Ilargi: Update 2.00 PM EDT The plan has been voted down in the House. I must admit, I had expected that 3 days was enough to come up with a version watered down enough to get a majority. For the rest of today, and beyond, chaos reigns on Wall Street. Anything could happen. Many more bank failures are now certain to follow soon. The House reconvenes no earlier than Thursday. A vote on a follow-up plan doesn't look likely before the weekend. By then, who knows what the world will look like?
Stocks Plunge as Bail-Out Plan Fails
Wall Street's worst fears came to pass Monday, when the government's financial bailout plan failed in Congress and stocks plunged precipitously - hurtling the Dow Jones industrials down nearly 780 points in their largest one-day point drop ever. Credit markets, whose turmoil helped feed the stock market's angst, froze up further amid the growing belief that the country is headed into a spreading credit and economic crisis.
Stunned traders on the floor of the New York Stock Exchange, their faces tense and mouths agape, watched on TV screens as the House voted down the plan in mid-afternoon, and as they saw stock prices tumbling on their monitors. Activity on the floor became frenetic as the "sell" orders blew in.
The Dow told the story of the market's despair. The blue chip index, dropped by hundreds of points in a matter of moments, and by the end of the day had passed by far its previous record for a one-day drop, 684.81, set in the first trading day after the Sept. 11, 2001, terror attacks. The selling was so intense that just 162 stocks rose on the NYSE - and 3,073 dropped.
It takes an incredible amount of fear to set off such an intense reaction on Wall Street, and the worry now is that with the $700 billion plan fate uncertain, no one knows how the financial sector hobbled by hundreds of billions of dollars in bad mortgage bets will recover. While investors didn't believe that the plan was a panacea, and understood that it would take months for its effects to be felt, most market watchers believed it was a start toward setting the economy right after a credit crisis that began more than a year ago and that has spread overseas.
"Clearly something needs to be done, and the market dropping 400 points in 10 minutes is telling you that," said Chris Johnson president of Johnson Research Group. "This isn't a market for the timid." The plan's defeat came amid more reminders of how troubled the nation's financial system is - before trading began came word that Wachovia Corp., one of the biggest banks to struggle due to rising mortgage losses, was being rescued in a buyout by Citigroup Inc.
It followed the recent forced sale of Merrill Lynch & Co. and the failure of three other huge banking companies - Bear Stearns Cos., Washington Mutual Inc. and Lehman Brothers Holdings Inc.; all of them were felled by bad mortgage investments.
And it raised the question: Which banks are next, and how many? The Federal Deposit Insurance Corp. has a list of over 110 banks that were in trouble in the second quarter, and that number surely has grown in the third. Wall Street is contending with all these issues against the backdrop of a credit market - where bonds and loans are bought and sold - that is barely functioning because of fears that anyone lending money will never be paid back.
The evidence of the credit markets' ills could again be found Monday in the Treasury's 3-month bill - investors were stashing money there, willing to take the tiniest of returns simply to be sure that their principal would survive in what's considered the safest investment. The yield on the 3-month bill was 0.15, down from 0.87, and approaching zero, a level reached last week when fear was also running high.
On Wall Street, according to preliminary calculations, the Dow fell 777.68, or 6.98 percent, to 10,365.45. The decline also surpasses the 721.56-point intraday decline record also set during the first trading day after the terror attacks. Still, in percentage terms, the decline remained well below the more than 20 percent drops seen on Black Monday of October 1987 and the Depression.
Broader stock indicators also tumbled. The Standard & Poor's 500 index declined 106.85, or 8.81 percent, to 1,106.42.
The technology-heavy Nasdaq composite index fell 199.61, or 9.14 percent, to 1,983.73.
If you go to the racetrack and bet on a horse, you receive a piece of paper that confirms the bet you made. There are many different varities of bets possible; for now, let’s say you simply bet on one specific horse to win the race.
After the race is over, you have either won your bet or lost it. There’s nothing difficult about the process, anyone can -learn to- understand it, and everyone, except in very rare circumstances, accepts it, both the winners and the losers.
What is happening in world finance these days is that a group of very heavy betters have become very heavy losers, and they have done so with borrowed money. In the past few years, in order to hide their losses, they have turned to a very clever little trick: they want to make us believe that the race is not over, even though we can all see that it is. In fact, if they have their way, the race will never be over, unless and until their horse wins.
The US government has joined the argument on the side of the losing betters. They have allowed the losers - who are their friends-, for years, to hide their predicament, their losing tickets, through Level 3 and off-balance sheet "creative accounting". Now that the government’s betting buddies’ creditors are losing patience, and demand their money back, which the buddies don’t have, the Fed and Treasury want to buy all those losing tickets, with money that belongs to the taxpayers whose best interests they are presumed to represent.
And they up the ante today: the president declares that this will cost the taxpayer nothing; and if you believe that one, you’ll like the guys who claim that there are profits to be made on this avalanche of losing bets.
Now there'll be plenty of "experts" who are more than willing to tell you that comparing mortgage-backed securities -to take just one sort of bet- with horse racing is inherently flawed. Their argument will be that there is true value behind the securities: the homes that were purchased with the underlying mortgages.
At first glance, that may look plausible: it seems clear that the homes are not all of a sudden worthless, so how could the mortgages and securities be? My first thought is that the horse you bet on is not worthless either just because it lost one race. But that doesn’t make you win your bet, does it? And the horse is still tired.
There are deeper problems with the "the home still has value" argument. The most flagrant is the actual purchase prices, which doubled or tripled in a decade, while no value was added to the home itself. From that follows that many homes were sold at prices that people couldn’t truly afford. The US has for that reason already seen milllions of foreclosures, with many more inevitably to come. And the elevated prices, of course. are also the ones the securities are based on.
So perhaps at some time in the future your losing horse might win a race, and perhaps at one point some money can be made on a new mortgage for a foreclosed home. But that makes no difference for your losing bet, and neither does it make the securities valuable again. Both races are over. For good. Which makes it impossible for the US taxpayer to play even on the losing betting tickets their government is about to buy with their money, while making a profit on them is too ridiculous to seriously discuss.
If home sales ever recover to any kind of extent, it will be at prices that are far lower than they have been so far in this millenium. That is the only way to make them affordable. And even if it happens, it is going to take years. In the meantime, the gambling losses will have to be paid.
Your government tries to convince you that your life will be miserable without their losing betting buddies. If you ask me, it will be much worse with them, because if you want to keep them around, you’ll have to pay their debts. And they’ll just use the money to go bet on the next race. Maybe you should keep the money and buy your own tickets. That way you get to keep the profits too, if there are any.
But if I were you, I’d lay off the gambling for a while. It looks to me like a sure bet that you’re going to need every penny you have just to feed your children.
PS: For stock markets, these are dark days indeed. I see Amsterdam lost almost 9%. Fortis Bank got $17 billion last night, but still lost 23%. Wall Street is a bit better so far, but National CIty (-50%) and FIfth Third (-35%) start to look like prime candidates for the next round of trouble.
Stocks Worldwide Tumble Most Since 1997
Stocks around the world fell the most since October 1997, the euro and the pound sank and bonds rose as governments raced to prop up banks infected by growing U.S. mortgage losses.
The Standard & Poor's 500 Index fell 3.8 percent after Wachovia Corp. required a takeover by Citigroup Inc. and lawmakers predicted a close vote on the Bush administration's $700 billion bank bailout. The British pound dropped the most against the dollar in 15 years after European governments stepped in to save Bradford & Bingley Plc, Fortis and Hypo Real Estate Holding AG. Commodities fell. The cost of borrowing in euros for three months soared to a record as banks hoarded cash.
"People are wondering if $700 billion will be enough," said Diane Garnick, who helps oversee $500 billion as an investment strategist at Invesco Plc in New York. "If you're not comfortable being in this type of market, then you shouldn't be making investment decisions now."
The MSCI All-Country World Index of 48 nations lost as much as 4.5 percent, the steepest plunge since the Asian financial crisis 11 years ago. The S&P 500 retreated 46.58 points to 1,166.43 at 12:35 p.m. in New York. Europe's Dow Jones Stoxx 600 Index sank 5.5 percent to 251.43, the lowest since January 2005. The MSCI Asia Pacific Index fell 2.1 percent.
The Irish Overall Index slumped 13 percent, the most in its 25-year history. The U.K.'s FTSE 100 Index has lost 15 percent in September, the steepest monthly drop since the October 1987 stock-market crash. India's Sensitive index tumbled 3.8 percent, Russia's Micex Index fell 5.5 percent and Brazil's Bovespa slumped 7.1 percent.
Treasuries rallied as investors sought the relative safety of government debt. The yield on 10-year Treasury notes fell 0.19 percentage point to 3.67 percent. The cost of borrowing in euros for three months rose to a record after government-led bailouts of banks heightened concern that more in Europe will fail, prompting financial institutions to hoard cash. The London interbank offered rate, or Libor, that banks charge each other for such loans climbed to 5.22 percent, the British Bankers' Association said.
The $700 billion package to shore up banks hammered out by Treasury Secretary Henry Paulson and congressional leaders over the weekend failed to calm investors. The crisis that began with bad home loans to subprime borrowers in the U.S. is threatening to push the global economy into a recession as consumers lose confidence and banks cut back on lending.
"The system is still under pretty considerable pressure," Jeffrey Palma, head of global equity strategy at UBS AG, said in a Bloomberg Television interview. "Until those uncertainties are really resolved a little bit, people aren't willing to suggest the worst is behind us."
