swap from Lehman and Lehman sold a similar swap to another bank, the two banks could agree to face each other directly. Such moves could also help prevent individual firms from scrambling to find new counterparties to re-hedge their positions with when the markets reopen on Monday, potentially unleashing turmoil in the credit markets. They could also help facilitate an orderly wind-down of Lehman's derivative positions, if that becomes necessary.
It is not known how much in CDS contracts Lehman has. In a survey last year by Fitch Ratings, Lehman was listed among the 10 largest CDS counterparties by number of trades and the amount of debt to which the contracts were tied. Wall Street traders poured into their offices Saturday for emergency meetings to consider the actions they would take if Lehman is forced into liquidation.
They broke into teams to evaluate their positions and exposure to Lehman in everything from energy trades to equity derivatives to credit, One trader said conditions in the credit default swap market and the short-term repo markets are more stable today than they were in March, when Bear Stearns nearly collapsed, but still, "if they go into liquidation," it is going to be a bad situation on Monday.
A disorderly unwind of Lehman's derivatives trades is only one worry. Another worry is that if Lehman collapses, its distressed assets - such as commercial real estate - could suddenly hit Wall Street for sale, forcing prices even lower and potentially forcing other dealers to mark down once again the value of their own holdings.
Lehman has hired law firm Weil, Gotshal & Manges LLP to prepare a potential bankruptcy filing, according to a person familiar with the situation. The New York-based Weil has a leading bankruptcy practice and advised Drexel Burnham Lambert on its 1990 bankruptcy filing.
In a Lehman bankruptcy, the firm's brokerage units would have to enter a Chapter 7 liquidation, in which a court-appointed trustee would take over, liquidate the firm's assets and get Lehman customers back their money. In general, securities that a customer holds at a brokerage firm are legally the investor's property and aren't exposed to the claims of the firm's creditors.
In trying to hold firm to their no-bailout stance even while pressing for a deal, federal officials could try to pit Bank of America and Barclays against each other. But that leverage can work only if both banks stay in the discussions. Bank of America and Barclays know each other very well, having considered a merger several years ago. More recently, Bank of America agreed to pay $21 billion for ABN Amro Holding NV's LaSalle Bank of Chicago in 2007.
That deal came at a time when Barclays was trying to buy ABN and fend off a European consortium bid. Bank of America's purchase was seen at the time as helping that Barclays bid, which ultimately failed. At Barclays, a big question will be whether CEO John Varley and his No. 2, Mr. Diamond, both agree on buying all or part of Lehman. Mr. Diamond is eager to expand Barclays's U.S. investment bank operations. But the unit, called Barclays Capital, is also responsible for write-downs the bank has recorded.
After 5 p.m., bank executives began leaving the meeting, some getting into cars inside a garage where they couldn't be photographed. Those seen leaving included Merrill Lynch & Co. Chairman and Executive John Thain and Citigroup Inc. CEO Vikram Pandit. Bank of New York Mellon Corp. Chairman and CEO Robert Kelly declined to comment.
While some executives had left the Fed meeting, those of other firms, including three carfuls of Barclays executives, remained at the Fed office past 6 p.m. At least 20 New York Fed staffers left from another exit. They refused to say if they were done for the night.
Doubts on Lehman's ability to reach deal
When Bear Stearns was rescued by JPMorgan Chase in March, bankers and regulators believed they had stopped the financial crisis from engulfing the rest of Wall Street. Exactly six months later, however, senior executives at Lehman Brothers are preparing for another frantic weekend of negotiations designed to stave off the investment bank's collapse.
Last night, at least two bidders were examining the possibility of mounting a bid for all or part of Lehman. Bank of America, the US lender, has teamed up with JC Flowers & Co, the financial investor, and China Investment Co, China's sovereign wealth fund, to consider a bid. Barclays, the UK bank, was also interested.
The outcome of the discussions is crucial to Lehman as the bank attempts to restore the confidence of counterparties and creditors and to prevent Moody's and Standard & Poor's, the ratings agencies, from cutting its credit rating. However, it is far from clear on what terms Lehman is able to agree a deal - if at all.
People close to the discussions said Lehman's $33bn portfolio of commercial real estate could prove a stumbling block for any deal. Potential buyers could be deterred by fears of further writedowns on the assets, which in turn would depress the value of Lehman's other businesses. During the conference call that followed Lehman's third-quarter results this week, its executives said the current writedowns of the assets were accurate.
They said Lehman had "stress-tested" its valuations and concluded that only a major collapse in property prices would force a revision. The book is marked at about 85 cents on the dollar, while its stakes in real estate investment firms Archstone and SunCal are carried at something less than 75 cents on the dollar.
However, those reassurances were questioned by several analysts, who argued that the properties could suffer further falls as the US real estate markets worsened. Potential buyers harbour similar concerns, according to people close to the discussions.
For Lehman's nearly 26,000 employees, the weekend discussions mark the end of a stunning collapse of confidence in the 158-year- old investment bank.
Throughout its recent history, Lehman bankers have praised the bank's cohesive culture and basked in its reputation as a smart, scrappy underdog that was consistently able to defy the odds by outwitting larger rivals. In 1998, Lehman fought back after Russia's default and the collapse of Long-Term Capital Management, the hedge fund, left the bank nursing heavy losses.
Following the terrorist attacks on the World Trade Center in September 2001, Lehman was forced to evacuate its offices in downtown Manhattan and relocate to a hotel. Rivals predicted the bank would soon have to sell out to a larger, better-capitalised rival. But Lehman not only survived but thrived as the boom in the credit markets boosted its core fixed-income business.
In the past year, however, Lehman has stumbled badly. Large investments in US commercial and residential real estate left it exposed when the market turned. At first, Lehman appeared to have weathered the storm in better shape than some
of its rivals. But heavy writedowns triggered large losses in the second and third quarters. As its share price plunged, efforts to raise fresh capital through negotiations with investors, including Korea Development Bank, proved fruitless.
By early this week, Lehman's share price was falling rapidly, prompting executives to bring forward the publication of the bank's results. On Wednesday, Lehman rushed out a survival plan that would involve hiving off up to $30bn of commercial property in a separately listed vehicle and selling a majority stake in the bank's fund management subsidiary.
The move would have enabled Lehman to avoid the need for further writedowns as the new company would hold the assets to maturity. But the plan was all but killed off by the plunge in Lehman's shares on Thursday, which sparked a frantic search for a buyer. Analysts believe a purchase of Lehman would propel BofA to a top-tier position in investment banking, which it has long coveted but never achieved.
The lure of such a position could prompt Ken Lewis, BofA's chairman and chief executive, to set aside his doubts about expanding in investment banking. Barclays could see Lehman as an opportunity to expand its Barclays Capital investment banking arm in the US while adding an equities business and a capability to advise on mergers and acquisitions.
But bankers believe Barclays, which recently raised £4.5bn ($8bn) in fresh capital, is unlikely to take on Lehman in its entirety and would need partners with deep pockets in order to compete with BofA. This leaves the question of what happens to Lehman if it cannot strike a deal. Although the bank has ample liquidity and access to the Federal Reserve's liquidity facility, failure to find a buyer would lead to a further loss of confidence among employees, creditors and counterparties.
"In the event LEH is unable to line up an acceptable strategic solution and is downgraded to the triple-B category, there would likely be severe ramifications to the firm," said Brian Zinser, an analyst at Merrill Lynch. "Liquidity would be impacted by less borrowing capacity and collateral postings under counterparty arrangements."
Bankers and U.S. Map Out Options in Lehman Crisis
As Lehman Brothers raced to find a buyer on Saturday, federal officials and Wall Street chieftains mapped out options to prevent an abrupt collapse of the crippled bank and arrest the downward spiral threatening other financial companies.
Several possibilities began to emerge as top Wall Street executives met under the guidance the Federal Reserve and Treasury Department. One would involve major banks and securities firms providing a financial backstop to facilitate a sale of Lehman. Another option would involve an agreement among Wall Street players to keep trading with Lehman as the bank seeks an orderly liquidation. Those briefed on the talks said the situation was still fluid and other options could emerge.
Adding urgency to the discussions were growing concerns that other big financial institutions like the insurance giant American International Group and Merrill Lynch might face a similar crisis and also need billions of dollars in capital to strengthen their businesses. The spreading troubles were the latest sign that even the government’s extraordinary interventions into private enterprise during the last year have not been enough to halt the unraveling of the financial system.
As the trading week ended, top officials from the Federal Reserve and the Treasury Department called an emergency meeting in Lower Manhattan with the heads of major Wall Street firms to insist that they find a way to rescue Lehman because their own companies might be next. The meetings, which involved top executives from Goldman Sachs, Morgan Stanley, JPMorgan Chase, Citigroup and other financial companies, continued on Saturday.
The group was working on two main contingency plans in case Lehman is unable to strike a deal to sell itself to one of several suitors — Bank of America or two British firms, Barclays and HSBC. Under one possibility being discussed, major financial firms would jointly inject new capital into Lehman, allowing it to spin off its portfolio of troubled securities into a separate company.
Under another option, Lehman would start an orderly liquidation of its assets on Monday. Its major competitors would agree to keep doing business and trading with Lehman as it unwound its business and portfolio. The Fed’s call for Wall Street institutions to support one of their own comes at a time when many of them are also short on capital. And yet entities that do have cash ready to invest, namely private equity firms, are not at the table.
Regulators do not want those firms, which borrow money to buy companies, controlling major financial institutions that provide the financing for their acquisitions. Many foreign investors, for their part, are reluctant to buy now after having seen earlier investments drop sharply in value. For months, Lehman and other companies assured investors that they had a handle on troubled assets tied to real estate. But those assets turned out to be worth less than the firms had thought.
As a result, many investors are no longer sure what such financial companies are worth, and they do not want to invest in them until they do. Many hedge fund managers and other traders have profited handsomely from bets that these stocks would fall in value.
Companies that took the biggest risks and used debt aggressively to build their businesses stumbled first, and now healthier companies are coming under pressure. Loans that were considered far better than the subprime mortgages, which kicked off the panic, turned out to be only marginally safer.
“You have to think of this like there is an epidemic going on — an epidemic of capital destruction,” said James L. Melcher, president of the hedge fund Balestra Capital, who has been bearish on the stock market.
The federal government has taken an unusually activist role in the crisis. This spring, the Federal Reserve arranged a hasty rescue for Bear Stearns, the wobbly investment bank. Then last week, federal regulators took over the country’s two largest mortgage finance companies. At every turn, officials hoped they had done what was needed to restore confidence in the markets, only to be greeted with another crisis.
Policy makers have signaled that they are not willing to provide financial support for a takeover of Lehman, as they did with Bear Stearns. Unlike Bear Stearns, which lost many clients and its access to money markets in just a few days, Lehman has been able to finance its business, especially after investment banks were allowed to borrow directly from the Fed. The problems that bedevil Lehman are more thorny questions about the quality of the securities it owns.
