Debt Rattle, November 1 2008: Cold Turkey

Lewis Wickes Hine Toter April 1913
Columbus, Georgia. Eagle and Phoenix Mill.
Hine: A 'dinner-toter' waiting for the gate to open. This is carried on more in Columbus than in any other city I know, and by smaller children. Many of them are paid by the week for doing it, and carry sometimes 10 or more meals a day. They go around in the mill, often help tend to the machines, which often run at noon, and so learn the work. A teacher told me the mothers expect the children to learn this way, long before they are of proper age."

Ilargi: Fannie Mae and Freddie Mac don’t issue mortgages, they buy loans issued by private lenders. If Fannie and Freddie are now made some sort of perpetual backstop for all mortgages, as Ben Bernanke suggests, the lenders can happily continue to try and issue loans and make huge profits, while all the risks and losses are transferred to the taxpayer.

If you would want to use Fannie and Freddie as a permanent backstop, then that can only be properly achieved with a model in which they issue the loans as well. The first thing needed is for whoever writes the mortgage to also run the risk of the borrower defaulting, and without selling the risk to investors. That way, there'll be a normal, read: much stricter, level of scrutiny.

And if you were thinking about coming up with arguments about free market capitalism, you need to realize that it no longer exists, it is a dead economic model, certainly in the US. It will never come back either. For that matter, the entire growth model is dead. Let's celebrate that. Perpetual growth is a dumb principle to use as a foundation on which to organize your society. It's not even an economic model, it's a ridiculous form of fringe religion. A sect. And all its proponenets should be forced to answer the question whether they think the laws of their religion trump the laws of physics.

Any religion based on the hope of a better life tomorrow, no matter how contorted, will attract followers, and speaking out against growth is a blasphemy in the eyes of the priests and flock of the world's largest congregation, far bigger than Christianity.

Yet, instead of focusing on the new found reality, instead of feeling liberated by the opportunity to move away from delusion and into a model that actually has a chance of succeeding, Bernanke et al want to try to revive the securitization freakishness through Fannie and Freddie. He should be forced under oath to explain before Congress what would happen if home prices in the US keep dropping, what that would mean for the taxpayer.

After all, every single rescue plan so far has failed miserably. 20% of all US homeowners are underwater, 50% of those in Nevada. The Case/Shiller index shows a 22% loss in average home values, with some California regions down as much as 65%. And it all gets worse rapidly. Should I reiterate once more Meredith Whitney's prediction that an overall 33% loss is so low as to be mathematically impossible? Might as well ask Ben and Hank a question or two before the next trillion dollar plan is adopted.


Mortgage backed securities are dead, and that is a good thing. They are perverse financial instruments that serve only the Hamptons crowd addicted so badly to 8 and 9 figure bonuses that they didn't think twice about mauling the hand that fed them. And no, the public hand should not now be forced to be the next and last resort to satisfy their appetite. That makes things worse, not better.

Everyone who's ever known a junkie from up close knows that there comes a point where you have to say ‘No Mas’; if you don't, you’ll be dragged down into helpless misery along with the addict. That is the point we are at. But "Bernanke Says the US Needs to Maintain a Role in Mortgage Securities". Oh, really, or else what, Ben? Or else home prices will be allowed to fall, and to realistic values to boot? Tell us who that would be bad for, please. All junks are good liars, don't forget that.

All this nonsense is directed at one simple goal: to prop up a hugely inflated market toiling at levels that defy gravity. And that goal can best be compared with a hopeless crack slave carrying a machete and threatening to kill his own mother if she doesn’t pay up yet another time for his next fix. And she knows her son will be back for more tomorrow. It takes a lot of courage for that mom to say no, even as she knows the inevitability of the outcome. Religions based on hope for a better tomorrow are hard to get rid of. When it comes to Bernanke and the perverted delusions he preaches, you, the taxpayer, are no different from a junkie's mom.

As for Fannie and Freddie, their existing portfolio’s will continue to bleed billlions for a long time to come, even as the US government demands they buy $500 billion more in additional loans over the next year. It truly is a limitless black hole. I still see folks like Gordon Brown and the US Fed and Treasury cabal talking about the profits the taxpayer will make on the trillions thrown at the banks, once the markets rebound.

These guys urgently need for Stephen Hawking to give them a black hole crash course. Hawking, after all, brilliantly figured out that there is indeed a possibility of information escaping from a black hole’s event horizon. He is therefore the ideal party to explain how minimal and elusive the returns will be.

It won't be easy, it never is, and there's not much hope for better on the horizon when you consider the utterly useless braindead economic reform proposals from both the US presidential candidates. But it's time to show these folks the door. You owe it to your children's children to shake the delusions. Cold Turkey.

---

Temperature's rising Fever is high
Can't see no future Can't see no sky
My feet are so heavy So is my head
I wish I was a baby I wish I was dead

Cold turkey has got me on the run

My body is aching Goose-pimple bone
Can't see no body Leave me alone
My eyes are wide open Cant get to sleep
One thing Im sure of I'm in at the deep freeze

Cold turkey has got me on the run

Thirty-six hours Rolling in pain
Praying to someone Free me again
Oh I'll be a good boy Please make me well
I promise you anything Get me out of this hell

Cold turkey has got me on the run

John Lennon Cold Turkey

---

The end of deflationary trade

The global shipping crash continues to get worse and this morning’s GDP data shows the US recession is already deeper than 2001 and probably 1990-91 as well. Meanwhile the International Monetary Fund seems determined to make the whole thing worse by imposing the most ruinous strictures on supplicant nations.

Yesterday the Baltic Dry freight rate index fell below 1000 for the first time in six years and last night it fell another 40 points to 885. In June the index was 11,900, so it has fallen 93 per cent in a few months – a crash far worse than anything ever seen in the stockmarket. The spot daily rental for a Capesize ship is now $6365, down from $234,000 per day over the space of a few weeks. Maybe that previous price was absurdly inflated, but at $6365 it is just $365 above the average daily cost of crews and fuel.

As a result the world’s ports are filling with empty ships because shipowners can’t afford to run them, as well as some full ships because the owners of the cargo won’t unload without a bank letter of credit, which banks are refusing to supply. Shipping companies are starting to file for bankruptcy in increasing numbers as they breach loan covenants, and a shipping researcher, Andreas Vergottis of Tufton Oceanic has told Bloomberg that a fifth of the world’s dry bulk companies may soon have negative net worth because the market for second hand ships has collapsed and the value of their fleets is below outstanding debt.