The U.S. House of Representatives began debating Paulson's plan to revive financial markets. About 100 of the 235 House Democrats agreed to back the plan, and Republican support is needed for passage, said Representative Rahm Emanuel, the Democratic caucus chairman.
The MSCI All-Country World Index has retreated 12 percent in September, the biggest monthly loss since Russia defaulted on its debt in August 1998. This month, the U.S. seized the two largest mortgage-finance companies, Fannie Mae and Freddie Mac; Lehman Brothers Holdings Inc. filed for bankruptcy; Merrill Lynch & Co. agreed to sell itself to Bank of America Corp.; American International Group Inc. was taken over by the Treasury; and Washington Mutual Inc. was seized by regulators in the biggest U.S. bank failure in history.
Canada's S&P/TSX Composite Index has fallen 16 percent in 2008, giving it the best performance among the 23 nations MSCI considers developed markets. Ireland's benchmark index has plunged 53 percent, the steepest loss. Among 25 emerging markets, the 2.1 percent gain in Morocco's Madex Free Float Index counts as the best performance, while the 58 percent drop in China's CSI 300 Index is the worst.
Financial institutions worldwide have reported more than $550 billion of credit losses and asset writedowns since the beginning of 2007, according to data compiled by Bloomberg. "This credit crisis is pretty deep and it's pretty deep throughout the financial industry," Jason Pride, who helps oversee about $6.5 billion as director of research at Haverford Trust Co. in Radnor, Pennsylvania, told Bloomberg Television.
Wachovia declined 91 percent to 93 cents before trading was halted by the New York Stock Exchange. Citigroup will absorb as much as $42 billion of losses on Wachovia's $312 billion pool of loans. The Federal Deposit Insurance Corp. will take on losses beyond that amount in exchange for $12 billion in preferred stock and warrants.
Citigroup rose 1.4 percent to $20.44. The bank halved its dividend and said it will raise $10 billion in capital.
Financial shares in the S&P 500 retreated 5.1 percent. National City Corp. plunged as much as 66 percent to $1.25, the lowest intraday level since April 1982. Sovereign Bancorp Inc. fell as much as 57 percent to an almost 16-year low of $3.60.
Morgan Stanley slumped 8.2 percent to $22.71. It agreed to sell a 21 percent stake to Japan's Mitsubishi UFJ Financial Group Inc. for $9 billion, seeking to shore up investor confidence after borrowing costs climbed and its stock fell by half.
European governments stepped in to rescue Fortis, Bradford & Bingley and Hypo Real Estate as tremors from the U.S. credit crisis were felt around the world.
The U.K. Treasury seized Bradford & Bingley, Britain's biggest lender to landlords, while governments in Belgium, the Netherlands and Luxembourg threw an 11.2 billion-euro ($16.3 billion) lifeline to Fortis. Germany guaranteed a loan to Hypo.
Crude oil fell as much as 8.4 percent to $97.95 a barrel in New York. Copper and corn also helped lead commodities lower, sending the S&P Goldman Sachs Commodity Index to a 6.3 percent decline.
Fed Pumps Further $630 Billion Into Financial System
The Federal Reserve will pump an additional $630 billion into the global financial system, flooding banks with cash to alleviate the worst banking crisis since the Great Depression.
The Fed increased its existing currency swaps with foreign central banks by $330 billion to $620 billion to make more dollars available worldwide. The Term Auction Facility, the Fed's emergency loan program, will expand by $300 billion to $450 billion. The European Central Bank, the Bank of England and the Bank of Japan are among the participating authorities.
The Fed's expansion of liquidity, the biggest since credit markets seized up last year, comes as Congress prepares to vote on a $700 billion bailout for the financial industry. The crisis is reverberating through the global economy, causing stocks to plunge and forcing European governments to rescue four banks over the past two days alone.
"Today's blast of term liquidity will settle the funding markets down, and allow trust to slowly be restored between borrowers and lenders," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. On the other hand, "the Fed's balance sheet is about to explode." Stocks around the world plunged the most since 1997 today and credit markets deteriorated further as authorities scrambled to save more financial institutions from collapse.
European governments have rescued four banks in two days and the Federal Deposit Insurance Corp. said today it helped Citigroup Inc. buy the banking operations of Wachovia Corp. after its shares collapsed. The Standard & Poor's 500 Index fell 3.8 percent and the cost of borrowing dollars for three months rose to the highest since January. The rate for euros hit a record.
"If people think the authorities may give in to fears, they are wrong," Financial Stability Forum Chairman Mario Draghi said today in Amsterdam, where the international group of regulators and finance officials is meeting. "There is willingness and determination on winning the battle to restore confidence and stability."
Banks and brokers have slowed lending as they struggle to restore their capital after $586 billion in credit losses and writedowns since the mortgage crisis began a year ago. The bankruptcy of Lehman Brothers Holdings Inc. also sparked fears among banks they wouldn't be repaid by counterparties, driving up the cost of short-term loans between banks.
"By committing to provide a very large quantity of term funding, the Federal Reserve actions should reassure financial market participants that financing will be available against good collateral, lessening concerns about funding and rollover risk," the central bank said.
The Bank of England and the ECB will each double the size of their dollar swap facilities with the Fed to as much as $80 billion and $240 billion, respectively. The Swiss National Bank and the Bank of Japan will also double their dollar swap lines, while the central banks in Australia, Norway, Sweden, Denmark and Canada tripled theirs. All the banks extended their facilities until the end of April 2009.
The Fed is also increasing the size of its three 84-day TAF sales to $75 billion apiece, from $25 billion. That means the Fed will make a total of $225 billion available in 84-day loans. The central bank will keep the sales of 28-day credit at $75 billion.
In addition, the Fed will hold two special TAF sales in November totaling $150 billion so banks can have funding available for one or two weeks over year-end. The exact timing and terms will be determined later, the Fed said. The TAF program began in December, totaling $40 billion.
The bank-rescue plan being debated by Congress today would give the Fed more power over short-term interest rates by providing authority as of Oct. 1 to pay interest on reserves held at the central bank by financial institutions. That would make it easier for the Fed to pump funds into the banking system.
Paying interest on reserves puts a "floor" under the traded overnight rate, which would allow a central bank "to provide liquidity during times of stress" without affecting the rate, New York Fed economists said in a paper last month.
Citigroup to Buy Wachovia’s Bank Assets for $1 a Share
Citigroup has agreed to buy Wachovia’s banking operations in a government-brokered deal for $1 a share in stock, a move that that would concentrate power within the nation’s banking industry in the hands of a few giant lenders, The New York Times’s Eric Dash and Andrew Ross Sorkin reported Monday morning.
Wachovia will remain a publicly traded company, but would retain only its nonbanking operations, including its asset management and retail brokerage units, the two companies said in a statement. It will also keep some of its wealth management businesses like Evergreen and Wachovia Securities.
Under the terms of the agreement-in-principle, Citigroup will pay about $2.16 billion in stock for Wachovia’s banking assets, and will assume Wachovia’s senior and subordinated debt, or about $53 billion. The deal is expected to close by Dec. 31. Citigroup will cut its dividend to 16 cents a share
As part of the deal, Citigroup will absorb up to $42 billion of losses on Wachovia’s $312 billion pool of loans — but the Federal Deposit Insurance Corporation will absorb losses beyond that. In return, the banking giant has given the FDIC $12 billion in preferred stock and warrants as compensation.
In a statement, the FDIC, which insures the nation’s retail bank deposits, emphasized that Wachovia did not fail and that the Deposit Insurance Fund would not be affected. “For Wachovia customers, today’s action will ensure seamless continuity of service from their bank and full protection for all of their deposits,” FDIC Chairman Sheila C. Bair said in a statement. “There will be no interruption in services and bank customers should expect business as usual.”
The sale to Citigroup further concentrates Americans’ bank deposits in the hands of just three banks: Bank of America, JPMorgan Chase and Citigroup would control more than 30 percent of the industry’s deposits. Together, those three would be so large that they would dominate the industry, with unrivaled power to set prices for their loans and services.
Given their size and reach, the institutions would probably come under greater scrutiny from federal regulators. Some small and midsize banks, already under pressure, might have little choice but to seek suitors.
The talks intensified on Sunday after a weekend of tense negotiations in Washington over a $700 billion rescue for the banking industry, The Times said. Only days earlier, federal regulators seized and sold the nation’s largest savings and loan, Washington Mutual, in one of a series of important deals that have reshaped the financial landscape.
As the credit crisis has deepened, a consolidation in the financial industry that analysts have predicted for years seems to be playing out in a matter of weeks. The impact will be felt on Main Street, Wall Street and in Washington. While the tie-ups may restore confidence in the industry, they also could leave a handful of big lenders to determine fees and interest rates on everything from home mortgages to credit cards to checking accounts. Some small and midsize banks may be unable to compete with these behemoths.
For Citigroup, the deal would be its largest acquisition since the landmark merger of Citicorp and Travelers Group a decade ago. It would also be an important milestone for for Vikram S. Pandit, Citigroup’s new chief executive who has been making the case to employees and investors that Citigroup is a “pillar of strength” in turbulent times.
With Wachovia’s branch network, Citigroup would get the domestic retail banking business that has eluded it for years. It would also give Citigroup a bigger platform to sell home loans and credit cards, and would give Citigroup access to more than $400 billion in more stable customer deposits, reducing its dependence on outside investors for funds.