The decision by policy makers sets up a crucial test for the financial system: Can the market resolve the panic by pairing Lehman with a willing and strong suitor? There is a growing consensus on Wall Street that the government may not be able to save every big firm whose failure would pose a risk to the system.
“The too-big-to-fail mantra or concept or government policy is in my opinion off the table and we have to deal with that,” said David H. Ellison, president and chief investment officer at the FBR Funds. “They are not going to save these companies.” So far, the market has struggled to correct the excesses of the recent credit boom on its own.
Analysts say many financial companies, including the insurer A.I.G., need to raise capital. But every time their stock prices fall, raising capital becomes harder. And when that happens, bondholders and credit rating companies start worrying, too. Stock prices fall even further — and the whole cycle repeats again.
On Friday afternoon, for example, Standard & Poor’s warned that it might lower A.I.G.’s credit rating because the drop in the company’s share price — 45.7 percent last week alone — could make it even harder for the company to raise capital. That partly explains why markets in general, and financial shares in particular, are gyrating ever more. Even after the Bush administration took control of the mortgage finance giants Fannie Mae and Freddie Mac last week, a step many thought might calm investors, trading volatility kept rising.
“Investors are like hyperactive first graders playing musical chairs,” said Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research. The government, for all its activism, has been unable to stabilize the markets for long — though policy makers would argue that their interventions have prevented failures from cascading through the financial system.
After the Federal Reserve arranged the emergency sale of Bear Stearns to JPMorgan Chase in March, the stock market rallied and many strategists and executives on Wall Street declared that the deal was a turning point. At the time, Richard S. Fuld Jr., the chairman and chief executive of Lehman Brothers, said that the Fed’s decision to lend directly to investment banks like his had eliminated the problems that felled Bear Stearns. Now, Mr. Fuld is expected to sell Lehman at a fire-sale price.
Stocks also rallied on Monday, after the Treasury Department and federal regulators took over Fannie Mae and Freddie Mac, only to sink the next day as concern over Lehman, A.I.G. and Washington Mutual spread. At the end of the week, the broad stock market was up modestly, but financial shares closed down 2.5 percent.
Downturns are typically more volatile than the booms that precede them, strategists say. Investors try to anticipate the recovery, though the actual turning point is often visible only in hindsight. But after a lot of bad news, some investors usually dive in, believing that the markets have reached a cathartic moment.
“There are lots of investors that don’t want to miss the absolute bottom,” said Allen Sinai, a former chief economist at Lehman Brothers who now has his own research firm, Decision Economics. “Unless you are a professional trader, and even then, it’s a very dangerous philosophy.” Many of the fundamental forces in the economy remain worrying. Home prices are still falling, though their rate of decline appears to have slowed in recent months.
And defaults on all kinds of loans are rising. In the broader economy, the unemployment rate is rising and consumer spending has been faltering. The losses created by rising defaults have impaired the ability and confidence of banks to lend to one another and to consumers. As financial institutions rein in risk-taking to protect themselves and preserve their dwindling capital, interest rates go up, lending standards tighten and credit lines are capped or severed.
“Every time there is another problem, it causes lenders to become that much more conservative, which then puts the squeeze on someone else,” said David A. Levy, the chairman of the Jerome Levy Forecasting Center, a research firm in Mount Kisco, N.Y. Many analysts believe that for the downward spiral to be broken, home prices must fall to a level that can be supported by factors like household income that have traditionally had a strong relationship to prices.
Also, the government has to determine how it will restructure Fannie Mae and Freddie Mac, which own or guarantee half of the nation’s home loans, said Thomas F. Cooley dean of the Stern School of Business at New York University. “We have to hit the bottom in housing prices,” he said, “and we have to just sort out how housing will be financed in future.”
Will Lehman be forced to break up?
The forced breakup of Lehman Bros. or even its liquidation became a possible scenario over the weekend as talks dragged on unsuccessfully Saturday between top U.S. financial officials and executives at major Wall Street firms trying to forestall the collapse of the investment firm and to keep weakness among financials from spreading.
According to a report in the online edition of the Wall Street Journal citing people familiar with the matter, the outlines of a rescue plan emerged, but at the same time talks revealed that a sale of the entire firm to a big bank could probably not be managed.
The Federal Reserve Bank of New York, Treasury officials and banking executives have been meeting since Friday evening in the hopes of engineering a plan for a private-sector rescue for the once-venerable investment firm before Asian markets open for trading Monday.
Shortly before 7 p.m. Eastern on Saturday, media outlets reported that no deal had been reached over Lehman's fate but that negotiations would likely continue between the Fed and bank executives on Sunday. As expectations of a deal swung to doubt, the Journal reported, plans emerged for firms to either buy pieces of Lehman or for an orderly winding down of the firm.
The Journal said that under one scenario, Barclays PLC or Bank of America Corp. would buy Lehman's valuable assets, such as its equities business, while the more risky real-estate assets would be merged into a another entity that would contain about $85 billion in souring assets.
Other Wall Street firms would try to inject some capital into that "bad bank" so that a flood of bad assets doesn't deluge the market, damaging the value of similar assets held by other banks and insurers, according to the report. The banks are also looking for the government to somehow support the bad bank.
An earlier story in the Journal reported that Treasury Secretary Henry Paulson has made it clear to participants in the talks, called Friday by the New York Federal Reserve, that no government bailout for Lehman should be expected. The Journal reported that while teams of bankers are working on the plans, it appears few banks are in a position to provide enough funding. Many banks are inclined to preserve capital ahead of third-quarter and year-end cash preservation moves.
Also, the report noted, banks don't want to see rivals such as Barclays or Bank of America pay so little for the valuable assets. Citing people familiar with the matter, the Journal said Bank of America, until today considered Lehman's most likely savior, seems to be less interested in a deal. Neither Barclays nor Bank of America wants to buy all of Lehman without some government assistance, the Journal said.
In addition to Paulson, New York Fed President Timothy Geithner and Securities and Exchange Commission Chairman Christopher Cox were present at the weekend talks. According to media reports, Federal Reserve Chairman Ben Bernanke is involved in the deliberations, but did not attend Friday night's meeting.
The Wall Street executives attending included Morgan Stanley Chief Executive John Mack, Merrill Lynch Chief Executive John Thain, J.P. Morgan Chase CEO Jamie Dimon, Goldman Sachs Group CEO Lloyd Blankfein, Citigroup Inc. head Vikram Pandit and representatives from the Royal Bank of Scotland Group PLC and Bank of New York Mellon Corp., as well as others, according to the Journal.
As hopes fade for a sale, a second group of bankers reportedly is weighing the alternative of liquidating the firm's business, according to reports. The Journal reported many Wall Street traders met Saturday to weigh their options if Lehman is forced into liquidation. One unnamed trader said conditions in the credit default swap market and the short-term repo markets are more stable today than they were in March, when Bear Stearns nearly collapsed, but said that if Lehman is forced to liquidate, Monday could be a grim day for financial markets.
Global fears intensified over the weekend that the possible collapse of the country's fourth-largest investment bank would hurt markets and damage confidence. German Finance Minister Peer Steinbrueck said Saturday said he hopes there will be an end to the uncertainty over the fate of Lehman before Monday.
"You have to ask the parties involved in the U.S.," Steinbrueck said at a press conference in Nice, France following a meeting of finance ministers and central bankers from the European Union. "But we're hearing that the U.S. authorities are trying to find a solution by Monday and before Asian markets open."
Speaking alongside Steinbrueck, Bundesbank President Axel Weber said the German central bank has been in contact with the country's banks and is aware of their individual exposures to Lehman. Weber said that if a Lehman resolution is found, "the impact should be limited."
The exposure of Dutch banks to Lehman isn't a cause for worry, Dutch Finance Minister Wouter Bos said. Bos told reporters at the Nice event that "it's hard to predict" what the outcome of Lehman's difficulties will be. But he said Dutch banks aren't at seriously at risk however things turn out. "I'm not worried," he said. "All I can do is make sure that my policies are robust."
Bos said he doesn't expect the turbulence in global financial markets to ease any time soon. "I would like (the turmoil) to end and in that sense I am worried," Bos said. "There will be a correction in financial markets for some time to come. If there's a dominant characteristic then it's uncertainty." Shares of the once-thriving Lehman slumped another 13% Friday on concern the sale may come at a distressed price.
Bank of America, J.C. Flowers, and the Chinese sovereign wealth fund China Investment Co. had been considering a joint bid for Lehman, the Financial Times reported on its Web site Friday. Lehman got bids for its asset-management business from private-equity firms including Bain Capital LLC and Clayton Dubilier & Rice Inc. The offers value the unit at about $5 billion, Bloomberg News reported, citing unidentified people familiar with the auction.
This weekend's negotiations show that, after more than a year, the credit crunch is still crushing firms that only recently dominated the world of finance. Bear Stearns, the fourth-largest U.S. investment bank, was bailed out in March, while Fannie Mae and Freddie Mac, two giants that control most of the country's mortgage market, were seized by the government a week ago.
After starting life as a cotton trading firm in Montgomery, Ala. more than 150 years ago, Lehman grew into the third-largest U.S. brokerage firm behind Morgan Stanley and Goldman Sachs. It was a fixed-income powerhouse and the largest mortgage underwriter. Lehman's mortgage business, while hugely profitable during the recent housing boom, proved its undoing as home prices slumped, foreclosures surged and the commercial real estate market began to crack.
Bailout Hide and Seek
On Friday, less than a week after the government took control of Fannie Mae and Freddie Mac, the White House announced that there is no reason at this time to account for the companies in the federal budget.
That is great news for officials who prefer to hide the cost of the bailout since it is due, in large part, to their failure to adequately regulate the financial markets and steward the economy. But it is an insult to taxpayers, whose money is at risk, and it is a reckless gambit.
The Congressional Budget Office reported on Tuesday that the government’s finances are deteriorating rapidly: the budget deficit for this year is expected to reach $407 billion, more than double last year’s shortfall, and to exceed $500 billion in 2009. The takeover of Fannie and Freddie, necessary though it is, will add to the deterioration. Airbrushing that away will only open the door to uninformed — or negligent — decisions on spending and tax cuts.
The White House says that the extent of the government’s control of Fannie and Freddie does not warrant including the companies’ operations in the budget. That is absurd. The government has seized the companies, firing their executives and installing new ones, offering to invest up to $200 billion in the companies if necessary, and most significant, making an ironclad promise to pay their trillions of dollars in obligations, if need be.
The White House also claims that the risk to taxpayers is not yet serious enough to require that the costs be shown in the budget. But there is a very real cost to guaranteeing the obligations of Fannie and Freddie, even if the government never has to cough up a penny. The taxpayer is on the hook while the guarantee is outstanding — and the Treasury says that will last past Dec. 31, 2009, when its bailout authority officially ends.