Like property-based loan agreements, shipping companies’ debt covenants have loan to value ratios that are typically 70 per cent. As the value of their fleets decline, banks are making margin calls. Meanwhile, as expected, US GDP fell in the September quarter – by 0.3 per cent. The only reason it wasn’t worse was government spending, which added 1.1 per cent to the rate of GDP change. There was another 0.6 per cent from private inventories – that is, unsold goods.

In any case, US economic data is always rushed out quickly, based on guesswork, and then revised later. Most of the guesses in this morning’s figure look optimistic, so it is very likely to be revised downwards. Even on this morning’s optimistic estimate, it is the first year-on-year decline in GDP since 1991, so this recession is already worse than 2001 and clearly has a long way to go.

And remember that in 1990-91 – and 1980 and 1973 and 1961 for that matter – the monetary and fiscal authorities were more or less in control. Or rather – they started it. Those recessions were caused by central bank and government efforts to control inflation. This time it’s all about a spontaneous collapse in private sector credit and governments around the world are desperately trying to counteract its effects with interest rate cuts, liquidity injections and fiscal stimulus.

That is…all except the IMF. It is imposing the most horrendous conditions on bailout loans to bankrupt countries. As the rest of the world’s official interest rates come down, Iceland’s this week went up 6 per cent, from 12 to 18 per cent, as a condition of its $US2 billion rescue package.

Hungary, Serbia, Belarus, Pakistan and Ukraine are now facing the most excruciating choice: default on their debts or ask the IMF for money at the expense of crushing their economies under the weight of a massive increase in interest rates. As Ambrose Evans-Pritchard writes in last night's London Telegraph: “A deflationary strategy of this kind could prove counterproductive – or worse – if applied in enough countries simultaneously. It would defeat a key purpose of the rescues, which is to stabilise the global financial system.”

Meanwhile China, the world’s greatest creditor nation, is now cutting interest rates as its economy slows. The emerging world in general has “recoupled” (if it was ever decoupled) and the removal of hedge fund investments in their currencies, government debt and sharemarkets will, in many cases, result in deeper recessions in those countries that in the US – where it all started.

Which is why global shipping has collapsed: it is the harbinger of the end of the era of trade, in which third-world labour costs kept first world inflation down and allowed interest rates to fall and stay low and debt to be increased to an historic degree.

That process of importing deflation (or, more precisely, disinflation) from developing nations – especially China and India – relied on trade: raw materials in; finished goods out. The fall in freight rates for both dry bulk carriers and container ships is telling us that it’s over.

---

Investors Raise Their Bets on Defaults in EU Countries

Investors are upping their bets that as the $12.2 trillion euro-zone economy heads into recession, costly bank-bailout plans could drive some European governments to default on their debt. In the credit-default swaps market -- where investors buy and sell derivatives that pay off when a debt issuer defaults -- the cost of swaps linked to euro-zone countries including Italy and Greece has doubled in the past month.

For Ireland, which introduced a €400 billion ($518 billion) bank-guarantee program last month that is twice the size of its gross domestic product, investors' cost of insuring against debt default has risen eightfold since the start of the year. "That the perceived probability of default for any industrialized country could be that high is extraordinary," said Simon Johnson, a professor at MIT Sloan School of Management and a former chief economist of the International Monetary Fund. "Emerging markets go through this all the time. But these are rich, prosperous economies."

The sharp moves also suggest that some market participants may be simply looking to profit from the fears that these nations may default. As the 15 countries that share the euro currency lurch into likely recession, the worry is that some governments -- particularly those with already-high debt loads -- have taken on more risk than they can handle. Another indicator of rising investor concern is the gap between the yields on the bonds issued by Germany and countries with marginally lower credit ratings, such as Italy and Greece. Those have widened to levels not seen in about a decade.

The divergence in bond yields points up that even though the euro-zone nations share a currency and a monetary policy administered by the European Central Bank, investors still price the countries' creditworthiness individually. Public finances typically worsen during a downturn. If bank balance sheets also deteriorate further due to the slowdown, it could force some governments to stump up more money and, investors worry, overwhelm state coffers. That's causing some investors to shun government debt, pushing up the yields on those bonds. Bond yields move in the opposite direction of prices.

On Thursday, the so-called spread between yield on the 10-year Italian Treasury bond and the corresponding German 10-year bond rose to 1.25 percentage point, after breaching the mark of a full percentage point Tuesday for the first time since the euro's launch in 1999. In early 2007, that gap was about 0.2 percentage point. Greek bonds are taking a similar beating. Earlier this month, Italy announced an unlimited plan to guarantee bank debt, though the government has said it doesn't expect any banks to tap it in the near future. Greece's plan includes guaranteeing up to €15 billion of bank-bond issues, injecting €8 billion into banks and buying up to €5 billion in banks' preferred stock.


Widespread investor wariness has thinned trading in government bond markets. That, in turn, increases investors' desire for assets they can sell quickly in a pinch and pushes up the yields on bonds perceived as riskier. Italy and Greece are among the euro zone's most indebted nations; last year, Italy's ratio of debt to gross domestic product was 104%, while Greece's was 95%. Nevertheless, the risk that these countries will actually default on their debt remains small. Credit-ratings agency Standard & Poor's gives Ireland the highest rating of triple-A on its debt, while Greece and Italy are in the single-A range.

The market for credit-default swaps has become a barometer for investors assessing the credit quality of a bond issuer. The cost of the swap rises the more investors are willing to pay for insuring against default. The cost of swaps on Italy, Greece and Ireland imply these countries run a 9% to 10% risk of default, according to data from Markit, a CDS pricing service. That pales in comparison with Argentina and Ukraine, where swap prices suggest a perceived default rate of more than 80%.

Still, in panicked markets, soaring swaps prices have preceded real calamity. Investor fears about the health of Wall Street firms like Bear Stearns Cos. and Lehman Brothers Holdings Inc. appeared in swap prices early on and contributed to capital flights that left the firms seeking government help. "These indicators have proven themselves to be a reliable indicator of trouble ahead, and we ignore them at our peril," Mr. Johnson said.

---

20% of U.S. Homeowners Have Mortgage Higher Than House Is Worth

Almost 20 percent of U.S. mortgage borrowers owed more on their loans in the third quarter than their house was worth as foreclosures depressed prices and the economy weakened, according to First American CoreLogic. More than 7.5 million properties already have negative equity and another 2.1 million will follow should home prices decline another 5 percent, Santa Ana, California-based First American, a seller of economic and real estate data, said in a report today.

Six states account for almost 60 percent of homes with negative equity, led by Nevada and Michigan. ``As long as job losses continue and people face resets on their mortgages, the housing market will be under severe distress,'' Sam Khater, a senior economist at First American in Tysons Corner, Virginia, said in an interview. ``We've created an entire class of homeowner that is very sensitive to price changes.'' Home prices fell in August in all 20 metropolitan areas measured by the S&P/Case-Shiller home-price index, which dropped 16.6 percent from a year earlier and has fallen every month since January 2007.