For Mr. Pandit, the deal has symbolic value, too. Although Citigroup has racked up nearly $50 billion in losses since the crisis began last summer and has watched the value of its shares sharply decline, the bank was also among the first to raise large amounts of capital. Mr. Pandit may point to the Wachovia deal as a sign of progress and an indication that the worst for the bank is behind.
It also will be seen as a stamp of approval from regulators. Only a few years ago, the Federal Reserve took the unusual step of banning Citigroup from making “significant acquisitions.” Gaining their approval to do a big deal on such short notice is likely to be viewed as a big vote of confidence in Mr. Pandit’s management team.
The talks intensified on Sunday after a weekend of tense negotiations in Washington over a $700 billion rescue for the banking industry. Citigroup worked feverishly to cement a deal on Sunday night, with the discussions moving past the midnight hour, according to a person briefed on the talks. Officials from the F.D.I.C. and Treasury Department stayed up late to try to get the transaction done.
Wachovia, like WaMu, has been hobbled by bad mortgages, making a merger more urgent and prompting federal regulators to push for a quick sale. Wachovia’s share price has plunged nearly 74 percent this year. In the last two weeks, Wachovia had entered into discussions with several possible suitors.
After the collapse of Lehman Brothers, Wachovia held talks with Goldman Sachs and Morgan Stanley and put out inquiries to other banks, according to The Times, which cited people close to the situation. Last week, it held discussions with Citigroup, Wells Fargo and Banco Santander of Spain, before the foreign bank’s interested cooled. As lawmakers worked in Washington on the financial bailout this weekend, Wachovia executives huddled in the Seagram Building offices of Sullivan & Cromwell on Park Avenue.
Robert K. Steel, a former top lieutenant of Henry M. Paulson Jr. at both Goldman Sachs and then the Treasury Department, who took over as Wachovia’s chief executive in July, arrived in New York to handle the negotiations in person, along with David M. Carroll, the bank’s chief deal maker, The Times said. At 8:15 am. on Saturday, Citigroup and Wells reportedly took their first peek at Wachovia’s books.
Regulators pressed the parties to move quickly. Senior officials at the Federal Reserve in Washington, and its branches in New York, Richmond and San Francisco held weekend discussions with all the banks involved. Top officials at the Federal Deposit Insurance Corporation and the Treasury were also in the loop, The Times said.
Timothy F. Geithner, the president of the Federal Reserve Bank of New York, personally reached out to executives involved in the process to assess the situation and spur it along, according to the report. Citigroup and Wells pressed regulators to seize Wachovia and let them buy its assets and deposits, as JPMorgan did with WaMu, or provide some sort of financial guarantee, as regulators did with JPMorgan’s acquisition of Bear Stearns, The Times said, citing people briefed on and involved with the process.
Both Citigroup and Wells Fargo are deeply concerned about absorbing Wachovia’s giant loan portfolio, which is littered with bad mortgages, these peopletold The times. Bankers had little time to assess the risk. Citigroup and Wells Fargo were unlikely to bid more than a few dollars per share for Wachovia, substantially less than the $10-a-share price where its stock was trading on Friday, according to The Times.
For Wells Fargo, a deal would extend its branch banking network across the Mississippi River, creating a nationwide franchise that would compete with Bank of America and JPMorgan Chase. Citigroup executives consider Wachovia a make-or-break deal for their consumer banking ambitions. If Citigroup were to buy Wachovia, it would gain one of the preeminent retail bank operations after struggling to build one for years.
It would also give Citigroup access to more stable customer deposits, allowing it to rely less heavily on outside investors for funds. If Citigroup fails to clinch a deal, its domestic retail operations would be far behind Bank of America and JPMorgan Chase. Vikram S. Pandit, Citigroup’s chief executive, was personally overseeing the talks.
With a big presence in California, where home prices have fallen particularly sharply, Wells Fargo has suffered big losses on mortgages and credit card loans. But Wells, unlike many banks, maintained relatively high lending standards, so it has not been crippled by the bust like many of its big competitors.
Wachovia, by contrast, has been ravaged. Its 2006 purchase of Golden West Financial, a California lender specializing in so-called pay-option mortgages, has proved disastrous. The bank also faces mounting losses on loans made to home builders and commercial real estate developers, and its acquisition of A. G. Edwards, a retail brokerage firm, turned out to be problematic. In June, Wachovia’s board ousted G. Kennedy Thompson, the bank’s longtime chief executive.
Borrowing Costs Soar as Bailouts Spur Loan Concern; Euribor Reaches Record
The cost of borrowing in euros for three months rose to a record after government-led bank bailouts heightened concern that more will fail, prompting financial institutions to hoard cash.
The euro interbank offered rate, or Euribor, climbed 10 basis points to 5.24 percent, the European Banking Federation said today. That's the biggest jump since June. The London interbank offered rate, or Libor, for three-month dollar loans rose to 3.88 percent, the highest level since Jan. 18 and up from 2.81 percent a month ago. Singapore's benchmark rate for such loans increased to the highest level in eight months.
Rising rates show central-bank attempts to breathe life back into money markets haven't succeeded, even after U.S. lawmakers agreed on a $700 billion plan to remove tainted assets from bank balance sheets. The ECB said today it will make additional funds available to banks through the end of the year in "special" auctions. The central banks of Japan and Australia added more than $20 billion to money markets.
"The root of the banking story is in the money markets, which are still in awful shape," said Padhraic Garvey, the Amsterdam-based head of investment-grade debt strategy at ING Bank NV. "Banks are dealing with central banks for liquidity purposes, but are very careful about dealing with one another in this environment, which effectively means that the interbank wholesale- money market is not working."
The U.K. Treasury seized Bradford & Bingley, Britain's biggest lender to landlords, while governments in Belgium, the Netherlands and Luxembourg extended an 11.2 billion-euro ($16.3 billion) lifeline to Fortis, Belgium's largest financial-services firm. Hypo Real Estate Holding AG, Germany's second-biggest commercial-property lender, received a 35 billion-euro loan guarantee from the state to fend of insolvency.
"Tensions remain elevated and liquidity is drying up," said Patrick Jacq, a fixed-income strategist at BNP Paribas SA in Paris. "After Fortis, this situation will persist as people worry that there will be more victims. Confidence has not been restored yet and that's a prerequisite before rates come down."
The Libor-OIS spread, the difference between the three-month dollar rate and the overnight indexed swap rate, jumped to a record 219 basis points today, after breaching 200 for the first time on Sept. 25. It averaged 8 basis points in the 12 months to July 31, 2007, before the credit squeeze began.
Funding is typically tighter at the end of quarters as companies try to settle trades and buttress their balance sheets.
The world's largest central banks are injecting liquidity into money markets as more than $554 billion in writedowns and losses tied to the U.S. mortgage market prompt banks to stockpile cash to meet their own funding needs.
The ECB said it will loan banks extra cash today for about five weeks. "The special term refinancing operation will be renewed at least until beyond the end of the year," it said in a statement. The ECB also lent banks $30 billion for one day in a separate operation. Banks deposited a record 28.1 billion euros with the ECB on Sept. 26 as they sought a haven for their cash, the central bank said today.
The difference between what banks and the U.S. Treasury pay to borrow money for three months, the so-called TED spread, was at 303 basis points today. It rose last week to the most since Bloomberg began compiling the data in 1984. It was 110 basis points a month ago.
Singapore's three-month interbank offered rate for U.S. dollars, or Sibor, increased for a third day, adding 1 basis point to an eight-month high of 3.79 percent, according to the Association of Banks in Singapore. In Hong Kong, the three-month Hibor rose 9 basis points to 3.49 percent, the Association of Banks in Hong Kong said.
Europe Sees Three Bank Bailouts in Two Days
The crisis sparked by the collapse of Wall Street investment banks continues to spread through Europe. Three major banks were bailed out by private banks or governments on Sunday and Monday, including Germany's Hypo Real Estate, the Dutch-Belgian Fortis and Britain's Bradford & Bingley.
As Washington lawmakers came to an agreement on an unprecedented $700 billion taxpayer-funded financial market bailout aimed at bringing the current crisis under control, Europe saw three massive bank bailouts on Monday. A consortium of banks has stepped in to save Germany's Hypo Real Estate, the British government has nationalized mortgage lender Bradford & Bingley and the governments of the Netherlands, Belgium and Luxembourg have taken 49 percent stakes in the national assets of Fortis, the largest European bank to be hit by the global crisis yet.
In Germany, a consortium of banks has stepped in to save Europe's largest mortgage lender from collapse. On Monday morning, the Deutsche Bundesbank, the German central bank, and the financial supervisory authority BaFin said the German finance sector had provided Munich's Hypo Real Estate with a credit line "sufficiently high" to save the company from insolvency.
The previous evening, Hypo Real Estate announced it would have to write down the goodwill in its stake in Depfa, an Irish bank, and would forego a dividend payment. The company did not state the scope of the write down. "This impairment will have a significant material effect on our profit and loss calculations for the group," Chairman Georg Funke said.
However, the Bundesbank and BaFin said the rescue package would be sufficient to save the company from failing as a result of problems created by the turmoil in the international financial markets. The organizations did not state which banks were involved in the bailout. Kerstin Vitvar, an analyst with UniCredit, told Reuters she estimated the value of the credit line at between €25 and €30 billion ($43 billion).