The Congressional Budget Office has said that it will calculate the cost of taxpayers’ risk and include it in its version of the budget, which is separate from the White House version of the budget. Having conflicting budgets is hardly a good way to restore confidence in the government’s financial management.
But the C.B.O. accounting will prevent the White House from saying, in effect, “yes, bondholders, your investments are fully guaranteed, but you, dear taxpayers, don’t worry, it costs you nothing.” As the government (read: taxpayers) assumes additional risks, it is more important than ever to get the accounting right. Accurately reflecting the budget cost of the Fannie and Freddie bailout would not lead to an explosion in public debt.
Prudent accounting, accurately applied, would limit the amount that must be counted against the nation’s overall debt ceiling. Accurately accounting for risk would limit the cost of making good on the companies’ obligations to a figure that reflects the likelihood of taxpayers actually having to pay up. No one yet knows the ultimate cost of the bailout, but it is already more than zero.
Why Hasn’t Lehman Come Calling on Fed’s Discount Window?
A critical difference between the Bear Stearns and Lehman Brothers crises: access to liquidity. Bear suddenly needed it and didn’t have it. Lehman went into a nosedive this week yet had the Federal Reserve’s discount window and other liquidity facilities available to it.
But what if the discount window is open and nobody comes? The Fed’s latest report on Thursday showed no borrowing by investment banks as of a day earlier. The lending program, known as the primary dealer credit facility, showed overnight borrowing at almost $40 billion in late March just a couple of weeks after its creation. (The Fed launched the facility during the weekend of the Bear Stearns crisis.)
Since early July, only two weekly reporting periods showed any borrowing — and even then a tiny amount. Why wouldn’t Lehman borrow? For one thing, it may not need to. As in the case of Fannie Mae and Freddie Mac, one of its key problems is with capital and not short-term funding. Another possibility: Taking a discount window loan while everyone is watching for it — and expecting it — might create a new set of confidence problems.
Because there was no borrowing leading up to this week, Lehman would’ve been tagged as the borrower of any loan taken out. (The Fed does not disclose the identities of the borrowers.) One way around it would be for several other firms — healthier ones — to step up and offer cover, taking loans and somehow signaling publicly that they also had done so. Another would be to wait until the weekly reporting period ended Wednesday and then borrow on Thursday, allowing a week of breathing room before the next report comes out.
This stigma problem has long plagued regular discount window borrowing for commercial banks. Word of borrowing can leak out through a firm. Or it could signal to the board and staff of regional Fed banks (because local banks borrow from their own districts) that a particular institution is facing funding trouble. It was one reason the Fed created its auction programs for commercial banks and securities firms. But stigma clearly has not been a problem for all financial institutions recently.
While investment banks didn’t borrow, lending to commercial banks (depository institutions) shot up to $23 billion as of Wednesday. That was up from $19 billion a week earlier. The recent borrowing has far outpaced the use of the discount window after the Sept. 11 terrorist attacks and other periods of financial stress. The Fed’s lowered rate for discount borrowing — now 2.25%, just a quarter point above the federal funds rate instead of a full point before the financial crisis — may be encouraging some banks to use the window.
The Fed considers the lack of PDCF borrowing to investment banks a sign of success. The mere presence of the lending program, as officials have argued repeatedly, can reassure the market and ease strains in the financial system. Firms trading with Lehman know that it has discount window access, perhaps preventing the funding crisis that otherwise would necessitate emergency borrowing.
And significant borrowing — suggesting heavy needs from investment banks — would be a much greater cause of concern. The calming effect is one reason why the Fed in late July, when borrowing was zero, extended the lending program along with a separate auction for investment banks until the end of January. The central bank cited “continued fragile circumstances in financial markets” and said the facilities would be withdrawn if it determines conditions “are no longer unusual and exigent.”
There could be many other reasons why Lehman didn’t borrow. Any borrower to the discount window must put up collateral that the Fed values on its own before making the loan. The Fed could decide not to put government money at risk by lending to a seriously troubled firm even against collateral. Members of the Senate Banking Committee, at a hearing in early April, asked about the suggestion on Wall Street that discount window availability would’ve prevented Bear’s liquidity crisis.
New York Fed President Timothy Geithner explained to lawmakers that the Fed, in lending to commercial banks, only allows “sound institutions to borrow against collateral.” He added: “And I can only speak personally for this, but I would think I would have been very uncomfortable lending to Bear, given what we knew at that time, if you could walk back the clock and think about what would happen if that facility had been in place before.”
The Fed doesn’t discuss the creditworthiness of any potential borrowers. There’s no indication that Lehman’s access to the window has been impaired. And its circumstances are quite different from Bear’s troubles. Beyond that, central bank officials probably would avoid any move that would hinder their ability to save a firm through existing lending programs and existing authority
U.S. Treasury moves to calm Japanese investors
Seeking to head off any unloading of Fannie Mae and Freddie Mac bonds by Japanese investors, the U.S. Treasury Department is taking the unusual step of directly contacting Japanese financial institutions about the plan to rescue the mortgage giants, according to a published report.
Because a massive unloading of Fannie Mae and Freddie Mac holdings could hamper the U.S. government's efforts to shore up the mortgage firms' finances, the Treasury Department is effectively asking investors to refrain from doing so, Japanese business daily Nikkei said on its Website in a report dated Friday.
According to sources familiar with the matter, Treasury Undersecretary for International Affairs David McCormick on Thursday phoned senior executives at major Japanese banks as well as the Life Insurance Association of Japan to explain Washington's plans for Fannie Mae and Freddie Mac, the report said.
McCormick is believed to have reiterated plans announced Sunday, including seizure of both mortgage giants and the government's intention to infuse funds if necessary. During the phone calls, he is also said to have urged Japanese institutions to continue investing with confidence in Fannie Mae and Freddie Mac.
According to a Nikkei report earlier this week, Japanese financial institutions own more than 15 trillion yen ($142.5 billion) in securities issued by based on data disclosed by domestic banks, life insurers and others as of March 31. Many Japanese investment trusts also include securities in their portfolios.
The Treasury Department is expected to continue contacting other major Japanese banks and institutional investors, and the Life Insurance Association of Japan is expected to notify its members of the explanations provided by the U.S., Nikkei said.
Wall Street privatizes US government: be very afraid
The US low-tax zealot, Grover Norquist, is famous for wanting to "shrink government down to the size where we can drown it in the bathtub".
Still alive, he is not turning in his grave, but his idea has been well and truly buried - and not by the Democrats he hates; they have been tongue-tied on the credit crisis. It is Wall Street, the paradigm of "red in tooth and claw" capitalism, that has turned to government subsidy on an unprecedented scale.
Low, ideally non-existent, taxes may be very desirable, but when free-market principles came into conflict with the survival of business as we know it, priorities were clear. The US Federal government's full faith and credit - in other words, the resources of American taxpayers - should be urgently deployed to preserve as much as possible of the financial industry.
Luckily for Wall Street, government was still too big to fit in that bathtub - and proved only too willing to take up the challenge. The scale of the operation has been huge. The Bear Stearns' takeover last March by JP Morgan was helped down by a spoonful of sugar in the form of $29bn of quasi-equity investment by the Federal Reserve Board that can only go down in value, never appreciate.
By March the Fed might have been forgiven for hardly noticing a mere $29bn: it had provided more than $250bn in liquidity assistance to the money markets, accepting dodgy mortgage paper as collateral. Lucky old Wall Street - though, to be fair, this liquidity was the only justifiable aspect of the Fed's conduct in the 15 months of credit crunch.
The "Bear" was only the hors d'oeuvre, as anyone could see. After a mid-summer Act of Congress promising major help to the mortgage market, the full scope of potential largesse from Washington was more thoroughly exploited last weekend when the two giant "government sponsored enterprises", nicknamed Fannie Mae and Freddie Mac - here collectively "Frannie" for convenience - were formally extended a Federal government guarantee by Treasury Secretary Paulson.
Frannie is emphatically, in fact by definition, not part of the sub-prime crisis. Out of the country's total home mortgages of $10.5 trillion the lowest tier, sub-prime, is (or was) about $1.5 trillion, with another dubious category called "Alt-A" (also not "prime"), of another $0.5 trillion.
Within sub-prime, came the so-called "Ninja" mortgages: qualifications required being No Income, No Job or Assets, and in the bulk of cases no documentation either. Wall Street's enthusiasm for this kind of paper led to the losses even at 15 per cent higher, house prices a year ago, requiring the hors d'oeuvre described above.
With house prices now nearly 20 per cent down from their peak, the story has moved on from sub-prime to prime. Frannie is the main course. The definition of a prime loan is one that can be taken onto the Frannie balance sheet, or placed with investors under a Frannie guarantee. With about $8.5 trillion of prime loans out there in total, Frannie is on the hook, in one form or another, for more than half, some $4.5 trillion.
Back in the sound-money days of more than a half-century ago, Senator Everett Dirksen came up with the classic thought about the US Federal government: "A billion here, a billion there… pretty soon you're talking about real money". How quaint that sounds. In these go-go days for fiscal "conservatives", it is more like "a trillion here, a trillion there…".
The Frannie deal is big even by today's standards. It single-handedly vaults the US from a public debt ratio in the sound-money range into the company of fiscal basket-cases like Italy and Belgium, and that long-standing economic invalid, Japan.
The chart shows how the net US government sector debt pre-Frannie was about the same size relative to the economy as Germany, though worse than other G7 peers such as Canada, Britain and France. Now with one bound, the addition of $4.5 trillion puts it up there with Italy and Japan.
Fed closes the door on hands-off economics. Source: Lombard Street Research
For connoisseurs, the post-Frannie endorsement of the rating agency, Standard & Poor's, may raise an eyebrow: the triple-A rating of the US government is unaffected, we were told after last weekend's events. Many a nasty, even catastrophic, deterioration of credit has started with such a reassurance.
I have myself dealt with bankruptcy of a company that was actually "in the can" less than a year after it was triple-A rated. But triple-A rated mortgage securities trading at 50 cents in the dollar are bad enough. A bank whose credit-worthiness requires public defence has generally lost it. A government has greater resources, but questions are bound to be asked.
Nor is the monetary policy of the Federal Reserve designed to give comfort. Last autumn and winter, only too clearly panicked by Wall Street's fear of meltdown, the Fed made huge cuts in interest rates, as well as advancing (much more reasonably) over a quarter trillion dollars to the money market. The sense of panic told global investors all they needed to know.
China's accumulation of reserves, running at $500bn a year, had to be kept in dollars to support its (unwise) policy of controlling the yuan/dollar exchange rate. But the funds all got shifted to government or Frannie paper - no doubt a major force behind the US government's backing of Frannie: sudden withdrawal of China's dollar support genuinely might lead to financial Armageddon, in contrast with a few badly needed Wall Street failures.
Others flew the dollar - to anything they could think of. The euro, the yen, but notably to oil and other commodity derivatives. Commodity derivatives held off the public exchanges, "over the counter" (OTC), grew six-fold in three years, from $1.5 trillion at the end of 2004 to $9 trillion at the end of 2007 (and no doubt more since, though the data have yet to be published).