U.S. foreclosure filings rose to a record in the third quarter, and will probably increase as the economy worsens and the availability of financing shrinks, RealtyTrac Inc., a seller of default data, reported on Oct. 22. The number of houses with loans higher than the property's value may increase to almost 25 percent should prices keep falling, First American said.

The economy suffered its biggest decline since 2001 in the third quarter, ushering in what may be the worst recession in a quarter-century. Polls show that economic turmoil is boosting the chances of presidential candidate Senator Barack Obama of Illinois and fellow Democrats in next week's elections. Gross domestic product contracted at a 0.3 percent pace from July to September, according to a Commerce Department report yesterday in Washington. The decline was smaller than forecast. Even so, the economy may be in for a larger drop this quarter as the record two-decade expansion in consumer spending came to an end.

The weak economy has hurt Republican candidate Senator John McCain of Arizona, who fell further behind Obama as the financial crisis intensified. A Bloomberg/Los Angeles Times survey taken Aug. 15-18 showed McCain leading with 42 percent to Obama's 41 percent; five weeks later, the poll showed Obama ahead by 49 percent to 45 percent. First American's home-price index, compiled from public property records that go back 30 years, showed a national drop of 11.2 percent in August from a year earlier. The rate of decline may increase to 12 percent by year end, Khater said.

A $500 billion plan under consideration by the U.S. Treasury and the Federal Deposit Insurance Corp. may help as many as 3 million homeowners in danger of default refinance their mortgages into affordable loans, people familiar with the matter said yesterday. FDIC Chairman Sheila Bair acknowledged this week that ``a framework'' for modifications was being discussed.

The states with the highest shares of homes with negative equity either had rapid appreciation in prices, manufacturing declines or a higher proportions of subprime loans, according to First American. Nevada had the highest share at 48 percent, followed by Michigan at 39 percent, Florida and Arizona each at 29 percent, California at 27 percent, Georgia at 23 percent and Ohio at 22 percent, First American said.

New York had the lowest share of homes with negative equity at 7 percent, followed by Hawaii at 8 percent, Pennsylvania at 9 percent and Montana at 10 percent, according to the report. The negative equity report was compiled from 41.7 million first and second mortgages and covers single-family homes, cooperatives, condominiums, town homes and multiunit attached properties up to four units, Khater said.

---

Bernanke mulls alternative forms of Fannie, Freddie

Federal Reserve Chairman Ben Bernanke on Friday launched the public debate over what the government should do with Fannie Mae and Freddie Mac once the financial-market crisis is over. Uncle Sam took over the two mortgage giants last month after they were judged to be operating in "an unsafe and unsound manner," in Bernanke's words.

Debate over alternative organizational structures for Fannie and Freddie "seems worthwhile," Bernanke said in a speech delivered via satellite to a conference on the meltdown in the mortgage industry at the University of California at Berkeley. The market for mortgage-backed securities has shrunk dramatically in the wake of the subprime-mortgage crisis, but the two government-sponsored entities have been able to continue to sell the securities, according to the Fed chairman.

This shows that some form of government guarantee is going to be needed if the public mortgage-securities business is to recover. But with government guarantees involved, then the problems of systemic risks and taxpayer involvement have to be dealt with, he said. How to craft a government backstop must be considered if Fannie Mae and Freddie Mac are privatized, as some experts have advocated, Bernanke added.

To get over this obstacle, the government might create a government mortgage-bond insurer. Covered bonds, which are popular in Europe, are another attractive option, but at the moment these securities can't compete with Federal Home Loan Bank funding for mortgage assets, he said. Another option is to turn Fannie and Freddie into public utilities, without shareholders. One approach could be to structure a quasipublic corporation without shareholders that would provide mortgage insurance generally, he commented.

Whatever course is chosen, the entities must be forced to shrink their loan portfolios, Bernanke elaborated. "We must strive to design a housing-financing system that ensures the successful funding and securitization of mortgages during times of stress, but that does not create institutions that pose systemic risks to our financial markets and the economy," he said.

---

Bernanke Urges 'Backstop' for Mortgage-Bond Market

Federal Reserve Chairman Ben S. Bernanke said the market for mortgage-backed bonds will require some form of government support through either guarantees or insurance programs to weather times of heightened stress. The Fed chief also said Fannie Mae and Freddie Mac, the largest sources of money for U.S. home loans, should retain some form of government support and oversight even if the companies are transformed from their current federal conservatorship to become private companies.

Bernanke's comments suggest he sees a permanent role for government support of homeownership through mortgage finance. Those views contrast with such free-market advocates as Alan Greenspan, who has urged an end to official support for Fannie and Freddie. Bernanke said the current crisis shows there wouldn't be a mortgage securities market without some government backing.

"The U.S. government's strong and effective guarantee of the obligations issued under the current government-sponsored enterprise structure must be maintained," Bernanke said today in remarks to a conference in Berkeley, California. "If the GSEs were privatized, it would seem advisable to retain some means of providing government support to the mortgage securitization process during times of turmoil."

Treasury Secretary Henry Paulson engineered the seizure of Fannie Mae and Freddie Mac on the weekend of Sept. 7 after the biggest surge in mortgage defaults in at least three decades threatened to topple the companies. Bernanke raised a number of scenarios for the future of the companies, without stating which option he prefers. Securitization, the process where home loans are packaged together into a bond and sold to investors, is important because it allows banks to distribute risk and provides a wider pool of capital to finance mortgages, Bernanke said.

One approach would be to create a government bond insurer which would allow issuers to obtain a government guarantee for their bonds for a fee, the Fed chief said. "This new agency would offer, for a premium, government- backed insurance for any form of bond financing used to provide funding to mortgage markets," Bernanke said. Mortgage securities "issued by the privatized GSEs as well as mortgage- backed bonds issued by banks would be eligible." The Fed chairman's comments suggest he believes that a market based on borrowers with anything but high credit ratings would remain fragile and in need of some government support, investors said.

"To require a perpetual government backstop is to say we are going to have perpetually inadequate underwriting standards," said Julian Mann, who helps manage about $10 billion as vice president at First Pacific Advisors LLC in Los Angeles. Bernanke also discussed the option of covered bonds, while noting that they might be less competitive with existing finance options. Covered bonds offer banks a way to raise money for new mortgages without either selling the loans or packaging them into securities. Instead, a bank issues bonds that are backed by a dedicated and regularly updated pool of loans, which stay on the bank's balance sheet.