On Monday, Hypo Real Estate's Funke said the package would cover the group's refinancing needs for the foreseeable future, and that the short- and middle-term credit lines of "more than several billions of euros" would be enough to shield the company from the influence of the "currently largely inoperative international money markets." As late as Sunday evening, the company -- the first amongst Germany's DAX index of blue chip firms to fall into the grip of the worldwide financial crisis -- appeared on the verge of declaring insolvency.
Meanwhile, underscoring the Europe-wide exposure to the crisis, the British government on Monday announced it would nationalize mortgage lender Bradford & Bingley. The Treasury said it would take over the troubled company's mortgage and loan books for £50 billion (€62.7 billion or $89.8 billion.) The government said it would take over the company's mortgages and facilitate the sale of its £20 billion pound savings and branch network to Spanish banking giant Santander.
"We are standing behind the system to stabilize it because to let Bradford & Bingley go down would have destabilized the entire system, especially given what's gong on in the world at the moment," British Finance Minister Alistair Darling told BBC radio. The bank focused on so-called buy-to-let mortgages for rental properties, whose owners have been hit hard by troubles in the United Kingdom's housing market, where falling property prices and rising mortgage rates have left many unable to cover their monthly mortgage payments.
The news came one day after the Dutch, Belgian and Luxembourg governments announced an €11.2 billion bailout of troubled Fortis bank, which saw a partial nationalization of the company. Fortis is Belgium's largest bank, and the government in Brussels is providing €4.7 billion for a 49 percent stake in the company's Belgian operations. Luxembourg is providing €2.5 billion for 49 percent of Fortis Bank Luxembourg, and the Dutch are investing €4 billion for 49 percent of Fortis Holding Netherlands.
Negotiations over the partial nationalization were led by Jean-Claude Trichet, the president of the European Central Bank, underscoring his concern over the financial stability of the euro zone, the area where Europe's common currency is used, if Fortis were to collapse. With over 85,000 global staff and cross-border structures, the governments felt it could not be allowed to fail.
The company's chairman has resigned and the governments are also forcing it to sell its stake in ABN Amro, the bank's main competitor, which it purchased as part of a consortium with Royal Bank of Scotland and Spain's Santander one year ago. The consortium paid €70 billion, the greatest amount ever paid to acquire a bank.
Since the purchase, Fortis shares have lost more than three-quarters of their value. Last week the company's shares dropped by a third over investor concern about its liquidity. Fortis itself paid €24 billion for its share in ABN Amro, reducing its available capital. As a result of the current credit crisis, the company has had trouble getting capital increases or selling off assets.
Paulson will have no peer under bailout deal
Despite all the constraints Congress supposedly wrapped around him, Treasury Secretary Henry M. Paulson is about to become the most powerful mortgage financier of the modern era -- most likely of any era.
Buried beneath the 100-plus pages of detail that Paulson's financial rescue plan has picked up during its 10-day journey from a Bush administration wish list to a bipartisan congressional compromise is the striking fact that the Treasury secretary got almost everything he sought -- an eventual $700 billion and the authority to spend it largely as he sees fit.
To be sure, congressional bargainers did make one huge change. And in the process, they created a potential stumbling block as the Treasury tries to stabilize the deeply damaged financial system by acquiring toxic mortgage-backed securities.
Under terms of the compromise announced Sunday, any firm selling troubled assets to the government would have to give Washington the right to take an ownership stake in the firm -- a more sweeping requirement than had been expected. While the aim is to let taxpayers profit when the financial system eventually recovers, administration officials worry that generally healthy companies may be discouraged from getting involved -- thereby reducing the effectiveness of the rescue effort.
Whether that turns out to be a big problem remains to be seen, however, and for the rest, Paulson's new powers will be almost breathtaking in their scope. He and his successor will have the right to buy not just mortgage-related securities at the heart of the crisis, according to the language of the bill, but under some conditions could buy any financial instrument "the purchase of which is necessary to promote financial market stability."
Moreover, the legislation encourages him -- in fact, requires him -- to combat the nationwide wave of home foreclosures by pushing mortgage service companies to rewrite some loans and to cut the interest rates or even the principal for financially strapped homeowners.
It even gives him the politically explosive power to cut deals with foreign, not just U.S., banks in some cases. "This is unquestionably the biggest bailout in American history," said Wesleyan University economist Richard S. Grossman, a scholar of financial crises. "I'm as nervous as everybody else about Paulson having all this power, but who else are you going to give it to?
"This isn't something that can be done by committee," he said. Congressional leaders sought to drive home the idea that they have added so many protections to the original 2 1/2 -page blueprint Paulson sent to Capitol Hill on Sept. 20 that the final plan is no longer an undeserved sop to a mismanaged financial industry. Instead, proponents say, it now represents ordinary Americans' best bet for preserving their savings, jobs and economic well-being.
And indeed, the compromise language of what's now called the Emergency Economic Stabilization Act does include huge changes from Treasury's original proposal. Among them: breaking the $700 billion into three installments, with only the first $350 billion quickly available; establishing no fewer than four oversight bodies to keep an eye on the Treasury secretary; and the addition of a limited right for people to sue over the program -- something Paulson initially sought to prohibit.
"This is not about a bailout of Wall Street," declared House Speaker Nancy Pelosi (D-San Francisco). "It's a 'buy-in' so we can turn our economy around." "This is about Main Street. It's about America. It's really about the fabric of American life," echoed Sen. Judd Gregg (R-N.H.), the ranking GOP member of the Senate Budge Committee.
Despite all of the added protections, a late Sunday draft of the measure was replete with delegations of all sorts of powers to Paulson, even in areas where lawmakers said they had made their biggest mark. For example, in setting up the measure's centerpiece -- its "troubled asset relief program" -- Paulson "is authorized to take such actions as the secretary deems necessary" to carry out the effort, including hiring, contracting and assigning companies to act as agents of the government, as well as buying, holding and selling assets.
Or again, in splitting up the $700 billion, the measure makes the first $250 billion immediately available and simply requires President Bush or his successor to declare that additional sums are needed in order to get the next $100 billion. When it comes to the final $350 billion, it doesn't require congressional approval, but instead gives lawmakers 15 days to vote their disapproval or the money starts flowing.
Still another example: House Republicans nearly derailed the whole effort late last week, claiming they had uncovered a cheaper alternative, a plan to have Washington offer companies a kind of insurance for their troubled mortgage-backed securities. By Sunday night, proponents of the scheme were saying that they had scored a major victory.
"My colleagues are much happier with this bill now," said Rep. James T. Walsh (R-N.Y.). "The insurance proposal is very popular." But while the compromise requires Paulson to set up such an insurance program, it goes out of its way to avoid requiring him to use it, saying only that the Treasury secretary "may develop guarantees of troubled assets and the associated premiums."
Treasury officials and many independent analysts have expressed deep skepticism that the insurance program could save Washington any money unless it set a price for coverage that was so high no one could afford it. "Normally you buy insurance before something bad happens," said Brookings Institution economist Douglas Elmendorf. "You can't really buy afterward."
House and Senate Democrats will likely see some of their own most cherished provisions treated much like the insurance measure -- with Paulson deciding how to handle them. For example, while Democratic lawmakers declared that the final bill would ban companies selling troubled assets to the government from giving their executives multimillion-dollar salaries and "golden parachute" severance packages, Treasury officials briefing reporters on background late Sunday said the actual provisions were extraordinarily narrow.
The ban would generally apply only to severance packages, not salaries, and then only to packages negotiated in the future, not ones already in place. In addition, the bans would only affect companies that sell large blocks of assets to Washington, and only when the executive is fired or the company had gone bust. "We want to encourage all institutions, including healthy institutions, to participate" in the program, said one of the Treasury briefers. "We're not abrogating existing [compensation] contracts."
A similar fate almost certainly awaits Democrat-drafted provisions to have the Treasury help financially stretched homeowners by jawboning mortgage servicers into renegotiating their mortgages. The measure requires Paulson to "maximize assistance for homeowners . . . and minimize foreclosures." But in the very same sentence, it says the Treasury has to make sure that taxpayers are not stuck with any additional costs, which makes any substantial additional aid to homeowners unlikely.
Even before unveiling the original plan, Paulson exercised sweeping influence over the nation's mortgage market, having orchestrated the government's Sept. 7 seizure of Fannie Mae and Freddie Mac, which between them owned or guaranteed nearly half of the mortgages in the U.S.
If the compromise measure is approved, the Treasury secretary will extend the government's reach into the one area of housing finance where it has thus far tread only lightly, the market for the kind of exotic financial instruments that Wall Street built atop the once-simple mortgage. No company or other government agency would have anything close to so large a portfolio of mortgages and mortgage-related securities -- and none ever has in American history.
While House and Senate leaders of both parties confidently predicted swift approval of the compromise measure Sunday, rank-and-file lawmakers were not quite as sure of the final outcome. "I think it's up in the air," said Rep. Christopher Shays (R-Conn.), who described himself as a "lean 'yes,' but not a committed 'yes.' "
He and many other lawmakers fear the political backlash if the plan doesn't work and financial markets continue to spiral downward. "This is a legacy vote; these are the votes you have to live with for the rest of your life," Shays said.
Treasury Gets Broad Power in Bailout Bill to Hire Contractors
Treasury Secretary Henry Paulson will have broad authority to hire financial managers quickly to help manage a $700 billion asset-purchase plan, according to the draft legislation under consideration.