This is eight times the size of public-exchange commodity derivatives about which information is more detailed. Nobody knows the form of these OTC positions. But oil prices doubled from $70 a barrel just before the credit crisis to over $140 at the peak in July this year - and have since seen one of the fastest commodity price collapses ever, to little over $100. Those positions contained huge speculative accounts.
Who pays for dearer oil? Chiefly, the US consumer. So the rescue of Wall Street has panicked the Fed into a policy that has hammered American taxpayers, just as they have been called upon to finance the bailout of Wall Street.
The Fed's goals, as specified by Act of Congress, are to sustain good growth and keep inflation low (in that order). By its subjection to Wall Street priorities, it has both stimulated price inflation - the CPI was up 5.6 per cent over the latest 12 months - and thereby cut the real value of US incomes, and with them US growth.
It has thus failed in both its mandated goals.
With one bullet - panicky interest rate cuts that have little relationship to saving Wall Street in any case - it has shot itself in both feet. The irony is - I hesitate to say "joke", though black joke it is - that Wall Street did not need it, and will not (of course) be grateful. Sometime over this weekend, probably - or maybe a little later - Lehman Brothers is expected to endure a similar fate to Bear Stearns six months ago.
Perhaps "Hank the hunk" Paulson, former head of the leading Wall Street firm, Goldman Sachs, will play his usual highly visible part in devoting US taxpayers' resources to the cause. And will the world come to an end? Just as was feared at Y2K, or the CERN experiment last week? Well, actually, no.
And Wall Street realised this on Thursday when, after several days' worry over Lehman's fate, the stock market managed to go down sharply at the opening and then realise that it did/does not matter so much after all, ending up sharply instead. Neither would it have mattered much last March, had Bear Stearns simply been let go. Finally light has dawned.
In the meantime, the world has been changed. Free markets have been abandoned in America at the crucial hour by their chief exemplars, the financial masters of the universe. Let us hope that the convictions of the British financial and political community, though less confidently flaunted, will prove more durable.
Firms that fail after doing stupid things - or sometimes firms that are just plain unlucky - should go to the wall. Opinions may differ as to which category Northern Rock (our own particular policy disgrace) falls into.
The economy will recover sooner if banks that have made stupid mortgage loans suffer, and house prices fall more rapidly to levels at which affordability is obvious and buyers come forward.
Society will also be more just. We should be grateful the Bank of England has an inflation target, not a confusing mishmash like the Fed. And that Mervyn King sticks to it. It seems that President Bush and the Republicans are not just well to the left of Grover Norquist. They leave clear blue water on the left of Gordon Brown, much to the envy of Euro-lefties no doubt, who would love to ditch what they call "neo-liberalism", and what we call free markets, as easily as the American right wing.
Small wonder Barack Obama is having trouble establishing a distinct political identity - not to mention a feasible economic policy. And where subsidy is concerned, whoever may lead, can Detroit be far behind?
We read of a request for $25bn of Federal help to the car industry - both Messrs McCain and Obama think the amount should be twice that. Pigs to the trough - with or without your lipstick!
A Financial Drama With No Final Act in Sight
A lot of smart people have tried to call the bottom on Wall Street this year. So far, they have all been wrong.
Since the financial crisis first hit in August 2007, markets — and the financial industry — have gone through a series of swoons, each more dizzying than the last. Last week, the crisis reached a new pitch, as Lehman Brothers, the fourth-largest United States investment bank, struggled to avoid joining Bear Stearns on the trash heap, and Washington Mutual, the largest savings and loan, saw its shares briefly fall below $2.
Now even Wall Street’s professional optimists have given up predicting exactly when their industry might stabilize. One senior executive at a top investment bank, speaking anonymously so he could speak freely, recently observed that the crisis was entering its “19th inning,” with no ending in sight.
Until now, the cataclysm in the banking and securities industry has damaged but not derailed the rest of the economy and the Fed and the Treasury signalled last week that they were not ready to bail out Lehman Brothers with taxpayer money. Economists generally predict that the United States will grow slowly over the next few months but avoid a deep recession, especially if oil prices fall further, easing pressure on consumers, and exports remain strong.
But as the Wall Street crisis moves into its second year, the risks to the overall economy are increasing. While the economy grew during the first half of the year, businesses are cutting jobs and consumers reducing spending. In August, the unemployment rate reached 6.1 percent, compared with 4.7 percent less than a year ago. Until the worst turmoil on Wall Street ends, the economy will struggle, said Sung Won Sohn, an economist at California State University, Channel Islands, who studies financial markets.
“Until and unless we have financial markets stabilize, I don’t think we will see a meaningful recovery in housing, and therefore in the economy,” Dr. Sohn said. He said he expected economic growth to remain close to zero through the middle of 2009 before finally beginning to accelerate.
Steven Wieting, the United States economist for Citigroup, said: “We’re describing the U.S. economy as recessionary.”
Unfortunately, Mr. Wieting — and other economists — say that the Federal Reserve and the government have few good options left to ease the pressure on financial firms or the economy.
The Fed has already cut short-term interest rates to 2 percent, below the rate of inflation, and the government has offered consumers and businesses $150 billion in tax rebates and cuts this year. The Fed has also taken several measures to buoy the financial industry, such as allowing more banks access to low-interest, short-term loans. Yet Wall Street continues to struggle through the aftereffects of the biggest speculative bubble in history.
Financial services companies have cut more than 100,000 jobs this year, according to Challenger, Gray & Christmas, an executive placement firm, and deeper layoffs may come this fall. Yet the picture may not be entirely bleak. When the chaos finally ends, Wall Street will almost certainly be smaller and more risk-averse. That change could eventually put the economy on firmer footing.
This year’s crisis appears to mark the end of a bubble in the financial markets that has lasted nearly two decades. The speculation began in technology stocks in the 1990s and turned to real estate, commodities and private equity buyouts this decade. Along the way it powered the New York City economy and helped drive income inequality nationally.
While the stock market has not been as frenzied this decade as it was at the end of the 1990s, rampant speculation took over many other financial markets, Mr. Wieting said. “In the last couple of years, financial activity became less related than we’ve seen before to real economic developments,” he said.
Now Wall Street is reeling, as a significant fraction of the speculative real estate loans that banks made during the boom years are underwater. Because banks have limited capital to absorb losses, investors worry that those losses will overwhelm them.
The problem has been worsened by the financial instruments that banks and hedge funds and insurance companies have created to swap loans and risk with each other.
In theory, those products can help investors and companies diversify risk, but they are nearly impossible to value. “Investors just don’t know what these assets are worth,” said Ed Yardeni, president of Yardeni Research. “There’s no transparency. It’s totally up to management to decide what these assets are worth and tell their accountants.”
For example, Lehman said last week that it had $20 billion in tangible equity— money that would theoretically be available to its shareholders if Lehman had to be liquidated. But those same shareholders valued Lehman at only $2 billion as of Friday, proof that they do not have confidence in the way Lehman has calculated its assets.
Now investors are demanding that banks like Lehman and Washington Mutual raise capital or sell their assets to raise cash and prove that they are solvent. But when banks are under pressure, they cannot easily find new investors or purchasers for their assets. It is as if a family were told to sell their home overnight, for cash, or lose it. They would surely receive a far lower price than the property would generate in a more orderly sale.
So, one by one, the banks that took on the most risk are facing the real possibility of going under. Those with stronger balance sheets, such as Morgan Stanley and Goldman Sachs and JPMorgan Chase, are suffering much less. For Wall Street, the lesson has been sobering — and unlikely to be forgotten for several years, said Dr. Sohn, the California State economist.
“The restraint in the credit markets will last quite some time,” Dr. Sohn said. In the mortgage business, which saw the worst excesses, loan practices may remain stricter for at least a decade, he said. The results will be both positive and negative, he said.
The speculation that has produced wide swings in commodities prices and vacant subdivisions across California and Florida may become less prominent. But people who want to buy homes may continue to struggle to get mortgages, even if they have excellent credit. Companies who need loans to expand, or just to survive rough economic patches, will also have a harder time finding financing.
“We went overboard,” Dr. Sohn said. “As a result, the financial market is imposing some discipline on our behavior, and it’s painful. But that’s how the system works.”Jared Bernstein, senior economist at the Economic Policy Institute, a liberal research group in Washington, said that, in a best-case scenario, greater risk aversion in the financial markets might eventually encourage the United States to rely less on bubbles and speculative lending to drive economic growth.
Instead, the government could pursue policies designed to drive wages higher for middle- and lower-class Americans, he said, allowing them to buy homes and cars without taking on ruinous debt. “We have to find a new way — or maybe it’s an old way — to stimulate enough demand for the economy to do what it’s supposed to do without speculative excess,” Mr. Bernstein said. “A recovery that’s driven by more broadly shared prosperity, where consumption is fairly evenly shared through the economy, that kind of growth is more sustainable.”
Even so, Mr. Bernstein said he was not cheering Wall Street’s deep struggles. “The financials are the heart of the credit system, and credit is the lifeblood of our economy,” he said. “There’s no question that we will pay a cost in terms of much diminished growth if this continues.”
IRS break boosts Fannie, Freddie and big banks
Tailor-made ruling helps agencies use tax losses to goose capital. Don’t try this at home, kids.
When Freddie Mac and Fannie Mae inflated their core capital in recent quarters through the questionable use of deferred-tax credits, they didn’t violate any accounting rules. But they certainly received preferential treatment from auditors, regulators and tax authorities even as they were being bailed out by the government.
While Treasury Secretary Henry Paulson placed the two companies in “conservatorship” early last week, the Internal Revenue Service, which Mr. Paulson oversees, rewrote certain tax rules that will allow the mortgage institutions to take advantage of those tax credits. And that will help keep them alive for the time being.
Other companies, especially commercial banks, could also boost their capital with deferred-tax assets and get away with it to a certain extent. But only the banks, or at least big ones, might be able to count on auditors and regulators being as lax on them as they were on Fannie and Freddie, because of the risk to the financial system their failure might pose.
“I don’t think auditors would have been quite as forthcoming with commercial banks, but largely they would have gotten the same treatment,” observed Robert Willens, a tax and accounting consultant.
In contrast, non-financial institutions would probably enjoy no such luck, experts say, because they aren’t quasi-governmental entities or significant enough to the financial system. In other words, go ahead and try to maximize those credits, industrial companies, just don’t expect preferential treatment from Uncle Sam if auditors or regulators have questions.
When companies have losses, they are allowed to recognize tax-deferred credits in the year of the loss, even though the reduction in taxes they produce will only be realized in future years in which they have taxable income, and thus a liability they can use the credit to reduce. Fannie Mae and Freddie Mac used that method to almost double the amounts they claimed as capital reserves.