Another alternative for Fannie Mae and Freddie Mac would be a public-utility model, where the two remain as shareholder- owned corporations and are overseen by public boards, Bernanke said. "Beyond simply monitoring safety and soundness, the regulator would also establish pricing and other rules consistent with a promised rate of return to shareholders," he said. The two companies could be folded into the Federal Housing Administration and become full government agencies that securitize mortgages, such as the Government National Mortgage Association, he said. The Fed chairman didn't discuss interest rates or the economy in the text of his remarks.

The Fed cut the main interest rate this week to a half- century low of 1 percent to limit damage from the collapse of the U.S. mortgage market and avert what may be the worst recession in a quarter century. Washington-based Fannie and McLean, Virginia-based Freddie own or guarantee nearly half the $12 trillion in U.S. residential mortgage debt outstanding. The Treasury agreed last month to inject up to $100 billion apiece in Fannie and Freddie to keep their net worth positive. Freddie's book value stood at $12.9 billion at the end of June, while Fannie's stood at $41.2 billion.

Eliminating Freddie's $18.4 billion in deferred tax credits would leave it with a book value of negative $6 billion and would cut Fannie's net worth in half, before factoring in other potential writedowns, analysts said. Bernanke noted that markets for GSE debt and mortgages have come under stress in recent days "because of widespread dislocations in financial markets generally." Yields on Fannie Mae and Freddie Mac corporate debt fell relative to benchmarks following Bernanke's remarks.

The difference between yields on Washington-based Fannie's 10-year debt and similar-maturity Treasuries fell 6.9 basis points to 121 basis points as of 2:30 p.m. in New York, after earlier falling as low as 119 basis points, according to data complied by Bloomberg. Richmond Fed President Jeffrey Lacker has endorsed the view of former Fed Chairman Greenspan that the government should nationalize Fannie Mae and Freddie Mac before splitting them up and selling them off. "I would prefer to see them credibly and demonstrably privatized," Lacker said in an Aug. 20 interview with Bloomberg Television.

Bernanke said it's an "open question" whether the GSE model "is viable without at least implicit government support."
"Private-label securitization has largely stopped," Bernanke said. The fact that GSE issuance continued suggests "at least under the most stressed conditions, some form of government backstop may be necessary to ensure continued securitization of mortgages," he said. Paulson hasn't taken a position on the future of the two mortgage finance companies beyond their current status under federal conservatorship, where they are overseen by the government while remaining shareholder-owned.

U.S. foreclosure filings rose to a record in the third quarter, and will probably increase as the economy worsens and the availability of financing shrinks, RealtyTrac Inc., a seller of default data, reported on Oct. 22. Almost 20 percent of U.S. mortgage borrowers owed more on their loans during the third quarter than their house was worth as foreclosures depressed prices and the economy weakened, according to First American CoreLogic, a Santa Ana, California- based seller of economic and real estate data.

Borrowing costs have remained high. U.S. 30-year mortgage rates tracked by Freddie Mac rose to 6.46 percent this week, up from 6.04 percent the previous week and 6.07 percent on Jan. 3. Banks are unlikely to compete for new loans and offer lower rates so long as the outlook for the economy remains dim, economists said.

---

Bernanke Says the U.S. Needs to Maintain a Role in Mortgage Securities

Federal Reserve Chairman Ben Bernanke sketched out a blueprint for handling the mortgage-securitization crisis -- an issue both presidential candidates have cited as a priority. Speaking to a mortgage-finance symposium in Berkeley, Calif., by videoconference Friday, Mr. Bernanke said policy makers may need to maintain a key role in mortgage securitization regardless of the fate determined for government-sponsored entities Fannie Mae and Freddie Mac. Among the options he outlined was creating a government bond insurer for mortgage funding.

"Government likely has a role to play in supporting mortgage securitization, at least during periods of high financial stress," Mr. Bernanke said. On Capitol Hill and along the campaign trail, Democrats and Republicans have traded blame for the troubles at Fannie and Freddie. For a decade, Fed officials and two presidential administrations have exerted pressure to overhaul the mortgage giants. Republican presidential candidate Sen. John McCain supports breaking up Fannie and Freddie, selling them off and cutting their government ties. Democratic candidate Sen. Barack Obama opposes a total privatization, supporting some degree of public involvement in the firms.

The government on Sept. 7 seized Fannie and Freddie, which together own or guarantee half the nation's mortgages, after months of uncertainty about their future. The government's action initially alleviated some pressure on the mortgage market. But the financial crisis has pushed consumer mortgage rates up, weighing on the housing market. On Thursday, the average for 30-year fixed-rate loans conforming to Fannie and Freddie standards was 6.63%, according to financial publisher HSH Associates, up from 6.34% in early September before the government put the firms into conservatorship.

Government-sponsored lenders have been the only firms producing and selling mortgage-backed securities to investors during the recent credit crunch. "Their ability to continue to securitize when private firms could not did not appear to result from superior business models or management," Mr. Bernanke said. "Instead, investors remained willing to accept GSE mortgage-backed securities because they continued to believe that the government stood behind them."

Having Fannie and Freddie compete as private firms -- perhaps after breaking them into smaller units -- would eliminate the conflict between private shareholders and public policy, diminish risks to the overall economy and financial system and allow them to be more innovative by operating with less political interference, Mr. Bernanke said. But "whether the GSE model is viable without at least implicit government support is an open question," he said. Even under privatization, Mr. Bernanke said "it would seem advisable" to provide government support for the mortgage-securitization process during periods of turmoil. He cited as a possible approach the creation of a government bond insurer, modeled on the Federal Deposit Insurance Corp., to provide government-backed insurance for bond financing to fund mortgage markets.

As an alternative, Mr. Bernanke suggested covered bonds -- debt issued by financial institutions and backed by a pool of high-quality assets -- with extensive regulation. Covered bonds are used widely in Europe as the primary source of mortgage funding on the continent. As a third option, he said the mortgage firms could be tied even more closely to the government through a public-utility model or a cooperative between mortgage originators and the government-sponsored mortgage firms. "A public-utility model might allow the enterprise to retain some of the flexibility and innovation associated with private-sector enterprises in which management is accountable to its shareholders," Mr. Bernanke said.

Mr. Bernanke's comments came as the latest economic data showed a nation retrenching. A final reading of consumer sentiment for October registered at 57.6, down from 70.3 in September, according to a Reuters/University of Michigan poll. The survey found consumers reporting "the most dismal assessments of their current financial situation ever recorded." Consumer spending fell 0.3% in September from a month earlier and is expected to decline in coming months amid credit constraints and job losses. The Commerce Department said incomes rose 0.2% in September from August, while wages and salaries gained just 0.1% during the month.