The bill would allow the Treasury chief to waive federal acquisition procedures "where compelling circumstances make compliance contrary to the public interest," according to a summary of the draft law. The Treasury would have to notify Congress of such waivers within seven days, and also ensure procedures are in place to reach out to minorities.
If the plan is enacted, the Treasury likely will need a lot of Wall Street expertise to manage the assets it acquires, said Tim Ryan, head of the Securities Industry and Financial Markets Association. Ryan also is former director of the Office of Thrift Supervision, which oversaw the Resolution Trust Corp., the agency that liquidated failed thrifts after the savings-and-loan crisis of the 1980s.
"What we learned through the RTC process is, if we're going to throw this type of assignment at the government -- any government, state, federal, U.S., anywhere -- they're not staffed to deal with this issue," Ryan said in an interview last week. Treasury's potential hiring of contractors to run the program will help because "they'll just do a better job and they'll get it done faster, and ultimately it'll be cheaper," Ryan said.
Paulson has already recruited from Wall Street to help manage the current financial crisis, the worst since the Great Depression. He hired Morgan Stanley on a $95,000 contract awarded under emergency procedures to help assess options for Fannie Mae and Freddie Mac, the mortgage companies that ultimately ended up in government conservatorship.
Paulson also last week hired former Goldman Sachs Group Inc. colleague Edward C. Forst, now executive vice president at Harvard University, on a $5,000 contract to help with the plan. The draft legislation would allow the Treasury to select the Federal Deposit Insurance Corp. as an asset manager for residential mortgage loans and mortgage-backed securities. If the Treasury looks to Wall Street for other staff, it should find plenty of affordable talent, Ryan said.
"There are people in this business who know this asset class who have recently, in the last six months, lost jobs, and they'll take a lot less pay than they got the last time," Ryan said in the interview.
Is this the U.S. Congress or the Board of Directors at Goldman Sachs?
Defend the republic from domestic enemies
Paulson Must Make $700 Billion Rescue for Banks Work
Treasury Secretary Henry Paulson and congressional Democrats hammered out a consensus on spending up to $700 billion to rescue the financial industry. There isn't consensus on whether it would work.
Lawmakers reached agreement yesterday as House Republican leaders backed away from opposition to the proposal after it included plans to create insurance for mortgage-backed securities. The House and Senate are scheduled to vote on the bill early this week, although it wasn't clear last night that it has sufficient votes to pass the House.
Giving the Treasury authority to buy so many distressed securities from lenders is without precedent, and it's unclear how the government will pay prices that strike a balance between protecting taxpayers and preventing more bank failures. "This has a reasonable chance of pulling back from the brink and having some success, but it's far from certain that will be the case," said former Fed Governor Laurence Meyer, now vice chairman of consultant Macroeconomic Advisers LLC in Washington.
Stocks tumbled around the world after the worsening credit crisis threatened to topple more banks. In Europe, governments have been forced to rescue Fortis, Belgium's largest financial- services company, and three other institutions in the past two days alone.
The region's Dow Jones Stoxx 600 Index dropped 3.5 percent and futures on the Standard & Poor's 500 Index declined 1.8 percent. While the dollar strengthened against the euro and the pound, the cost of borrowing the U.S. currency for three months rose to 3.88 percent, the highest level since January. That's up from 2.81 percent a month ago.
"You're not resolving the two fundamental issues: You still have to recapitalize the banking system, and household debt is going to stay high," said Nouriel Roubini, chairman of Roubini Global Economics and economics professor at New York University.
The bill gives Paulson $250 billion at the start to buy assets, increasing the amount to $350 billion upon "written certification" from the president that the secretary is "exercising the authority" to buy assets. The Treasury chief, or whoever succeeds him, may use the remaining $350 billion if Congress fails to reject a request for it within 15 days.
The proposed law lets Paulson buy assets "at the lowest price that the Secretary determines to be consistent with the purposes of this Act." The bill doesn't require any specific method for the purchases beyond saying mechanisms such as auctions or reverse auctions should be used "when appropriate." Treasury officials declined to discuss how the plan will be implemented.
Democratic and Republican leaders trust that Paulson can avert a collapse after Lehman Brothers Holdings Inc. filed for bankruptcy and the government was forced to take over American International Group Inc. Success hinges on whether he can help banks raise capital after $556 billion in writedowns and losses, and get credit flowing through the economy.
"We have clearly seen a run of failures of financial institutions not like anything we've seen since the Great Depression," House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, told reporters yesterday. "If we didn't do this, there would be far worse pain in the sense of the lending freezing up."
The plan, which foreign banks with U.S. operations can also tap, failed to staunch concerns across global markets about the health of the banking system. Governments have been forced to rescue Belgium's Fortis, Iceland's Glitnir Bank hf, U.K. mortgage lender Bradford & Bingley Plc and Germany's Hypo Real Estate Holding AG in the past two days. "It's a fragile situation," Paulson said in an interview on CBS television's "60 Minutes" program broadcast yesterday. "It's gotta do it, and we're going to make this work."
The draft legislation was posted on the House Financial Services Committee's Web site yesterday. It includes a provision to give taxpayers equity stakes in the companies that benefit from the plan. The bill has a section aimed at limiting the pay of executives at companies that take advantage of assistance by prohibiting tax deductions for officials that exceed $500,000, which is half the normal deductible limit. It also allows "clawbacks" of money already paid to executives at troubled companies and forbids so-called golden parachutes.
The legislation takes steps to let some 800 community banks that held preferred stock in Fannie Mae and Freddie Mac before the mortgage giants were taken over by the federal government on Sept. 7, make better use of losses for tax purposes than they would otherwise be allowed.
House Republicans offered early resistance to the Paulson plan. They complained that it put the country on the road to socialism and instead argued that elimination of the capital gains tax would spur a wave of investment that would render the bailout plan unnecessary.
House Minority Leader John Boehner of Ohio commissioned Virginia Representative Eric Cantor to draft a rival plan without telling Democrats or Paulson. The plan, which depended on self-funded insurance premiums, was abandoned after Democrats lashed out at Republicans at a White House meeting Sept. 25.
Ultimately, Republicans got none of the tax breaks they sought, though the bill includes a limited self-funded insurance program for companies that benefit from the bailout. Last night Boehner, the top House Republican, urged his colleagues to support the bailout plan.
Some House Republicans, such as Representative Mike Pence of Indiana, are still holding out. "We now have a deal that promises to bring near-term stability to our financial turmoil, but at what price?" Pence said in a letter to colleagues. Pence called the plan "the largest corporate bailout in American history" and that it would "nationalize almost every bad mortgage in America."
Paulson, the 62-year-old former Goldman Sachs Group Inc. chairman, said such a strategy is necessary to stabilize financial markets. "We will have turbulence and turmoil in our financial system for some time, but I believe that this is going to work," he said on "60 Minutes."
Yet as members of Congress and their staffs worked late nights over the past week negotiating and writing compromise legislation, money markets failed to improve. "It just raised some doubts in my mind whether this was going to be sufficient," said Meyer, who was on the Fed board when the Asian financial crisis struck in 1997.
Should the plan fail, "there may have to be a more substantial participation by the federal government to buy mortgages," Frank said last night. Any alternative proposal would involve "significant purchases directly of the foreclosed mortgages." Paulson and Federal Reserve Chairman Ben S. Bernanke, who will be on a five-member oversight board for the program, have signaled that their priority is shoring up the nation's banks even if it means they don't get taxpayers the cheapest prices for the devalued assets the government buys.
The proposal also sets the stage for an overhaul of financial regulation next year, something Frank is already planning. The draft bill requires the Treasury secretary to report to Congress and make recommendations by April 30 on whether to regulate additional participants in the financial markets.
"It'll give us some temporary respite from the earlier pressures," said Joseph Mason, a Louisiana State University finance professor who formerly worked in the bank-research division of the Office of the Comptroller of the Currency. "If we don't use that respite to design more permanent policy, we will find ourselves back in the same place."
Fed Would Gain More Power Over Short-Term Rates in Rescue Bill
The Federal Reserve would gain more power over short-term interest rates as part of Congress's $700 billion legislation to revive credit markets, making it easier for the Fed to pump funds into the banking system.
The draft bill, released yesterday, gives the Fed authority as of Oct. 1 to pay interest on reserves held at the central bank by financial institutions. That would encourage banks to deposit excess funds with the Fed rather than dumping them into the money markets and distorting its overnight federal funds rate.
The flood of liquidity pumped into the financial system by the Fed to encourage interbank lending over the past year has made it harder for the central bank to gauge market conditions and keep fed funds at its 2 percent target. The rate has traded between zero and 7 percent since Sept. 15.
"It's probably a good thing," said Marvin Goodfriend, a former senior policy adviser at the Richmond Fed who is now professor of economics at Carnegie Mellon University in Pittsburgh. Allowing payment of interest on reserves will "enable the Fed to have credit policy that's independent of its monetary policy," he said.
While containing the interest provision sought by Fed Chairman Ben S. Bernanke since May, the draft legislation increases congressional scrutiny of the Fed's emergency loans in connection with the collapses of Bear Stearns Cos. and American International Group Inc. The bill requires the central bank to submit reports to Congress on loans to nonbanks since March 1 as well as updates at least every two months while the loans are outstanding.
The Federal Open Market Committee sets a target for the federal funds rate, which the New York Fed is obligated to achieve on a daily basis through temporary and permanent purchases or sales of bonds in the open market. Banks are required to hold a proportion of their customers' deposits in an account at the central bank.