According to Financial Accounting Statement 109 on accounting for income taxes, companies typically have to record what is called a valuation allowance to reduce the size of any deferred-tax assets on their balance sheets. That means that based on available evidence, the firm has to figure out whether “it is more likely than not” that some portion or all of the deferred-tax asset will not be realized.
To do so, a company has to consider both positive and negative evidence as to whether it will post profits in the future and in turn generate sufficient future taxable income to be able to use the credits. If the positive evidence outweighs the negative, a company can include all or a portion of the deferred-tax assets in its capital, and with it, avoid a potential hit to shareholder equity from its losses.
“When a company has had a continued loss and doesn’t anticipate future profits to offset the deferred-tax assets, it ¬shouldn’t be on the books,” said George Victor, a partner at Holtz Rubenstein Reminick. Still, Mr. Victor conceded, “that’s a judgment call.” And he noted that it’s up to auditors to look at management’s judgment and either agree or challenge it.
In the case of Fannie Mae and Freddie Mac, the companies hadn’t shown a profit in several years and have little prospect of future profit until the housing market recovers. Yet that didn’t prevent them from including the full amount of their deferred-tax assets in core capital, without which they wouldn’t have met their regulator’s capital requirements.
“They’re not writing down the tax assets at all,” said Mr. Willens, even though “it’s almost impossible to avoid a write-down when you have a history of cumulative losses. Nevertheless, these guys have been able to avoid it with the concurrence of their auditors.” PricewaterhouseCoopers was Freddie Mac’s auditor, and Deloitte & Touche was Fannie Mae’s.
In fact, the mortgage guarantors claimed they were on solid ground in taking the credits. In August, Freddie Mac reported $37.1 billion in regulatory core capital as of June 30, which was an estimated $8.4 billion in excess of its statutory minimum capital requirement and an estimated $2.7 billion beyond the 20% surplus required by the Office of Federal Housing Enterprise Oversight, its regulator.
Deferred-tax assets represented $18.4 billion, or almost 50%, of Freddie Mac’s regulatory capital, up from $10 billion at the end of 2007. “We believe that the realization of our net deferred-tax assets is more likely than not,” Freddie Mac said in its second-quarter earnings filing with the Securities and Exchange Commission.
“The positive evidence we considered primarily included our intent and ability to hold the available-for-sale securities until losses can be recovered, our history of taxable income, capital adequacy […] and forecasts of future profitability,” the Freddie Mac filing explained. “The negative evidence we considered was the three-year cumulative book loss.”
For its part, Fannie Mae said its regulatory capital stood at $47 billion as of June 30, $14.3 billion above its statutory minimum capital requirement and $9.4 billion above its 15% surplus requirement. About $20 billion of that regulatory capital, or about 43%, consisted of deferred-tax assets, up from $13 billion at the end of 2007.
“What we do is we make an assessment on the recoverability based on the taxable income the company generates,” Steve Swad, then CFO of Fannie Mae, said in a second-quarter earnings conference call last month. “And just remember that our taxable income is higher than our book income because there’s no reserve building expense. Based on that, we think it’s sufficient to recover the asset.”
But at the same time, Fannie Mae noted in its second-quarter results that there were a variety of uncertainties that made estimates for 2009 challenging, including “the ability to recover our deferred-tax assets.”
The IRS issued a new tax rule last week to help the mortgage companies retain all net operating losses despite the change of ownership, making it even easier for Fannie Mae and Freddie Mac to take advantage of the deferred-tax assets. Normally, companies find it difficult to take advantage of them after they change hands.
“The Treasury is contributing to the accounting conclusions of the deferred-tax assets,” said Mr. Willens. “We were surprised to see they were rewriting the rules just for these two institutions. Everybody else would see their tax benefits severely curtailed, but not in this case. They seem to be getting special treatment.”
White House refuses to incorporate Fannie and Freddie into government budget
The White House refused yesterday to follow the lead of the Congressional Budget Office in classifying Fannie Mae and Freddie Mac as part of the government sector, insisting that they remained outside the federal budget.
Jim Nussle, the director of the White House Office of Management and Budget, said: "I have decided to maintain the GSE's [government sponsored enterprises] non-budgetary status." He said the OMB had "considered many factors in this decision, including the level of federal ownership, degree of control, economic risk to the taxpayer and temporary nature of this arrangement".
The decision means that the Bush administration will present its budgets to Congress on a different basis from that on which Congress's budget watchdog will assess them. In effect, the Bush administration is saying that Fannie and Freddie remain arm's length entities, while the CBO is saying government control over them is now so tight they are, in effect, part of the government.
At stake is the appropriate treatment of $5,400bn (£3,000bn) in Fannie and Freddie assets and liabilities - equal to the entire publicly held debt of the US - as well as continuing operations by the two companies. The CBO said that following this week's decision by the government to take control of the companies, they should be accounted for as part of the government.
However, it cautioned that this does not necessarily imply a $5,400bn increase in reported US debt, since $3,600bn of the Fannie and Freddie liabilities are in the form of mortgage guarantees and the treatment of all their obligations will be subject to public rather than private accounting rules.
The White House insisted that Fannie and Freddie should not be incorporated into the budget at all but accounted for separately. In terms of future operations, the CBO will treat Fannie and Freddie outgoings and receipts as government spending and revenues.
However, it will not treat transfers between the Treasury and the two entities as government spending - merely as transfers between two arms of government. The White House will not treat their outgoings and receipts as government spending and revenues. However, it will treat transfers between the Treasury and the two entities as government spending.
Fed Direct Loans Lose Stigma as Banks Push Borrowing to Record
Commercial banks that a year ago rebuffed a Federal Reserve program to provide cheaper cash may be increasingly dependent on it.
Borrowing from the Fed's discount window hit record levels in six of the past eight weeks, and reached $23.5 billion as of Sept. 10, Fed data show. By comparison, lending averaged just $779 million a week in the three months after New York Fed President Timothy Geithner urged banks to use the program.
The increasing use of the funds risks delaying banks' disposal of nonperforming assets and capital raising. It also may make it tough to restore the rate on the loans to the historical 1 percentage point premium over overnight funds, analysts said. The Fed has lowered the rate nine times since August 2007.
The low cost may "delay necessary adjustments" at banks, said Vincent Reinhart, a resident scholar at the American Enterprise Institute in Washington who was director of the Fed's monetary affairs division from 2001 to 2007. Lenders may "have a hard time if the Federal Reserve tries to take it away," he said.
Geithner, along with Fed Vice Chairman Donald Kohn, told a group of banks including Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. on an Aug. 17 conference call that tapping the so-called discount window was a "sign of strength."
They were combating what officials called a "stigma" -- that borrowing from the Fed was an indication of serious weaknesses. Policy makers later expressed frustration about the discount window as a tool for injecting funds into the financial system, and rolled out alternative programs.
Banks had cheap funding during the credit boom, when bond yields reached half-century lows. With mounting losses from the mortgage debt market and the economic downturn, they are rushing to the Fed instead. Borrowing has climbed since March, when the Fed lengthened the term of the loans to 90 days. The discount rate is now 2.25 percent, compared with a 2.82 percent rate for three-month funds lent between banks. The Fed's benchmark federal funds rate is 2 percent.
"The problem is, you can never go off the methadone," said Jim Bianco, president of Chicago-based Bianco Research LLC, referring to a drug used to wean addicts off of heroin. Along with the discount-window lending, the Fed also provides $150 billion of funds to commercial banks through cash auctions, where it receives collateral including mortgage-backed debt. For investment banks, the Fed has a $200 billion program for lending Treasuries, also in exchange for a variety of collateral.
By depleting its store of Treasury securities and taking on asset-backed securities, the central bank is diminishing the quality of its balance sheet, said former Richmond Fed President Al Broaddus. That may eventually hurt the Fed's credibility in other ways, including its monetary-policy commitment to keep consumer prices stable, though such a result isn't "anywhere near" yet, he said.
Central bank lending from the discount window "should not continue to grow and persist over a long period of time," Broaddus said. "That needs to be watched and managed very carefully." Fed Vice Chairman Donald Kohn said in May the central bank should eventually phase out its special lending programs, giving way to private lenders. "Central banks should not allocate credit or be market makers on a permanent basis," Kohn said. "That should be left to the market."
Moving the discount rate back toward the 1 percentage point premium and overnight duration may be difficult as funding strains remain and financial turmoil continues. The collapse of the U.S. subprime-mortgage market has led to losses and writedowns by financial institutions totaling $511 billion since the beginning of last year.
A gauge of bank funding costs, a premium on three-month bank loans over the overnight indexed swap rate, which is a measure of what traders expect for the Fed's benchmark rate, rose to 84 basis points yesterday, compared with 69 basis points three months ago.
"The markets are in disarray," said Chris Rupkey, who follows the Fed as chief financial economist for Bank of Tokyo- Mitsubishi UFJ Ltd. in New York. While central bank policy makers are leery about increasing aid to banks, "at this point the Fed's hands are tied."
The Fed's new liquidity tools may prove to be long-lasting policy instruments once the crisis does subside, Bianco said. They could become routine mechanisms for adjusting credit, in the way the federal funds rate became the benchmark around 1990, Bianco said. "What was set up to be temporary is now starting to look like it's becoming permanent," he said.
US acts over commodity swaps
New steps to curb speculation in commodity markets have been launched by US regulators in response to growing pressure from Washington lawmakers.
In a report, the Commodity Futures Trading Commission, the main regulator of commodity markets, told the US Congress yesterday that it was imposing "enhanced control" on dealing by Wall Street banks and forcing them to publish new data on their positions.
The CFTC's measures will focus on swaps, which are private contracts between investment banks and clients such as hedge funds or airlines that provide an exposure to commodity prices without investing directly in futures. The swap market is mostly unregulated, which some lawmakers in Washington have described as a loophole for speculators and blamed for high oil prices.
Swap dealers also receive exemptions for speculative positions limits that apply to other speculators into the commodities markets. The CFTC had recently admitted in a report that there was "a need for greater transparency in the manner and amount of trading that occurs through swap dealers". The move signals a growing concern among regulators about the activities of financial investors across the commodity markets sector.
But in a rare dissident vote, Bart Chilton, one of the four CFTC commissioners, said the actions were insufficient. "I do not believe the Commission's recommendations go far enough," he said. The CFTC said it would review whether Wall Street swap dealers would maintain their exemptions in exchange for them reporting when their clients reach certain positions levels and providing "certification" that none of their speculative clients exceeds position limits.
"[This] is a practicable way of ensuring that non-commercial counterparties are not purposefully evading the oversight and limits of the CFTC and exchanges, and that manipulation is not occurring outside of regulatory view," it said. However, the CFTC report insisted that financial investors did not appear to be behind the rise in commodity prices in the past year, noting that while oil prices had risen, investors in the $200bn commodities indices industry lowered their exposure.
Speculators cannot hold more than a certain amount of commodities futures in regulated markets, such as the Nymex where oil is traded but by entering into swap agreements they could circumnavigate those limits.