The report also showed that the Fed's preferred inflation gauge, the price index for personal-consumption expenditures, was up 4.2% from a year earlier, lower than the 4.5% gains in July and August. Excluding food and energy, prices rose 2.4% in September from a year earlier, compared with a 2.5% gain in August. Fed officials generally aim for a core-inflation rate between 1.5% and 2%. In the coming year, inflation is expected to moderate further due to the downturn.

---

Massive Effort to Save Mortgages

J.P. Morgan Chase & Co. launched an ambitious plan Friday to modify the terms of $70 billion in mortgages for borrowers who are behind on their payments or soon could be. The move by the New York bank will cover as many as 400,000 borrowers. They'll be moved into loans carrying lower interest rates, smaller principal amounts or other more-affordable terms.

The changes will particularly focus on a type of loan structured in such a way that the borrower's outstanding balance sometimes grows month after month. J.P. Morgan inherited $54 billion of such loans with its takeover of the beleaguered thrift Washington Mutual Inc. in September. The plan comes amid intense national focus on a root cause of global financial turmoil: rising home foreclosures, and what the role of banks and government should be in helping struggling homeowners. The banking industry is under much political pressure address the foreclosure problem.

Rival Bank of America Corp. has two loan-modification pools in place, one hashed out with state attorneys general. At the government level, after other programs failed to halt the rise in foreclosures, the Federal Deposit Insurance Corp. recently floated a plan that could help three million troubled borrowers; it is being considered by the White House. The FDIC also is assisting strapped borrowers who had mortgages with IndyMac Bancorp, which the FDIC seized this summer. Such moves would tackle one of the last elements of the global financial upheaval as yet untouched by a major federal program.

The mortgage crunch that began in the middle of last year spawned the financial crisis. Big financial players had invested trillions of dollars in securities backed by risky mortgages, which starting in mid-2007 became difficult to value. Banks hobbled by these bad investments reined in lending, spawning the wider credit crunch as a result. The U.S. government has tackled problems in the banking system and credit markets, but thus far hasn't succeeding in stanching the bleeding of failing homeowners. Economists and government officials agree that the economy and financial markets can't fully revive until there's a halt to the decline in housing prices, a phenomenon that is worsened by foreclosures.


"It doesn't make sense for us to wait" to tackle the problem, said a J.P. Morgan executive, Charles Scharf. "We've heard loud and clear and are listening to what some of the thought leaders around the country are saying." Mr. Scharf runs the retail division, which includes mortgages and branch banking, at J.P. Morgan, the largest U.S. bank in stock-market value. The move also suggests that banks are realizing they can improve the value of their loan portfolios through mass modifications rather than foreclosures, which tend to produce larger losses. Until now, mortgage holders have been reluctant to renegotiate loans or have been doing so one-by-one, a time-consuming process. The bundling of loans into securities that are then sold to investors further complicates matters.

The announcement by J.P. Morgan steps up pressure on other mortgage companies to respond with relief programs for stressed borrowers, said Stuart Feldstein, president and co-founder of SMR Research Corp., a Hackettstown N.J., firm that specializes in consumer lending. "The precedent has clearly been set and we can expect to see more of these," he said. Nationwide, 7.3 million American homeowners are expected to default on their mortgages between 2008 and 2010, about triple the usual rate, according to Moody's Economy.com, a research firm. Some 4.3 million of those are expected to lose their homes.

J.P. Morgan's exposure to the problems increased sharply when it acquired the assets of the Seattle-based Washington Mutual. WaMu, which was seized by regulators, had a large exposure to the difficult housing market of California. In taking it over, J.P. Morgan acquired $16 billion of subprime mortgages. The mortgages affected by J.P. Morgan's program represent 4.7% of the home loans it owns or that are serviced by one of the bank's units, EMC Mortgage Corp. While the program to give these mortgages easier terms is likely to cost J.P. Morgan billions of dollars in interest payments and loan fees, it is also likely to save the bank from the costly and lengthy process of foreclosing homes and selling them. The plan expands upon programs already in place at the bank to help strapped homeowners.

The bank's Mr. Scharf declined to estimate the plan's financial impact on the bank. "Our goal in doing this was to come up with something that we think will lead the industry in helping as much as possible on this issue," he said. J.P. Morgan's push is especially aimed at so-called option adjustable-rate mortgages, or options ARMs. These allow borrowers to make a minimum payment that may not even cover the interest due -- resulting in a higher loan balance. Under the plan, option ARMs that are accumulating interest will be replaced with fixed-rate loans that are more stable for borrowers and seen as far less likely to default. J.P. Morgan said it wouldn't begin the foreclosure process on borrowers during the next 90 days, as it opens loan-counseling centers and takes other steps to launch the program.

J.P. Morgan unveiled the plan days after receiving $25 billion in federal capital from the Treasury's program to shore up financial institutions and get credit flowing. Mr. Scharf declined to comment on whether the bank would use any of those funds for the mortgage overhaul. "The stronger you are, the more willing you are to spend money and do a whole series of things," he said, noting that the government cash "certainly makes decisions easier." Of the two loan-modification pools at rival Bank of America, one targets 265,000 borrowers with all types of mortgages. The other was hashed out with 14 state attorneys generals and involves 400,000 subprime and option-ARM customers serviced by the big lender Countrywide Financial Corp., which Bank of America purchased July 1.

Another big rival bank, Wachovia Corp., acquired roughly $120 billion of option ARMs as part of its 2006 purchase of Golden West Financial Corp. Wachovia initiated a loan-refinancing program before agreeing to its pending takeover by Wells Fargo & Co. That effort targets the option-ARM portfolio. J.P. Morgan's plan drew cautious optimism from Iowa Attorney General Thomas Miller, who recently called on mortgage lenders to launch broad loan-modification programs. John Taylor, chief executive of the National Community Reinvestment Coalition, called it "a gutsy move on their part," adding : "They are bending over backward to try to reach out to these people." The coalition represents 600 community groups and has urged the government and industry to help homeowners. Republican presidential candidate John McCain has gone further than any program in place, proposing a to have the government buy $300 billion in troubled mortgages outright.

---

Fifth Third Bancorp Takes Over Assets in 17th Bank Failure

Freedom Bank, based in Bradenton, Fla., became the 17th bank to fail this year. On Friday, banking regulators declared Freedom Bank insolvent and named the Federal Deposit Insurance Corp. as receiver. The FDIC approved the assumption of all Freedom's deposits by Fifth Third Bank, a unit of Fifth Third Bancorp.

Fifth Third said it will assume about $250 million of deposits, including all uninsured deposits. The FDIC will retain substantially all of Freedom's loan portfolio for later disposition. The deal gives Fifth Third about $675 million in deposits in the Bradenton-Sarasota-Venice Metropolitan Statistical Area and raised its deposit market share in that market to fourth from eighth, according to recent FDIC data.