Paying interest on reserves puts a "floor" under the traded overnight rate, which would allow a central bank "to provide liquidity during times of stress" without affecting the rate, New York Fed economists said in a paper last month. New Zealand's central bank has adopted such an approach.
The Fed had already received authority in 2006 to start paying interest on reserves in October 2011. Bernanke asked House Speaker Nancy Pelosi in May to expedite the authority. U.S. lawmakers are reviewing the $700 billion plan to buy troubled assets from financial institutions, and the House and Senate may vote tomorrow.
The draft legislation doesn't mention the Fed in the three- line section that would provide the interest-payment authority. The bill says that the part of the 2006 law giving the Fed the power "is amended by striking `October 1, 2011' and inserting `October 1, 2008'." In 2006, the Congressional Budget Office estimated that Fed interest payments would cost the government $1.4 billion in the first five years.
"I expect them to use it to manage the funds rate more efficiently," said Lou Crandall, chief economist at Wrightson ICAP LLC, in Jersey City, New Jersey. A measure of availability of cash among banks, known as the Libor-OIS spread, widened to 2.08 percentage points, the most on record, on Sept. 26. In the year before the credit crisis started in August last year, the spread averaged 8 basis points.
Commercial banks borrowed $39.4 billion from the Fed's discount window for the week ending Sept. 24, almost double the previous period, as the financial crisis deepened and funding from other banks dried up. Counterparty fears also increased in the wake of Lehman Brothers Holdings Inc.'s bankruptcy filing on Sept. 15.
U.S. authorities investigating Fannie and Freddie
Fannie Mae and Freddie Mac, the mortgage-finance companies seized by the U.S. government, said Monday they have received federal grand jury subpoenas and said they are the subject of an inquiry by the Securities and Exchange Commission. The subpoenas request documents related to accounting, disclosure and corporate governance, Fannie and Freddie said in separate statements. Freddie said the investigation seeks papers dating back to Jan. 1, 2007.
Fannie and Freddie are among 26 companies being investigated by the Federal Bureau of Investigation for possible accounting misstatements in a probe of the subprime-mortgage market collapse, a senior law-enforcement official said this month. Federal agencies have come under pressure by lawmakers to hold companies responsible for the loan crisis that rocked Wall Street and led to the biggest housing slump since the 1930s.
The Treasury Department and Federal Housing Finance Agency on Sept. 7 put the government-sponsored enterprises back under federal control for the first time in about 40 years after their $14.9 billion in net losses threatened to further disrupt the housing market. Fannie and Freddie said they were notified on Sept. 26 that the U.S. Attorney for the Southern District of New York and SEC were seeking documents. Both companies said they will cooperate.
Fannie and Freddie, created by Congress to raise homeownership, own or guarantee at least 42 percent of the $12 trillion in U.S. residential-mortgage debt outstanding. They make money by buying home loans and mortgage securities, profiting on the difference between their cost of borrowing and the yield on the debt. They also guarantee and package loans as securities.
The companies are operating under a conservatorship in which the Treasury committed to invest as much as $200 billion in preferred stock and extend credit through 2009 to prevent a collapse of Fannie and Freddie, protecting investors owning more than $5 trillion of their debt and mortgage-backed securities.
The Crisis Explained - Really
Analogies are never perfect, but here's one using horse racing. Don't expect a perfect correspondence to the banking situation, but I think it is close enough for government work.
Joe goes to the track and bets $2 on a horse. Two guys standing nearby get into a discussion and Fred says to Sam, "I'll bet you $5 that Joe wins his bet." Next to them are Bill and Bob. Bill says: "I'll bet you $10 that Fred welshes on his bet if he loses." Next to them is Sally. Sally says: "For $3 I'll guarantee to Bill that if Bob fails to pay off, I'll make good on the bet."
Sally then goes to Mary and borrows the $7 needed in case she has to ever pay off and promises to pay back $8. She doesn't expect to every have to pay since she believes Bob will always make good. So she expects to net $2 no matter what happens to Joe.
A quick calculation indicates that there is now 2+5+10+3+7 = $27 riding on the outcome of the horse race. Question how much has been "invested" in the horse race? Answer:
$50,000 by the owner of the horse who is expecting to recoup his investment from the winnings of the horse and other future deals. Everyone else is gambling, not investing. The issue with the home market is that the only "investor" was the person who bought the home. All those engaged in the meaningless derivatives spun off from this are gambling.
You can see how quickly the face value of all these side bets can exceed the underlying investment. Who is holding these side bets - not the homeowner? It is the people at the failing investment banks, hedge funds and similar enterprises. Notice that the bailout is being directed at them not the homeowners.
The real world is, of course, even more complicated. Over the last 30 years people have been allowed to place bets on everything starting with the value of stock averages. They might as well bet on the temperature in Newark at 8:00 AM.
So when you hear everybody saying this is a crisis caused by the housing collapse, be skeptical. We are in the midst of a classic pyramid or Ponzi scheme and there is no way out except for people to lose a lot of money. All that is different this time is that it is the taxpayers who are being asked for the cash.
Think of it as a giant Chinese take-away with more courses than you can possibly eat – and more dollars than you can possibly make sense of. According to the Brookings institution, foreigners hold more than $14 trillion in US assets, bigger than the entire US national output.
US Treasury securities – that is, government “IOU”s – account for $2.5 trillion of that total. And if you bear with me just a little longer, and follow me down this statistical trail, we see that China holds the lion’s share of this foreign-held US debt portfolio. As of July 2008, mainland China held $518.7 billion in US Treasury bonds, more than half of its estimated $1.2 trillion in reserve assets.
So why am I wasting my time telling you all this? The point is that foreigners – and China in particular, though also emerging markets in Mexico, Brazil and Russia as well as oil-rich states in the Middle East – are going to play a yeoman’s role in financing this bailout.
The Wall Street Journal goes so far as to say that the “success of the pending rescue of the US financial system probably depends as much on the central banks of China and the Middle East as on Congress and the Federal Reserve.” In other words, it’s not just Main Street, USA that’s going to shoulder the costs of this bailout – but also Main Street, Beijing. Or Main Street, Moscow.
That is why the US needs to seriously woo the Chinese, Russians, Mexicans, Brazil and others if it hopes to pull off this rescue without a hitch. As the Journal notes, the Fed and Treasury’s sales pitch on the bailout plan is aimed almost as much at China as at Congress and the American public, and at persuading them that the US economy is not about to implode.
So far, no one really seems to fear such a prospect – though there are signs of growing skittishness to invest in American financial institutions.
Kenneth Rogoff, a Harvard economist, recently wrote about the “extraordinary” resiliency of the dollar in the face of a “once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three-month US Treasury Bills have now reached 64-year lows. It’s almost as if the more the US messes up, the more the world loves it.”
But this tough love could prove very short-lived if the bailout goes awry, especially because the credit contagion spreads quickly to other sectors of the economy as many analysts say it’s already doing.
Whatever happens, the financial balance of power in the world is undergoing a realignment as the US model of high-risk capitalism tries to cover its exposed flank. At this week’s Economic Forum in Tianjin, touted as the Chinese “Davos”, Chinese participants are making many of the Western business and financial leaders in attendance eat humble pie. In other words, they are turning tables and suggesting that the US is no longer in a position to give anyone economic lessons.
And suddenly, Washington’s power elite find themselves cast in the role of global supplicant. According to the WSJ, the Treasury is even planning a sort of "road show" for its bailout to bring the skeptics - the Chinese among them - around. The German Finance Minister, Peer Steinbrueck, was blunt last week when he said that the US is poised to lose its superpower status in the world financial system.
The Chinese take-away from the Wall Street kitchen is about to move to the next course – and there are bound to be more guests around the table.
Financial Troubles Humble U.S.
The success of the pending rescue of the U.S. financial system probably depends as much on the central banks of China and the Middle East as on Congress and the Federal Reserve.
The U.S. is turning to foreign governments and other overseas investors to buy a good chunk of what could total $700 billion in Treasury debt expected to finance the bailout. Foreign investors also are needed to shore up the depleted capital of the nation's financial institutions, seen in the plan by Japan's Mitsubishi UFJ Financial Group to buy a large stake in Morgan Stanley, which is weighed down by bad debt and market distrust.
This is a bittersweet moment in U.S. economic history. In one sense, the growing importance of foreign cash represents the triumph of a half-century of U.S. proselytizing for a global financial system in which money flows from those who have it to those who need it. But it is also an unmistakable sign of U.S. economic decline. The global financial system the U.S. designed had anticipated that American banks and financial firms would be the world's financial lifeguards; now those institutions are like exhausted swimmers a stroke or two away from drowning.
The financial crisis makes clear how much the interests of foreign lenders have become a top concern in Washington. A big reason the Fed and Treasury stepped in to rescue mortgage giants Fannie Mae and Freddie Mac, say U.S. financial officials, was to reassure foreign leaders including China, which holds roughly $1 trillion in U.S. debt, that U.S. securities were safe. "Superpowers do not normally ask their diplomats to reassure other nations on questions of credit-worthiness," says former U.S. Treasury Secretary Lawrence Summers.
Just 10 years after the U.S. oversaw the financial rescue of Asian nations, the U.S. now risks becoming the world's largest subprime borrower. This change of fortune has been hard to swallow. In a televised address Thursday, President George W. Bush blamed the current financial crisis on the "massive amount of money [that] flowed into the United States from investors abroad," rather than on greedy decisions by U.S. mortgage lenders and borrowers. In Friday's presidential debate, both candidates railed against U.S. economic dependence on China.