GM chief to lobby Congress for $25 billion in low-cost loans
General Motors' chief executive Rick Wagoner will today join an intense lobbying drive by the embattled US motor industry to secure approval from Congress for at least $25bn in low-cost loans.
Mr Wagoner will be among witnesses at an all-day Senate energy committee hearing aimed at facilitating, in the words of its sponsors, "the development of comprehensive legislation to address America's many energy challenges". The loans were included in an energy bill passed in December to finance the retooling of plants for more fuel-efficient vehicles, especially hybrid and electric cars. The bill also provided for a 40 per cent jump in fuel-economy requirements for cars and light trucks.
However, Congress has yet to appropriate funds to guarantee the loans, and the energy department must still draft detailed regulations. Mr Wagoner is likely to make little direct reference to the aid package, but will instead focus on highlighting that huge investments in new technologies will be needed if the US is to gain control of its energy needs. Such investments would require a far-reaching alliance between the industry, government and other players, with the government in the vanguard.
But senators are likely to press Mr Wagoner on the issue of the loans. Critics have questioned whether the loans amount to no more than a bail-out for the struggling US carmakers. The industry is urging members of Congress to appropriate the funds before they adjourn at the end of the month for the campaign leading up to the general election on November 4.
Neil De Koker, president of the Original Equipment Suppliers Association, which represents auto parts makers, said in an interview that "timing is very, very tight". Mr De Koker will add his voice to the lobbying effort with a visit to Capitol Hill next Friday, possibly accompanied by the chief executives of several parts suppliers.
One lobbyist said that industry was racheting up pressure on the politicians, with carmakers and suppliers peppering politicians with "phone calls, phone calls and more phone calls". The loan scheme, known as the Advanced Technology Vehicles Manufacturing Incentive Programme, would be available to all vehicle manufacturers with operations in North America, as well as parts suppliers.
However, the three Detroit carmakers - GM, Ford Motor and Chrysler - and their suppliers would be by far the biggest beneficiaries. They see the loans as a way of bridging a cash crunch that is likely to continue for at least the next 18 months.
Recipients would pay interest at less than half prevailing market rates. With their credit ratings deep in junk territory, the carmakers currently borrow at rates well into double digits.
Mr De Koker estimated that the industry needs $100-150bn to modernise its plants. "We really need the loan guarantees to meet a national goal that the government has set," he said, adding that the request comes "at a time when the domestic industry is in a very difficult financial condition".
All three Detroit carmakers are struggling to cope with a steep downturn in US light-vehicle sales, as well as an unexpected stampede by buyers from highly profitable sport-utility vehicles and pick-up trucks to smaller, more fuel-efficient cars. GM posted a $15.5bn second-quarter loss, while Ford reported an $8.7bn deficit.
Himanshu Patel, analyst at JPMorgan, told clients yesterday that the loan programme could materially lessen the chances of any of the Detroit carmakers filing for bankruptcy protection. Both presidential candidates, John McCain and Barack Obama, have thrown their support behind the loans. Michigan and Ohio, the two states most dependent on the auto industry, are key swing states in the election.
GM to provide $10.6 billion to support Delphi
Delphi Corp. said on Friday that former parent General Motors Corp has increased its support to $10.6 billion, from $6 billion, to speed the auto parts maker's emergence from bankruptcy.
Delphi, which filed for bankruptcy protection in the United States. in 2005, said in a Bankruptcy Court filing that without GM's stepped-up support, "a viable stand-alone business plan may not be possible." As part of the plan, which needs approval of the U.S. Bankruptcy Court in New York, GM will assume $3.4 billion in pension liabilities for Delphi's hourly factory workers, more than double the amount GM had agreed to in the initial restructuring plan, Delphi said.
Delphi has been trying to negotiate a revised reorganization plan since investors led by Appaloosa Management backed out of a $2.55 billion equity plan to support its emergence in April. The auto parts maker said the changes would put Delphi in a position to pursue exit financing, including through an equity-based rights offering, to support its business plan under current market conditions.
GM has taken a total of $11 billion in charges for Delphi's reorganization, including $2.8 billion in the second quarter. Delphi also filed a motion to freeze its hourly and salaried worker pension plans ahead of its emergence from court protection. The current reorganization plan called for a pension freeze upon its emergence from bankruptcy.
The company would like to freeze the salaried pensions effective at the end of September. Union approval would be needed to freeze the hourly pension plans before the company's emergence from bankruptcy. Delphi had faced the threat of legal action by the U.S. Pension Benefit Guarantee Corp. unless it reached an agreement with GM to transfer part of its pension liabilities to the automaker.
Abandon oil sands, urges big investor
One of Britain's biggest investors will launch a campaign this week to persuade Shell and BP to drop their plans for heavy investment in oil sands and shale projects in North America.
Co-operative Asset Management is concerned that the huge environmental costs of producing crude from oil sands or shale could change the economics of these so-called 'unconventional' fuel sources, putting the oil companies and their investors at risk of a huge wasted investment.
Paul Monaghan, head of sustainability and social goals at the Co-op, points to research showing that extracting oil from shale creates eight times as many emissions as conventional oil production, while oil sands produce three times as much. While these sources are economic at current oil prices, a fall in crude or a rise in the price of carbon under the trading system could make them much more expensive.
'The worry is that, within five years, it will be unstoppable,' said Monaghan. 'I think it is stoppable now.' The Co-op will enlist the support of other large institutional investors at a seminar outlining the issues this week. Niall O'Shea, a responsible shareholding analyst, said: 'We believe that companies investing heavily in unconventionals are too focused on short-term profit and their strategy is too defensive. They are becoming increasingly expensive to produce.'
Shell is already committed to a $16bn (£8.9bn) project aimed at generating 15 per cent of its production from unconventionals, while BP's investment is around $6bn. The amount of oil available is huge - the Canadian sands alone, situated largely in the province of Alberta, have around twice the total reserves of Saudi Arabia.
The companies say that the higher emissions will be mitigated by carbon capture and storage schemes, but O'Shea says these will not be in operation until 2020. 'Oil sands [production] will be out long before that.'
The exploitation of the oil sands is controversial even within North America. According to polls, some two thirds of Albertans support a moratorium on new projects until new environmental standards are in place. But the state government in Alberta is keen to attract investment from oil companies, leaving them to largely determine how to regulate their activities. As a result, critics say, the environmental rules are lax and loosely enforced.
In the US, legislators have proposed a law which could restrict imports of the most polluting types of fossil fuels, such as that from oil sands. But Greg Stringham of the Canadian Association of Petroleum Producers dismissed this move as 'rhetoric': 'I do not think the US is in a position to choose what kind of oil it gets. The US has spoken a lot about energy security, so it will not want to jeopardise supplies from Canada - a safe, close, and growing source.'
Central bankers saw disaster coming
Many of the world's central bankers saw signs of a credit crisis five years ago, said former Bank of Canada governor David Dodge, but no one foresaw the “period of great financial danger and unrest” that followed the meltdown in credit markets last summer.
“We've known for a long time, going back to 2003 and 2004, that we were building up to a global problem that needed to be resolved,” Mr. Dodge said during an interview to mark his new career as an Ottawa-based senior adviser to one of Canada's largest law firms, Bennett Jones LLP.
The biggest danger, he said was the overheated U.S. housing market and proliferation of mortgage-linked securities, which left global investors and major financial institutions exposed to billions of dollars of losses.
Some powerful critics such as former U.S. Federal Reserve Board chairman Alan Greenspan privately warned for years “that a disaster was waiting to happen” in a real estate sector fed by historically easy access to mortgages, he said. But Wall Street and other regulators turned a deaf ear.
“It was very hard to get reform because there was the perception that if you make mortgages more accessible, you are helping homeowners, but what you're really doing is driving up home prices.”
In a wide-ranging interview during which he discussed monetary policy for the first time since retiring from the bank in January, the 65-year-old bureaucrat and academic was uncharacteristically blunt about “ridiculous” mortgage investment innovations.
Mr. Dodge pointed to the soon-to-be ended private sector life of U.S. mortgage backers Freddie Mac and Fannie Mae as “stupid” and the U.S. Treasury's intervention into the sale of hobbled Wall Street giant Bear Stearns Cos. Inc. as “brilliant.”
Mr. Dodge's sharp language is a departure from the careful central-bank-speak that defined his seven years at the helm of the Bank of Canada.
Market watchers who devoted careers to parsing his language for nuances that could reshape currency and interest rate outlooks will now have to recalibrate their Dodgemeters for much franker economic assessments.
Even seven months after leaving the central bank, he occasionally catches himself when he loses that well-rehearsed central banker reserve and openly shares his unease over market dangers. For example, when applauding the Washington-managed takeover of Bear Stearns, he said: “This was a huge systemic problem and if any of the major counterparties would have gone, the whole house of cards – no, I should say, the whole system – would have frozen.”
Part of the appeal of joining a law firm, Mr. Dodge said, is the freedom he will have to speak out about economic issues. Unlike most retiring central bankers who move on to lucrative posts at investment banks or hedge funds, Mr. Dodge said he believed “I wouldn't have the freedom to talk about issues” if he worked for a financial institution “engaged in selling certain kinds of products.”
Unleashed from his central bank duties, he is planning major speeches in the next few months at the C.D. Howe Institute and the University of Western Ontario's Ivey School of Business to give his take on the roots and remedies for a global credit crunch that is choking economies and toppling once untouchable financial institutions.
While he declined to discuss his planned speeches in detail, it is clear a major focus will be the financial system's failures in recent years and the need for more co-ordinated regulation. Much of the blame for the current credit crisis, he said, is the evolution of mortgage-backed securities that allowed banks to shift increasingly risky U.S. mortgage loans off their balance sheets into poorly understood securities sold around the world.
The “ridiculous” motivation behind the mortgage-backed securities, he said, was for banks to avoid the cost of setting aside capital reserves as required by bank regulators to cushion against potential losses. Once the mortgages morphed into securities, he said traditional caution about credit risk was abandoned and regulators learned too late that the innovations would trigger billions of dollars of losses.
“All of us didn't recognize the extent to which it would come back to hurt financial institutions,” he said. The solution, he said, will be a more centralized and interventionist approach. Financial innovation has shifted billions of dollars of one-time bank products such as mortgage loans into virtually unregulated markets that need more transparency and tougher accounting standards.
One answer, he said, would be to regulate investment firms with the kind of credit and capital rules that govern retail banks. Investment houses such as Bear Stearns and Lehman Brothers Inc. were heavily exposed to the real estate crisis through the sale of and investment in mortgage-linked securities, but unlike banks they were not required to set aside capital reserves to cushion against losses.
Changing the regulatory regime, he concedes, will trigger “an enormous fight” from investment bankers and pose a “very difficult challenge” for rule makers who have to write laws for a constantly innovating market.
Maybe that's why, he says with large grin, “working for a law firm is such a good fit.”