Most of the failed banks have been small. The largest so far this year was the $307 billion Seattle thrift Washington Mutual Inc., which was seized by federal regulators Sept. 25. The bulk of WaMu's operations were sold to JPMorgan Chase & Co. The second largest of the year was the $32 billion IndyMac Bank, taken down July 11 in Pasadena, Calif. Another bank in Bradenton, First Priority Bank, failed in August. That was the first bank failure in Florida, a state still reeling from a spate of overbuilding and credit problems, since 2004.

Fifth Third said it will operate Freedom Bank's four branches beginning Monday under the Fifth Third Bank name. Customers should continue to use their existing branches until Fifth Third integrates Freedom's deposit records. After a transition period, Freedom's customers will have access to Fifth Third's 16 locations in the Bradenton-Sarasota market as well as to its nearly 1,300 branches and more than 2,300 ATMs in 12 states.

Fifth Third said it will work with Freedom's employees to identify potential job opportunities. Fifth Third's shares were at $10.86, up 0.1%, in after-hours trading.

---

City fury over terms of Barclays bailout

Barclays faces the possibility of an investor revolt after announcing it is taking cash from Middle-Eastern investors, at a hefty cost, as an alternative to accepting the UK government bailout which its rivals HBOS, Lloyds and Royal Bank of Scotland are benefiting from.

The bank, which last month turned down the Government bailout offered to the sector, announced yesterday that it will raise £7.3bn from investors in Qatar and Abu Dhabi. Existing shareholders in the bank still need to approve the proposal on 24 November – and that may not go through without protest judging by yesterday's fall in the bank's share price. The stock fell by as much as a fifth before closing 13 per cent lower. Some politicians also waded into the bank's business, with the Liberal Democrat Treasury spokesman Vince Cable branding the deal a "scandal of mammoth proportions".

Barclays, whose chief executive, John Varley, pictured, has been coming under increasing pressure, said last month it would raise capital privately, while rivals Royal Bank of Scotland, Lloyds TSB and HBOS agreed to take up to £37bn of taxpayers' funds to help rebuild balance sheets that have been badly hit by the credit crisis and to prepare for possible recession. That could leave the Government as a majority shareholder in RBS and with over 40 per cent of a combined Lloyds/HBOS. Ministers have said they will limit executive pay and halt dividends for shareholders until preference shares are repaid, but said it would not interfere with strategy.

Barclays executives said they think the bank should gain a competitive advantage "in the current market landscape" by not having the Gov-ernment limiting its nimbleness. The resulting transaction will leave Middle-Eastern investors with a substantial chunk of Barclays. Under the plan, the bank is paying 14 per cent interest for 10 years on some of the preferred-like shares being used. That is the highest rate yet being charged for bank capital, and all the more when compared to the 11-12 per cent the Government is asking from other banks in cash.

While the company argues the after-tax rate of about 10 per cent is cheaper than the Government's offer, some analysts say Barclays will probably be continuing to pay the interest for six more years than its peers. And analysts at Collins Stewart said they estimate that, including banker and adviser fees and other initial extras, Barclays will actually end up paying the equivalent of about 16 per cent interest in the first year. "Government intervention is being avoided, albeit at a very high cost," Collins Stewart's Alex Potter said.

Middle East investors will own up to one-third of the UK's second-largest bank after the operation, which is aimed at repairing damage from the global financial crisis. Barclays will get up to £3.5bn as a personal investment from Sheikh Mansour Bin Zayed al Nahyan, one of the brothers of Abu Dhabi's ruler – and as of recently the owner of Manchester City football club. That could give him a double-digit stake in the company. The bank is also raising up to £2bn from Qatar's sovereign wealth fund and £300m from a member of Qatar's royal family. That could eventually leave Qatar investors holding up to a sixth of Barclays shares.

Barclays' investor base has been transformed in the past two years as it has raised funds from investors in China, Singapore and Japan as well as the Middle East, and the bank expects to benefit commercially from the links, as well as getting cash. Barclays said profit in the first nine months of this year was "slightly ahead" of the same level a year earlier. Banks have been appealing to investors from Asia and the Middle East for capital for months as the credit crunch takes its toll, but cash is becoming costlier as funds that helped European and US banks at the beginning of the credit crunch and made huge losses are becoming harder to convince to part with their money.

Barclays is structuring the fundraising through a range of complex capital instruments that will allow it to rebuild capital to levels required by the UK regulator without taking advantage of taxpayer cash. The bank is raising £3bn through an issue of reserve capital instruments (RCIs) that will pay annual interest of 14 per cent until June 2019. Convertible notes will make up the remaining £4.3bn.

Barclays has already lost billions of pounds from credit-related asset writedowns and is faced with a sharply slowing UK housing market and economy. In July, the bank had already raised £4.5bn from shareholders to prop up its capital base. It wrote down a net £129m on credit market assets for the third quarter. The number was that small because £1.2bn of total writedowns were offset by a gain of £1.1bn on an upward revaluation of some issued notes.

---

Rescued bank RBS to pay millions in bonusesRescued bank RBS to pay millions in bonuses

"RBS 'making monkeys' out of the government"

Royal Bank of Scotland, which is being bailed out with £20bn of taxpayers' money, has signalled it is preparing to pay bonuses to thousands of staff despite government pledges to crack down on City pay. The bank has set aside £1.79bn to cover "staff costs" - including discretionary bonuses - at its investment banking division for the first six months of the year alone. The same division caused a £5.9bn writedown that wiped out the bank's profits for the same period.

The government had demanded that boardroom directors at RBS should not receive bonuses this year and the chief executive, Sir Fred Goodwin, is walking away without a pay-off. But below boardroom level, RBS and other groups are preparing to pay bonuses to investment bankers who continue to generate profits. The disclosure drew fierce criticism from Vince Cable, the Liberal Democrat Treasury spokesman. "The government said they would attach strict conditions on bonuses and it is very clear they are doing nothing of the kind. "The banks are just making complete monkeys of them."

He suggested the government would not have agreed to bail out any standalone investment bank. RBS and others had become "entangled with casino-style investment banking operations", he said. Despite the continuing financial turmoil and widespread criticism of the bonus culture in the City, the bank is understood to believe the payments are defensible. A source said: "I think everybody would expect [that those responsible for writedowns] would not get a bonus. But there are people who still made fairly substantial money in other product areas - you cannot just not pay them bonuses, they will just go elsewhere." Asked about the likely bonus culture after taxpayer-funded bail-out, the source said: "If the government does end up becoming a shareholder, RBS is still a listed entity. It remains the board's responsibility to ensure it is run commercially."