Powerful nations have been humbled before by an overdependence on foreign capital. Council on Foreign Relations economist Brad Setser notes that Britain was forced to end its seizure of the Suez Canal in 1956 because of U.S. opposition. Washington's main weapon: its threat to slash financial support for Britain, whose economy had been battered by World War II.
The U.S. isn't in remotely as bad shape as postwar Britain. It still is the world's sole military superpower, and the U.S. currency is still dominant. The latter is important because even if foreign holdings of U.S. debt grow, as is likely, the U.S. alone prints the dollars needed to pay those debts.
Even so, foreign lenders have a great deal of sway. If they were to dump U.S. government debt -- or be unwilling to buy more -- the interest rates needed to attract buyers of Treasurys would soar. The already fragile U.S. economy would absorb yet another hit. China, Saudi Arabia and other big foreign holders are unlikely to take antidollar measures precisely because they own so much U.S. debt. To the extent the dollar declines, so does the value of those nations' holdings. Mr. Summers calls this situation "the financial balance of terror."
But it is naive to assume that this so-called balance will protect U.S. interests indefinitely. Senior Chinese economists have voiced growing dismay about the outlook for the dollar, and the introduction of an additional $700 billion in debt might drive the currency's value down further, at least in the short term. "I think foreigners are being taken for a ride by the U.S. government," says Andy Xie, an independent economist in Shanghai.
Sovereign-wealth funds -- huge government investment funds -- have largely sat on their hands rather than buy additional stakes in U.S. financial firms. China Investment Corp., for instance, has been wary of increasing its investment in Morgan Stanley after it was criticized sharply at home for taking equity stakes in U.S. financial companies that have nose-dived.
In the Middle East, too, state investment funds in Kuwait, Qatar and Abu Dhabi say they have no plans to jump to the rescue of ailing Wall Street banks. In one hopeful sign for the U.S., some smaller state funds are looking for bargains in real estate, finance and insurance. "For investors that have the liquidity and have patient capital, I can see good opportunities," said Talal Al-Zain, chief executive of Bahrain's $10 billion fund, Mumtalakat.
The U.S. economy has managed to grow in recent years, even though Americans don't save much and the government has run huge deficits, because foreigners kept lending. The same was true in the 1980s. Now the U.S. needs foreign capitals to keep lending. C. Fred Bergsten, director of the Peterson Institute for International Economics, a Washington think tank, says the Treasury will have to stage a "road show" to explain the rescue plan to overseas lenders who may be considering euro investments instead.
Domestically, the reliance on foreign money means a loss of autonomy that Americans are simply going to have to get used to. Part of the accommodation is already occurring. The controversy over investments by sovereign-wealth funds has been reversed. Last year, lawmakers worried the funds would gain political influence by investments in U.S. companies; now U.S. policy makers are worried that they won't buy new stakes. Efforts to erect restrictions against foreign trade may also lose momentum. The U.S. needs the world's money more than it thought it would and won't want to rile potential lenders.
European Retail Sales Fell Fourth Month in September
European retail sales fell for a fourth month in September as higher consumer prices and the worsening credit squeeze sapped confidence, the Bloomberg purchasing managers index showed. The measure of sales in the euro area fell to 46.2 from 47.7 in August. A reading below 50 indicates contraction. The index is based on a survey of more than 1,000 executives compiled for Bloomberg News by Markit Economics.
Banks have become more reluctant to lend as the U.S. financial turmoil spreads, undermining global economic growth and pushing confidence among executives and consumers in the euro region to the lowest since the slump in the wake of the Sept. 11 attacks in 2001. At the same time, inflation remains close to a 16-year high, lowering consumers' purchasing power.
"Consumer spending will remain very subdued," said Gilles Moec, an economist at Bank of America Corp. in London. "There's a risk of another negative quarter" after the region's economy contracted in the three months through June.
Retail sales dropped in Germany and Italy, two of the three largest economies in the 15-nation euro region. French shops sold more for a third month. European retailers are firing workers at the fastest pace in almost three years, the report showed.
Fiat SpA, Italy's largest manufacturer, suffered a 23 percent decline in Italian car sales in August. Gruppo Coin SpA, Italy's largest department-store chain, said second-quarter profit fell 75 percent after consumer confidence sagged to near a 15-year low.
The Italian government last week cut its 2008 economic growth forecast to 0.1 percent, the slowest pace in five years, and less than a June estimate of 0.5 percent. Unemployment in Italy probably rose for a fifth quarter in the three months through June, a report will show today, according to the medium forecast of 15 economists in a Bloomberg News survey.
"We expect consumer spending to contract again in the third quarter, reflecting the impact of a weaker labor market and of the July oil-price peak," said Paolo Pizzoli, an economist at ING Wholesale Banking in Milan. Today's report showed that retailers' gross margins continued to fall as shops needed to offer greater discounts to attract customers, Markit Economics said. Inflation in the euro zone reached 3.8 percent in August, almost twice the European Central Bank's 2 percent target.
The declining profit margins and weak economic conditions are forcing European retailers to cut staff. German department store owner Arcandor AG announced plans to eliminate at least a fifth of jobs at the headquarters of its Karstadt unit, Germany's largest department-store chain, and lowered its profit forecast for 2009.
Retail sales in Europe's largest economy fell for the fourth month. More than a third of German retailers didn't meet sales targets for September and some companies saw consumer demand falling faster than expected, the report showed. The German economy contracted 0.5 percent in the second quarter and may not recover in the third as investments falter and consumer spending slumps. The threat of job losses may further undermine consumer sentiment and spending.
French retailers seem to be coping with the global slowdown as sales expanded in September and consumer confidence in Europe's second-largest economy unexpectedly rose for the first time in more than a year as the retreat in fuel prices left people with more to spend. Crude oil prices have fallen almost 30 percent since the peak of $147.27 a barrel on July 11.
PPR SA's, the owner of luxury clothes maker Gucci Group, last week confirmed sales and profit will increase this year. Chief Executive Officer Francois-Henri Pinault said a slowdown of "one or two years" is in store following four years of luxury-goods expansion. The gains may be short lived as the spreading credit crunch threatens to further choke economic growth.
"The strength of the global financial crisis will have consequences on economic growth and employment in France," President Nicolas Sarkozy told ministers on Sept. 26 at the weekly Cabinet meeting in Paris.
Ilargi: John Gray is perhaps my favorite thinker today. I have to add, though, that I think he’s stronger in his analysis then in his conclusions.
A shattering moment in America's fall from power
The global financial crisis will see the US falter in the same way the Soviet Union did when the Berlin Wall came down. The era of American dominance is over.
Our gaze might be on the markets melting down, but the upheaval we are experiencing is more than a financial crisis, however large. Here is a historic geopolitical shift, in which the balance of power in the world is being altered irrevocably. The era of American global leadership, reaching back to the Second World War, is over.
You can see it in the way America's dominion has slipped away in its own backyard, with Venezuelan President Hugo Chávez taunting and ridiculing the superpower with impunity. Yet the setback of America's standing at the global level is even more striking.
With the nationalisation of crucial parts of the financial system, the American free-market creed has self-destructed while countries that retained overall control of markets have been vindicated. In a change as far-reaching in its implications as the fall of the Soviet Union, an entire model of government and the economy has collapsed.
Ever since the end of the Cold War, successive American administrations have lectured other countries on the necessity of sound finance. Indonesia, Thailand, Argentina and several African states endured severe cuts in spending and deep recessions as the price of aid from the International Monetary Fund, which enforced the American orthodoxy.
China in particular was hectored relentlessly on the weakness of its banking system. But China's success has been based on its consistent contempt for Western advice and it is not Chinese banks that are currently going bust. How symbolic yesterday that Chinese astronauts take a spacewalk while the US Treasury Secretary is on his knees.
Despite incessantly urging other countries to adopt its way of doing business, America has always had one economic policy for itself and another for the rest of the world. Throughout the years in which the US was punishing countries that departed from fiscal prudence, it was borrowing on a colossal scale to finance tax cuts and fund its over-stretched military commitments. Now, with federal finances critically dependent on continuing large inflows of foreign capital, it will be the countries that spurned the American model of capitalism that will shape America's economic future.
Which version of the bail out of American financial institutions cobbled up by Treasury Secretary Hank Paulson and Federal Reserve chairman Ben Bernanke is finally adopted is less important than what the bail out means for America's position in the world. The populist rant about greedy banks that is being loudly ventilated in Congress is a distraction from the true causes of the crisis.
The dire condition of America's financial markets is the result of American banks operating in a free-for-all environment that these same American legislators created. It is America's political class that, by embracing the dangerously simplistic ideology of deregulation, has responsibility for the present mess.
In present circumstances, an unprecedented expansion of government is the only means of averting a market catastrophe. The consequence, however, will be that America will be even more starkly dependent on the world's new rising powers. The federal government is racking up even larger borrowings, which its creditors may rightly fear will never be repaid. It may well be tempted to inflate these debts away in a surge of inflation that would leave foreign investors with hefty losses.
In these circumstances, will the governments of countries that buy large quantities of American bonds, China, the Gulf States and Russia, for example, be ready to continue supporting the dollar's role as the world's reserve currency? Or will these countries see this as an opportunity to tilt the balance of economic power further in their favour? Either way, the control of events is no longer in American hands.