- On the roots of the global credit crunch:
What we had was a financial system where leverage increased quite substantially while credit controls declined. Financial instruments were introduced and nobody had any idea about the risks.
- On the need for greater government intervention in financial markets:
We have moved so much into the market in rather complex ways that it is hard to see how we can avoid systemic crises without bringing all of the big system financial players into some sort of collective regulatory oversight.
- On the failure of wiser heads to restrain Wall Street:
So much of this originated from trading books and traders don't come at things from the point of view of credit risk. Alan Greenspan spent the last decade saying this is a disaster waiting to happen. It was very hard to get reform because there was this perception that if you make mortgages more accessible, you are helping homeowners.
- On why Canada didn't need a Freddie Mac/Fannie Mae style intervention:
We didn't get ourselves in the stupid position that the Americans did with Freddie and Fannie. … To pretend that these [players] can operate according to private sector principles is just lunacy.
- On the writedowns by banks on mortgage-linked securities:
All of us didn't recognize the extent to which these off-balance-sheet products would come back to hurt financial institutions. There was a sense that if they were off balance sheet, they couldn't be hurt. These products were designed to avoid capital reserves. It was ridiculous.
Alt-A Mortgages Next Risk for Housing Market as Defaults Surge
For Dean Nessen, the choice of a mortgage was easy. By agreeing to pay only interest for three years, the self-employed salesman didn't have to show proof of income and landed a rate of 6.25 percent. Now, four years later, Nessen's industrial coatings business has gone belly up and his rate has jumped to 10.6 percent.
He can't afford the payments and may have to move his family out of their home in Commerce Township, Michigan. Homeowners lured by low introductory rates to Alt-A mortgages, which typically require little or no proof of a borrower's income, may fuel the next wave of foreclosures and further delay a recovery from the worst housing decline since the 1930s.
Almost 16 percent of securitized Alt-A loans issued since January 2006 are at least 60 days late, data compiled by Bloomberg show. Defaults will accelerate next year and continue through 2011 as these loans hit their three- and five-year reset periods, according to RealtyTrac Inc., an Irvine, California-based foreclosure data provider. "Alt-A will be another headache," said T.J. Lim, the London-based global co-head of markets at Unicredit Group. "I would be very worried about anything issued in the last half of 2006 and the first half of 2007."
About 3 million U.S. borrowers have Alt-A mortgages totaling $1 trillion, compared with $855 billion of subprime loans outstanding, according to Inside Mortgage Finance, a trade publication in Bethesda, Maryland. Of the Alt-A borrowers, 70 percent may have exaggerated their income, said David Olson, president of mortgage research firm Wholesale Access in Columbia, Maryland.
Risks extend beyond banks and consumers to Washington-based Fannie Mae, which owned or guaranteed $340 billion of Alt-A mortgages in the second quarter, equal to about 11 percent of its total single-family mortgage credit book of business. The loans accounted for half of the company's second-quarter credit losses, according to a regulatory filing. Alt-A holdings at McLean, Virginia-based Freddie Mac were $190 billion, or 10 percent of its mortgages, in the second quarter, according to the company's Web site.
Fannie Mae said on Aug. 8 it won't accept any new Alt-A loans after Dec. 31. While subprime home loans describe a type of borrower --those with bad or limited credit histories -- Alt-A, or Alternative A- paper, are shorthand for a type of loan developed in the mid- 1980s.
Many Alt-A loans go to borrowers with credit scores higher than subprime and lower than prime, and carried lower interest rates than subprime mortgages. So-called no-doc or stated-income loans, for which borrowers didn't have to furnish pay stubs or tax returns to document their earnings, were offered by lenders such as Greenpoint Mortgage and Citigroup Inc. to small business owners who might have found it difficult to verify their salaries.
Alt-A loans were used to expand home ownership among first- time buyers as prices climbed out of reach for many of them, according to Rick Sharga, executive vice president for marketing at RealtyTrac. "To grow, the market had to embrace more borrowers, and the obvious way to do that was to move down the credit scale," said Guy Cecala, publisher of Inside Mortgage Finance. "Once the door was opened, it was abused."
By 2005, the credit score required for an Alt-A loan fell as low as 620, traditionally the definition of a subprime borrower, said Steve Donlin, a former mortgage broker who's now vice president of operations at Loan Safe Solutions Inc. in Corona, California, which helps people negotiate changes to loans they can't afford. Alt-A mortgages with credit scores as low as 620 were insured until March 2008 by PMI Group Inc., the second largest U.S. mortgage insurer, said spokesman Nate Purpura.
Almost all stated-income loans exaggerated the borrower's actual income by 5 percent or more, and more than half increased the amount by more than 50 percent, according to a study cited by Mortgage Asset Research Institute in its 2006 report to the Washington-based Mortgage Bankers Association.
Some mortgage brokers and loan officers urged borrowers to inflate incomes, exaggerate job titles or increase loan size because lenders could profit by selling riskier Alt-A loans to investors, said Jim Croft, founder of Reston, Virginia-based Mortgage Asset Research Institute. "When homes prices were going up, people were saying, `If I don't buy now, I'll never be able to buy,"' Croft said.
Falsifying information on a mortgage application is a crime, said FBI Special Agent Stephen Kodak in Washington. It's rarely investigated because the FBI targets what it calls "fraud for profit" schemes involving people who lie to get multiple mortgages and have no intention of repaying them, rather than individuals lying about their income to buy a house they intend to live in, Kodak said.
The Alt-A market grew more than seven-fold to $400 billion in 2006 from $55 billion in 2001, according to Inside Mortgage Finance. Since home prices peaked in July 2006, they have fallen 18.8 percent nationally, leaving an estimated 29 percent of borrowers who bought in the last five years with houses worth less than what they owe on their mortgages, according to Zillow.com, an Internet real estate valuation site.
The "serious delinquency" rate for Alt-A mortgages issued in 2007 hit 10 percent in half the time it took for those from 2006 to reach the same level, Moody's Investors Service said in a report last month. "Alt-A loans have turned toxic," Cecala said. The combination of exaggerated income, falling home prices and payments that reset higher is "a recipe for disaster," he said.
When Linda and Mark Pavlick bought their three-bedroom house in West Deer, Pennsylvania, 16 years ago, they paid $68,000. They now owe $105,000. The house was recently appraised for $80,000, Linda Pavlick said. "The decision to redo the loan was probably the worst decision we ever made," said Pavlick, an administrative assistant at a psychiatric hospital.
When their interest rate jumped to 12.25 percent last year, making the monthly payment about half their combined take-home pay, the Pavlicks and their 17-year-old son had to choose between paying the mortgage and the monthly gas bill, Linda Pavlick said.
"We went three months without gas," she said. "I used an electric plate to cook. But heating up the water for a shower, to wash your hair, that was the toughest. I've learned a lot of lessons, but this isn't one I'd wish on anybody." The Pavlicks turned to a community housing group called Association of Community Organizations for Reform Now, or ACORN, which helps borrowers recast their loans with lenders.
Still, Linda Pavlick said she and her husband, who operates road-patching equipment for the Pennsylvania Department of Transportation, have no idea if their lender will comply. "There's been rough times in all of this and I don't know where this is going," Pavlick said. About one-third of Alt-A loans are payment-option adjustable- rate mortgages, said Donlin of Loan Safe Solutions.
A borrower with an option ARM can pay as low as 1 percent interest by deferring some of the money owned until the loan balance reaches a predetermined limit, usually 110 percent to 120 percent of the original mortgage amount. Then payments immediately rise. They also automatically shoot up after a set time period of up to five years. The loans accounted for 8.9 percent of the almost $3 trillion in U.S. home loans made in 2006, according to an estimate by Inside Mortgage Finance.
Wachovia Corp., with $122 billion, and Washington Mutual Inc., with $52.9 billion, were the U.S. lenders with the most option ARMs on their balance sheets at the end of the second quarter, according to regulatory filings. Both ousted their chief executive officers, Wachovia in July and Washington Mutual on Sept. 8, over failure to stem mortgage losses.
The value of non-performing real estate loans at Wachovia, the fourth-largest U.S. bank, rose to $11.9 billion, or 2.4 percent, of all loans on the books in the second quarter and increased from the $1.9 billion, or 0.5 percent, of non-performing loans a year earlier.
Non-paying consumer real estate loans at Charlotte, North Carolina-based Wachovia increased five-fold, to $7.6 billion, in the second quarter from $1.5 billion a year earlier. The bank said those losses were driven by "Pick-a-Pay" loans, otherwise known as payment-option adjustable-rate mortgages.
"We continue to mitigate the risk and volatility of our balance sheet through prudent risk-management practices, including increased collection efforts," Wachovia said in its quarterly report, issued Aug. 11. Washington Mutual, the biggest U.S. savings and loan, said the value of option ARMs that weren't being paid grew to $3.2 billion in the second quarter from $1.6 billion at the end of 2007, according to regulatory filings. The Seattle-based thrift announced it would no longer offer option ARMs.
Other banks with option ARM holdings include Countrywide Financial Corp., acquired July 1 by Charlotte-based Bank of America Corp., with $27 billion; Newport Beach, California-based Downey Financial Corp., with $6.9 billion; and IndyMac Bancorp Inc., the Pasadena, California-based lender now run by the Federal Deposit Insurance Corp. after a run on deposits, with $3.5 billion, according to Inside Mortgage Finance.
Lehman Brothers Holdings Inc., the New York-based securities firm that yesterday entered talks with potential buyers, held $26.6 billion of securities backed by Alt-A loans in 2007, ranking second behind Countrywide, Inside Mortgage Finance said. Washington Mutual, under pressure to raise capital for the second time in five months to cover loan losses, ranked ninth with $9.65 billion.
The backlog of growing mortgage delinquencies has overwhelmed mortgage servicers, who collect monthly payments from homeowners and distribute them to securities investors, said Nessen, the Michigan borrower. Nessen, 41, said he made phone calls repeatedly over five months and failed to reach a person who could work out a deal with him at Saxon Mortgage Services Inc., the service company that collects his payments. Saxon was purchased by Morgan Stanley in 2006.
"Granted, they are overwhelmed by people in my situation," Nessen said. "But that doesn't help me." Saxon has responded to higher delinquency rates by increasing the number of employees working on loan modifications by 60 percent during the past three months, according to company spokeswoman Jennifer Sala. "Saxon is committed to structuring solutions in a timely manner for qualified borrowers so they can remain in their homes," Sala said in an e-mail.
Bank of America, which became the largest U.S. mortgage servicer when it acquired Countrywide, has 4,500 counselors to help borrowers modify loans, more than double the number the two lenders had last year, according to spokesman Terry Francisco. Des Moines, Iowa-based Wells Fargo Home Mortgage, the second- largest U.S. mortgage servicer, increased the number of employees handling loan modifications to 1,000 from 200 in 2005, said spokesman Kevin Waetke.