Several US politicians have seized on an investigation by the Guardian last month which showed six Wall Street banks - Goldman Sachs, Citigroup, Morgan Stanley, JP Morgan, Merrill Lynch and Lehman Brothers - had set aside $70bn (£42.5bn) in pay and bonuses for the first nine months of the year. Five are in line to benefit from a $700bn US taxpayer bail-out. The sixth, Lehman Brothers, has collapsed - though not without securing considerable bonus payouts for staff in the US.

Henry Waxman, chairman of the House oversight committee, wrote to chief executives of America's nine largest banks this week asking them to hand over information about their pay and bonus plans. In his letter Waxman cites the Guardian report and says: "Some experts have suggested that a significant percentage of [bankers' pay] could come in year-end bonuses and that the size of the bonuses will be significantly enhanced as a result of the infusion of taxpayer funds."

Staff costs at RBS's investment banking division include salaries already paid in the first six months of the year, national insurance and profit-sharing contributions as well as funds earmarked for end-of-year bonuses. The sum set aside is 20% lower than the equivalent figure for the first six months of 2007. Banking sources privately acknowledge that the sight of these bonus accruals may provoke anger. They concede the industry's pay and bonus regime is under unprecedented strain as it fails to reflect profitability, asset writedowns or share price declines.

---

UK government knew of problems with Icelandic banks in March

Gordon Brown was alerted to Iceland's growing financial crisis nearly six months before the island's banks collapsed jeopardising the savings of British investors, it was reported last night. Opposition MPs have demanded an investigation into warnings received by the Government and Bank of England over the huge cashflow problems facing Iceland's banks.

They finally collapsed in October, forcing the British Government to guarantee the deposits of individual savers at a potential cost of billions of pounds. Councils, police authorities and charities are still waiting to discover whether they will recover their money. Channel 4 News reported that the Bank of England and Government were aware of serious problems in Iceland as long ago as March, but decided not to alert British depositors for fear of triggering the collapse of that country's banks.

It claimed Mr Brown discussed the situation with Geir Haarde, hisIcelandic counterpart, on 25 April and advised him to approach the International Monetary Fund for help. Mervyn King, the Governor of the Bank of England, commissioned a study into Iceland's financial problems the same month, Channel 4 News said. But King rejected a plea from the Central Bank of Iceland for help in shoring up its currency, the krona. According to the programme, Mr King turned down the request, explaining that the country's banking system was "far too large".

Whitehall sources refused to discuss the timings of the meetings, but insisted it had been right not to gopublic prematurely with fears about Iceland. A Treasury spokesman said: "We are clear we took the appropriate action to protect depositors, and we continue to discuss the matter with the Icelandic authorities." But Vince Cable, the Liberal Democrat Treasury spokesman, said it was striking that the Bank Governor "judged the Icelandic banks were in such a dangerous and volatile condition that it would be difficult to save them, and yet the authorities ignored all of this information".

---

China Manufacturing Contracts as Crisis Trims Exports

China's manufacturing contracted as the worst financial crisis since the Great Depression eroded export demand. The Purchasing Managers' Index fell to a seasonally adjusted 44.6 last month from 51.2 in September, the China Federation of Logistics and Purchasing said today in an e-mailed statement. That was the lowest since the gauge was launched in July 2005. A reading below 50 reflects a contraction, above 50 an expansion.

China's cabinet has pledged extra infrastructure spending to stimulate the world's fourth-biggest economy amid the global slowdown. The government has already lowered rates three times in the past two months, increased export rebates and cut property transaction taxes. "The government needs effective stimulus measures to spur growth," said Wang Qian, a Hong Kong-based economist at JPMorgan Chase & Co. "The external economic outlook is worsening rapidly."

Manufacturing contracted in July for the first time since the survey began in 2005. It also shrank in August. The October index was a record low. China's economy grew at the slowest pace in five years in the three months through September as export orders shrank and industrial production waned. The expansion cooled for a fifth straight quarter, to a 9 percent gain from a year earlier.

Chinalco Luoyang Copper Co., a Chinese processor of the metal, said orders fell 20 percent in the third quarter as domestic and international demand weakened. The global slowdown is curbing demand for the nation's goods. The International Monetary Fund estimates that advanced economies will expand 0.5 percent next year, the slowest pace since 1982. Falling property sales and prices in major cities are another drag on China's growth.

The index is based on a survey of more than 700 companies in 20 industries, including energy, metallurgy, textile, automobiles and electronics. The output index fell to 44.3 in October from 54.6 in September, while the index of new orders dropped to 41.7 percent from 51.3. The index of export orders declined to 41.4 percent from 48.8, the statement said.The inventory index climbed to 51.4 from 50.5, it said.

---

Chill winds blow through China's manufacturing heartland

The dislocated head of a baby doll stares blindly through the gate; WALL-E and Barbie Pet Doctor boxes are strewn across the yard. Two weeks ago, toymaking giant Smart Union was churning out goods for children across the United States and Europe. Now it is in liquidation and 7,000 former employees are in shock.

"One day we went to work as usual, the next it was all closed," said Wei Sunying, gazing through the barred gate of the factory in Dongguan in southern China where she spent eight years painting plastic components in a fume-filled room. "Thousands of us are looking for jobs now. We walk around every day till our feet ache but we can't find anything."

Few in the west have heard of Dongguan, but the chances are that your shoes, your TV or your children's toys originated here. Exports have built a city of up to 14 million inhabitants — twice the population of Greater London — almost all migrant workers from the countryside. Its economy has grown 15% annually in recent years. Now the global financial and economic crisis is proving the final straw for exporters already punished by rising costs and a stronger currency.

In the last year, chill winds have blown through the baking Pearl River Delta. Sixty-seven thousand small and medium-sized businesses in China collapsed in the first half of 2008, many in these manufacturing heartlands, says the national economic planning body. Toy firms have been particularly badly hit, thanks to safety scares and product recalls. Textile firms, with wafer-thin margins, are also reeling.

Next came tighter credit for many foreign-owned firms, such as Hong Kong's Smart Union. And then, in the last two months, a sharp drop in US and European demand as consumers reined in spending. A local trade association predicts that by the end of January, Dongguan and its neighbours Shenzhen and Guangzhou will lose 9,000 of their 45,000 factories. "Many factories are looking at completely empty order books," warned Stephen Green, head of China research at Standard Chartered, who believes the export sector will be stagnant and could even shrink next year.