The fate of empires is very often sealed by the interaction of war and debt. That was true of the British Empire, whose finances deteriorated from the First World War onwards, and of the Soviet Union. Defeat in Afghanistan and the economic burden of trying to respond to Reagan's technically flawed but politically extremely effective Star Wars programme were vital factors in triggering the Soviet collapse.
Despite its insistent exceptionalism, America is no different. The Iraq War and the credit bubble have fatally undermined America's economic primacy. The US will continue to be the world's largest economy for a while longer, but it will be the new rising powers that, once the crisis is over, buy up what remains intact in the wreckage of America's financial system.
There has been a good deal of talk in recent weeks about imminent economic armageddon. In fact, this is far from being the end of capitalism. The frantic scrambling that is going on in Washington marks the passing of only one type of capitalism - the peculiar and highly unstable variety that has existed in America over the last 20 years. This experiment in financial laissez-faire has imploded.
While the impact of the collapse will be felt everywhere, the market economies that resisted American-style deregulation will best weather the storm. Britain, which has turned itself into a gigantic hedge fund, but of a kind that lacks the ability to profit from a downturn, is likely to be especially badly hit. The irony of the post-Cold War period is that the fall of communism was followed by the rise of another utopian ideology.
In American and Britain, and to a lesser extent other Western countries, a type of market fundamentalism became the guiding philosophy. The collapse of American power that is underway is the predictable upshot. Like the Soviet collapse, it will have large geopolitical repercussions. An enfeebled economy cannot support America's over-extended military commitments for much longer. Retrenchment is inevitable and it is unlikely to be gradual or well planned.
Meltdowns on the scale we are seeing are not slow-motion events. They are swift and chaotic, with rapidly spreading side-effects. Consider Iraq. The success of the surge, which has been achieved by bribing the Sunnis, while acquiescing in ongoing ethnic cleansing, has produced a condition of relative peace in parts of the country. How long will this last, given that America's current level of expenditure on the war can no longer be sustained?
An American retreat from Iraq will leave Iran the regional victor. How will Saudi Arabia respond? Will military action to forestall Iran acquiring nuclear weapons be less or more likely? China's rulers have so far been silent during the unfolding crisis. Will America's weakness embolden them to assert China's power or will China continue its cautious policy of 'peaceful rise'? At present, none of these questions can be answered with any confidence. What is evident is that power is leaking from the US at an accelerating rate. Georgia showed Russia redrawing the geopolitical map, with America an impotent spectator.
Outside the US, most people have long accepted that the development of new economies that goes with globalisation will undermine America's central position in the world. They imagined that this would be a change in America's comparative standing, taking place incrementally over several decades or generations. Today, that looks an increasingly unrealistic assumption.
Having created the conditions that produced history's biggest bubble, America's political leaders appear unable to grasp the magnitude of the dangers the country now faces. Mired in their rancorous culture wars and squabbling among themselves, they seem oblivious to the fact that American global leadership is fast ebbing away. A new world is coming into being almost unnoticed, where America is only one of several great powers, facing an uncertain future it can no longer shape.
The Monster That Ate Wall Street
They're called "Off-Site Weekends"—rituals of the high-finance world in which teams of bankers gather someplace sunny to blow off steam and celebrate their successes as Masters of the Universe. Think yacht parties, bikini models, $1,000 bottles of Cristal.
One 1994 trip by a group of JPMorgan bankers to the tony Boca Raton Resort & Club in Florida has become the stuff of Wall Street legend—though not for the raucous partying (although there was plenty of that, too). Holed up for most of the weekend in a conference room at the pink, Spanish-style resort, the JPMorgan bankers were trying to get their heads around a question as old as banking itself: how do you mitigate your risk when you loan money to someone?
By the mid-'90s, JPMorgan's books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad. But what if JPMorgan could create a device that would protect it if those loans defaulted, and free up that capital?
What the bankers hit on was a sort of insurance policy: a third party would assume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices.
While the concept had been floating around the markets for a couple of years, JPMorgan was the first bank to make a big bet on credit default swaps. It built up a "swaps" desk in the mid-'90s and hired young math and science grads from schools like MIT and Cambridge to create a market for the complex instruments. Within a few years, the credit default swap (CDS) became the hot financial instrument, the safest way to parse out risk while maintaining a steady return.
"I've known people who worked on the Manhattan Project," says Mark Brickell, who at the time was a 40-year-old managing director at JPMorgan. "And for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important."
Like Robert Oppenheimer and his team of nuclear physicists in the 1940s, Brickell and his JPMorgan colleagues didn't realize they were creating a monster. Today, the economy is teetering and Wall Street is in ruins, thanks in no small part to the beast they unleashed 14 years ago. The country's biggest insurance company, AIG, had to be bailed out by American taxpayers after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and scores of other entities.
So much of what's gone wrong with the financial system in the past year can be traced back to credit default swaps, which ballooned into a $62 trillion market before ratcheting down to $55 trillion last week—nearly four times the value of all stocks traded on the New York Stock Exchange. There's a reason Warren Buffett called these instruments "financial weapons of mass destruction."
Since credit default swaps are privately negotiated contracts between two parties and aren't regulated by the government, there's no central reporting mechanism to determine their value. That has clouded up the markets with billions of dollars' worth of opaque "dark matter," as some economists like to say. Like rogue nukes, they've proliferated around the world and now lie hiding, waiting to blow up the balance sheets of countless other financial institutions.
It didn't start out that way. One of the earliest CDS deals came out of JPMorgan in December 1997, when the firm put into place the idea hatched in Boca Raton. It essentially took 300 different loans, totaling $9.7 billion, that had been made to a variety of big companies like Ford, Wal-Mart and IBM, and cut them up into pieces known as "tranches" (that's French for "slices"). The bank then identified the riskiest 10 percent tranche and sold it to investors in what was called the Broad Index Securitized Trust Offering, or Bistro for short.
The Bistro was put together by Terri Duhon, at the time a 25-year-old MIT graduate working on JPMorgan's credit swaps desk in New York—a division that would eventually earn the name the Morgan Mafia for the number of former members who went on to senior positions at global banks and hedge funds. "We made it possible for banks to get their credit risk off their books and into nonfinancial institutions like insurance companies and pension funds," says Duhon, who now heads her own derivatives consulting business in London.
Before long, credit default swaps were being used to encourage investors to buy into risky emerging markets such as Latin America and Russia by insuring the debt of developing countries. Later, after corporate blowouts like Enron and WorldCom, it became clear there was a big need for protection against company implosions, and credit default swaps proved just the tool. By then, the CDS market was more than doubling every year, surpassing $100 billion in 2000 and totaling $6.4 trillion by 2004.
And then came the housing boom. As the Federal Reserve cut interest rates and Americans started buying homes in record numbers, mortgage-backed securities became the hot new investment. Mortgages were pooled together, and sliced and diced into bonds that were bought by just about every financial institution imaginable: investment banks, commercial banks, hedge funds, pension funds. For many of those mortgage-backed securities, credit default swaps were taken out to protect against default.
"These structures were such a great deal, everyone and their dog decided to jump in, which led to massive growth in the CDS market," says Rohan Douglas, who ran Salomon Brothers and Citigroup's global credit swaps division through the 1990s.
Soon, companies like AIG weren't just insuring houses. They were also insuring the mortgages on those houses by issuing credit default swaps. By the time AIG was bailed out, it held $440 billion of credit default swaps. AIG's fatal flaw appears to have been applying traditional insurance methods to the CDS market. There is no correlation between traditional insurance events; if your neighbor gets into a car wreck, it doesn't necessarily increase your risk of getting into one.
But with bonds, it's a different story: when one defaults, it starts a chain reaction that increases the risk of others going bust. Investors get skittish, worrying that the issues plaguing one big player will affect another. So they start to bail, the markets freak out and lenders pull back credit. The problem was exacerbated by the fact that so many institutions were tethered to one another through these deals.
For example, Lehman Brothers had itself made more than $700 billion worth of swaps, and many of them were backed by AIG. And when mortgage-backed securities started going bad, AIG had to make good on billions of dollars of credit default swaps. Soon it became clear it wasn't going to be able to cover its losses. And since AIG's stock was one of the components of the Dow Jones industrial average, the plunge in its share price pulled down the entire average, contributing to the panic.
The reason the federal government stepped in and bailed out AIG was that the insurer was something of a last backstop in the CDS market. While banks and hedge funds were playing both sides of the CDS business—buying and trading them and thus offsetting whatever losses they took—AIG was simply providing the swaps and holding onto them. Had it been allowed to default, everyone who'd bought a CDS contract from the company would have suffered huge losses in the value of the insurance contracts they hadpurchased, causing them their own credit problems.
Given the CDSs' role in this mess, it's likely that the federal government will start regulating them; New York state has already said it will begin doing so in January. "Sadly, they've been vilified," says Duhon, who helped get the whole thing started with that Bistro deal a decade ago. "It's like saying it's the gun's fault when someone gets shot." But just as one might want to regulate street sales of AK-47s, there's an argument to be made that credit default swaps can be dangerous in the wrong hands.
"It made it a lot easier for some people to get into trouble," says Darrell Duffie, an economist at Stanford. Although he believes credit default swaps have been "dramatically misused," Duffie says he still believes they're a very effective tool and shouldn't be done away with entirely. Besides, he says, "if you outlaw them, then the financial engineers will just come up with something else that gets around the regulation." As Wall Street and Washington wring their hands over how to prevent future financial crises, we can only hope they re-read Mary Shelley's "Frankenstein."