Chase Home Lending, a unit of New York-based JPMorgan Chase & Co., expects to spend at least $200 million more in 2008 on servicing loans, loss mitigation and defaults than it did last year, said spokesman Thomas Kelly. Nessen said the home he shares with his wife and three children, ages 7, 3 and 13 months, is scheduled for sheriff's auction at the end of the month.
How Washington Failed to Rein In Fannie, Freddie
Gary Gensler, an undersecretary of the Treasury, went to Capitol Hill in March 2000 to testify in favor of a bill everyone knew would fail. Fannie Mae and Freddie Mac were ascendant, giants of the mortgage finance business and key players in the Clinton administration's drive to expand homeownership.
But Gensler and other Treasury officials feared the companies had grown so large that, if they stumbled, the damage to the U.S. economy could be staggering. Few officials had ever publicly criticized Fannie Mae and Freddie Mac, but Gensler concluded it was time to urge Congress to rein them in. "We thought this was a hand-on-the Bible moment," he recalled. The bill failed.
The companies kept growing, the dangers posed by their scale and financial practices kept mounting, critics kept warning of the consequences. Yet across official Washington, those who might have acted repeatedly failed to do so until it was too late. Last weekend, the federal government seized control of the two companies to protect the very mortgage market they were created to lubricate.
The cost to taxpayers could run into the tens of billions of dollars. As policymakers now set out to decide what role government, and the two companies, should play in the mortgage business, the failures of the past two decades offer a cautionary tale.
Blessed with the advantages of a government agency and a private company at the same time, Fannie Mae and Freddie Mac used their windfall profits to co-opt the politicians who were supposed to control them. The companies fought successfully against increased regulation by cultivating their friends and hounding their enemies.
The agencies that regulated the companies were outmatched: They lacked the money, the staff, the sophistication and the political support to serve as an effective check. But most of all, the companies were protected by the belief widespread in Washington -- and aggressively promoted by Fannie Mae and Freddie Mac -- that their success was inseparable from the expansion of homeownership in America.
That conviction was so strong that many lawmakers and regulators ignored the peril posed to that ideal by the failure of either company. In October 1992, a brief debate unfolded on the floor of the House of Representatives over a bill to create a new regulator for Fannie Mae and Freddie Mac. On one side stood Jim Leach, an Iowa Republican concerned that Congress was "hamstringing" this new regulator at the behest of the companies.
He warned that the two companies were changing "from being agencies of the public at large to money machines for the stockholding few." On the other side stood Barney Frank, a Massachusetts Democrat who said the companies served a public purpose. They were in the business of lowering the price of mortgage loans.
Congress chose to create a weak regulator, the Office of Federal Housing Enterprise Oversight. The agency was required to get its budget approved by Congress, while agencies that regulated banks set their own budgets. That gave congressional allies an easy way to exert pressure.
"Fannie Mae's lobbyists worked to insure that [the] agency was poorly funded and its budget remained subject to approval in the annual appropriations process," OFHEO said more than a decade later in a report on Fannie Mae. "The goal of senior management was straightforward: to force OFHEO to rely on the [Fannie] for information and expertise to the degree that Fannie Mae would essentially regulate itself."
Congress also wanted to free up money for Fannie Mae and Freddie Mac to buy mortgage loans and specified that the pair would be required to keep a much smaller share of their funds on hand than other financial institutions. Where banks that held $100 could spend $90 buying mortgage loans, Fannie Mae and Freddie Mac could spend $97.50 buying loans.
Finally, Congress ordered that the companies be required to keep more capital as a cushion against losses if they invested in riskier securities. But the rule was never set during the Clinton administration, which came to office that winter, and was only put in place nine years later.
The Clinton administration wanted to expand the share of Americans who owned homes, which had stagnated below 65 percent throughout the 1980s. Encouraging the growth of the two companies was a key part of that plan. "We began to stress homeownership as an explicit goal for this period of American history," said Henry Cisneros, then Secretary of Housing and Urban Development. "Fannie and Freddie became part of that equation."
The result was a period of unrestrained growth for the companies. They had pioneered the business of selling bundled mortgage loans to investors and now, as demand from investors soared, so did their profits. Near the end of the Clinton administration, some of its officials had concluded the companies were so large that their sheer size posed a risk to the financial system.
In the fall of 1999, Treasury Secretary Lawrence Summers issued a warning, saying, "Debates about systemic risk should also now include government-sponsored enterprises, which are large and growing rapidly." It was a signal moment. An administration official had said in public that Fannie Mae and Freddie Mac could be a hazard.
The next spring, seeking to limit the companies' growth, Treasury official Gensler testified before Congress in favor of a bill that would have suspended the Treasury's right to buy $2.25 billion of each company's debt -- basically, a $4.5 billion lifeline for the companies. A Fannie Mae spokesman announced that Gensler's remarks had just cost 206,000 Americans the chance to buy a home because the market now saw the companies as a riskier investment.
The Treasury Department folded in the face of public pressure. There was an emerging consensus among politicians and even critics of the two companies that Fannie Mae might be right. The companies increasingly were seen as the engine of the housing boom. They were increasingly impervious to calls for even modest reforms.
As early as 1996, the Congressional Budget Office had reported that the two companies were using government support to goose profits, rather than reducing mortgage rates as much as possible. But the report concluded that severing government ties with Fannie Mae and Freddie Mac would harm the housing market. In unusually colorful language, the budget office wrote, "Once one agrees to share a canoe with a bear, it is hard to get him out without obtaining his agreement or getting wet."
Fannie Mae and Freddie Mac enjoyed the nearest thing to a license to print money. The companies borrowed money at below-market interest rates based on the perception that the government guaranteed repayment, and then they used the money to buy mortgages that paid market interest rates. Federal Reserve Chairman Alan Greenspan called the difference between the interest rates a "big, fat gap."
The budget office study found that it was worth $3.9 billion in 1995. By 2004, the office would estimate it was worth $20 billion. As a result, the great risk to the profitability of Fannie Mae and Freddie Mac was not the movement of interest rates or defaults by borrowers, the concerns of a normal financial institution. Fannie Mae's risk was political, the concern that the government would end its special status.
So the companies increasingly used their windfall for a massive campaign to protect that status. "We manage our political risk with the same intensity that we manage our credit and interest rate risks," Fannie Mae chief executive Franklin Raines said in a 1999 meeting with investors. Fannie Mae, and to a lesser extent Freddie Mac, became enmeshed in the fabric of political Washington.
They were places former government officials went to get wealthy -- and to wait for new federal appointments. At Fannie Mae, chief executives had clauses written into their contracts spelling out the severance benefits they would receive if they left for a government post. The companies also donated generously to the campaigns of favored politicians.
The companies' political action committees and employees have donated $4.8 million to members of Congress since 1989, according to the Center for Responsive Politics. But Fannie Mae wasn't just buying influence. It was selling government officials on an idea by making its brand synonymous with homeownership. The company spent tens of millions of dollars each year on advertising.
Even Greenspan, who shared the concerns of Treasury officials about the unrestrained growth of Fannie Mae and Freddie Mac, refrained for years from using his bully pulpit to urge action. He too wanted a hot housing market.
In tying itself to politicians and wrapping itself in the American flag, Fannie Mae went out of its way to share credit with politicians for investments in their communities.
"They have always done everything in their power to massage Congress," Leach said. And when they couldn't massage, they intimidated. In 2003, Richard H. Baker (R-La.), chairman of the House Financial Services subcommittee with oversight over Fannie Mae and Freddie Mac, got information from OFHEO on the salaries paid to executives at both companies.
Fannie Mae threatened to sue Baker if he released it, he recalled. Fearing the expense of a court battle, he kept the data secret for a year. Baker, who left office in February, said he had never received a comparable threat from another company in 21 years in Congress. "The political arrogance exhibited in their heyday, there has never been before or since a private entity that exerted that kind of political power," he said.
In June 2003, Freddie Mac dropped a bombshell: It had understated its profits over the previous three years by as much as $6.9 billion in an effort to smooth out earnings. OFHEO seemed blind. Months earlier, the regulator had pronounced Freddie's accounting controls "accurate and reliable."
Humiliated by the scandal, then-OFHEO director Armando Falcon Jr. persuaded the White House to pay for an outside accountant to review the books of Fannie Mae. The agency reported in September 2004 that Fannie Mae also had manipulated its accounting, in this case to inflate its profits. The companies were humbled. The flaws of their business practices were laid bare.
The companies soon faced new bills in both the House and the Senate seeking increased regulation. The Bush administration took the hardest line, insisting on a strong new regulator and seeking the power to put the companies into receivership if they foundered. That suggested the government might not stand behind the companies' debt.
Fannie Mae and Freddie Mac succeeded in escaping once more, by pounding every available button.
The companies orchestrated a letter-writing campaign by traditional allies including real estate agents, home builders and mortgage lenders. Fannie Mae ran radio and television ads ahead of a key Senate committee meeting, depicting a Latino couple who fretted that if the bill passed, mortgage rates would go up. The wife lamented: "But that could mean we won't be able to afford the new house." Most of all, the company leaned on its Congressional supporters.
In the Senate, Robert F. Bennett (R-Utah) added an amendment giving Congress the ability to block receivership, weakening that bill to the point where the White House would no longer support it. Bennett's second-largest contributor that year was Fannie Mae; his son was then the deputy director of Fannie's regional office in Utah.
Fannie Mae even persuaded the New York Stock Exchange to allow its shares to keep trading. The company had not issued a required report on its financial condition in a year. The rules of the exchange required delisting. So the exchange created an exception when "delisting would be significantly contrary to the national interest." The amendment was approved by the Securities and Exchange Commission. FNM would remain on the NYSE.
As Fannie Mae and Freddie Mac were trying to recover from their accounting scandals, a new and ultimately mortal threat emerged. Yet again, the warnings went unheeded for too long. The companies had begun buying loans made to borrowers with credit problems.
Fannie Mae and Freddie Mac had been losing market share to Wall Street banks, which were doing boomtown business packaging these riskier loans. The mortgage finance giants wanted a share of the profits. Soon, the firms' own reports were noting the growing risk of their portfolios. Dense monthly summaries of the companies' mortgage purchases were piling up at OFHEO.
An employee at one of the companies said it was already a constant discussion around the office in 2004: When would the regulators notice? "It didn't take a lot of sophistication to notice what was happening to the quality of the loans. Anybody could have seen it," the staffer said. "But nobody on the outside was even questioning us about it."
President Bush had pledged to create an "ownership society," and the companies were helping the administration achieve its goal of putting more than 10 million Americans into their first homes. Fannie Mae and Freddie Mac's appetite for risky loans was growing ever more voracious.
By the time OFHEO began raising red flags in January 2007, many borrowers were defaulting on loans and within months Fannie Mae and Freddie Mac would be running out money to cover the losses. Finally, as the credit crisis escalated, Congress passed a bill two months ago establishing a tough, new regulator for the companies. It was too late.