Green predicts that China will grow 7.9% next year — well below the double-digit figures enjoyed over the last half decade — while others suggest it could fall closer to 7%. That sounds enviable to western countries facing recession. But with the working age population still growing, China needs at least 8% growth to maintain the current employment rate. And the fall-out will be highly concentrated in provinces such as Guangdong. "The social impact of this is going to be huge. The problems are getting bigger and bigger," said Wooyeal Paik, who is researching Dongguan's industry and migrant workforce at the University of California at Los Angeles.

"Impromptu protests by disgruntled workers left jobless and without pay are becoming more common; they have resorted to petitioning local officials for backpay because they have few other ways to remonstrate and be compensated. "They will complain more and they will go to local government offices more... You will see demonstrations and picketing. And probably there's a risk of violence against bosses — especially foreigners." Dongguan's government stepped in to reimburse the Smart Union workers to the tune of 24,000 yuan (£2.2m) after thousands gathered at the factory gates and outside local authority offices.

But two months' back pay — 1200 yuan for most — will not last long. There is no redundancy package and a lawsuit by workers appears to have limited prospects of success. Wei, from Guizhou, is one of many struggling to find new work. Even if she could read the job adverts, most ask for recruits under 35; she is just over 40. "I came here as a migrant worker because my children need money for schooling," she said. "Now I can't support my children. I don't even have enough money to get back home and it's expensive to stay here."

Even job offers aren't always what they seem, said 26-year-old Fang Jianlin, whose friends were recently conned.
"Recruiters told them the conditions and the salaries were very good, but on the way to the place they were asked for money. They got robbed; some were even beaten," he said. Smart Union was such a popular employer that Fang paid a hefty "introduction fee" to win his job there. At worst, he and his wife would earn around 600 yuan a month; at the busiest times, when production ran until 2am, they could take home 2,100 yuan each.

But he and his wife will return to his village in Sichuan in a few days, where his parents are rearing their children, unless new work turns up. They are not sure how they will support the family, but cannot afford the 50 yuan a day in rent, food and transport to stay here. It's a sobering end to the dream which lures millions of workers to Dongguan each year, where they struggle and study their way towards the promise of a regular income; perhaps even a place in the burgeoning middle classes. At the city's night schools, thousands of workers end their long days with classes on everything from car maintenance to law.

Bob Li is one of the area's success stories. He arrived in 1995 as a casual labourer. "Everyone in my hometown had heard Guangdong was covered in gold," he said. Now he manages a factory for Richall, which supplies durable bags to companies such as Walmart, Carlsberg and Disney. Twenty-five thousand totes for Tesco are stacked up awaiting delivery. But he is unnerved by the economic downturn. "These days it is getting more and more difficult for factories like us," he said, citing the cost of wages and materials. "The exchange rate is already a huge issue here; people are losing interest. The price of our materials has risen because they're made from oil... Taken together, costs have risen by 30%-40%."

To some extent, Dongguan has become a victim of its own success. The rising prosperity of the region has created inflationary pressures. Workers want higher wages; new labour laws are designed to wipe out sweatshops but bring higher costs, which squeeze many companies. Manufacturers have already fled inland to cheaper provinces, in many cases encouraged by Guangdong authorities, who hoped to move the province up the value chain — condensing 200 years of western industrial history into fewer than 15.

"We have a policy to empty the cage for the new birds," Guangdong's vice-governor, Wan Qingliang, told reporters this month. "The ultimate target is to build the Pearl River Delta into the core region of modern manufacturing." Others are unsure of the wisdom of the policy in the face of a worldwide downturn. "Places like Guangdong miscalculated the development of the economy. They actually tried to push those labour intensive and small and medium sized enterprises out of the [established industrial] area because they wanted hi-tech industries there. But when something bad happens, like the economic downturn, what are they going to do?" said Paik.

He acknowledges that numerous East Asian economies, such as Japan, have moved up the value chain in just the same way; and that the Chinese government deserves to be confident, given its economic record. "But they haven't experienced a serious economic downturn except right after 1989 and have been overconfident in their policy of the quick transformation of industrial structure toward hi-tech in Guangdong," he cautioned. The risk is that officials push the city off the economic ladder rather than up it. Whether new subsidies, export tax rebates and other support for small businesses can save them remains to be seen.

Yet China's rising living standards in the 30 years since economic reforms were launched has left most people optimistic about its long-term prospects. Migrant workers returning home think they may come back in a few years. A security guard at the shuttered Smart Union plant is plotting out his course to university. "If we compare the situation to when I first arrived, I have already found my pot of gold," said Li, the factory manager. "But I can still see it's just the beginning."

---

Sri Lanka's Deficit, Foreign Debt Put Economy at Risk, IMF Says

Sri Lanka's widening current-account deficit, a dependence on foreign borrowings and an overvalued currency pose "serious risk" to the nation's economic stability, the International Monetary Fund said. The South Asian economy, facing among the highest inflation in Asia exceeding 20 percent this year, must undertake reforms to ease consumer prices, consolidate public spending and increase financial supervision to reduce the pressure on the local currency, the IMF said.

"Amid increased international risk aversion, raising external finance will become increasingly challenging," the Washington-based agency concluded in a report yesterday after a consultation on Oct. 17. "Sri Lanka's external accounts are vulnerable to a reduction in investor risk appetite." The risk of a global recession pushed up the number of worldwide borrowers at risk of credit rating cuts to the highest this month since September 2005, Standard & Poor's said in a report yesterday. The IMF agreed last month to consider emergency loans to Hungary, Ukraine and Iceland to prevent the turmoil in global credit markets from escalating.

Sri Lanka's current-account deficit will widen to $3.33 billion, or 7.9 percent of gross domestic product, in 2008 and 8.2 percent in 2009, the IMF forecasts, versus 4.2 percent last year. Economic growth will slow to 6.1 percent in 2008 and 5.8 percent in 2009, from 6.8 percent in 2007, it said. Governor Novard Cabraal and policy makers at the Central Bank of Sri Lanka on Oct. 20 kept its benchmark repurchase rate at six-year high of 10.5 percent, unchanged in 20 straight meetings since February 2007 to cool prices. Inflation accelerated 28.2 percent in June, the highest in Asia, as global crude oil traded near a record.

The government's increased reliance on dollar-denominated short-term commercial debt add to public debt distress, while rising bad loans among local lenders suggest the banking system could face "sizeable vulnerability" to higher borrowing costs, the IMF said. The central bank's foreign-exchange reserves are expected to increase by 7 percent to $3.27 billion, enough to finance 2.2 months of imports and cover 57 percent of short-term foreign debt, the IMF forecasts. The country's external debt will amount to about 46 percent of its gross domestic product this year, down from 52 percent in 2007.

The IMF said risks to external stability are associated directly with a loose fiscal policy and a build-up of short-term and foreign-currency debt and recommended authorities "monitor closely short-term foreign liabilities and maturity risk."

---