1935 Chevrolet Master 5 window coupe in front of the Old Cathedral in Vincennes, Indiana
Ilargi: One in 8 US mortgage holders are in trouble, either delinquent or in foreclosure. The U.S. real estate market lost $2.4 trillion in value last year. In one year. Obama is set to spend $75 billion on a plan that is awfully bad from the outset, if only because it ignores the possibility that prices will deteriorate further, which is the same sort of blind-eyed assumption as the administration basing its budget plans on a 3.2% growth rate for the US economy in 2010. US home prices have much further to fall, and GDP will not grow but shrink in 2010. How can you possible get things right if you deliberately ignore the very real option that, first, the economy will continue to plunge and second, your trillions won‘t stop that from happening? I know, I know, I've explained it a thousand times by now, and it gets repetitive, but it also gets crazier as time rolls along.
American domestic real estate "values" (by now I use the term in a purely poetic sense) will fall at the very least another 25%, and I honestly can't see anything out there that would halt the fall at that level. Moreover, all the bail-out and rescue money spent so far has landed in a blazing black hole, and you would need to spend the entire wealth of the nation before Stephen Hawking's law of information returning from the hole would come into effect. We are simply witnessing the worst possible government policy imaginable, and down here we've been warning about that for a very long time. And I know that it would be valid to ask why I keep on repeating the same thing in the face of the fact that the present power structure can't avoid creating the worst of all worlds, that to save anything at all we will first have to live through the downside not only of the outcome, but also of the cause, which happens to be that very power structure.
Citigroup shares fell below $1 today. anyone want to bet on the chance we’ll get the money back that have been thrown in so far? Think the government will pump in more? That last one I wouldn't dare bet against. Still, Citi is no more. The same goes for General Motors. Much of the media attention today went to the auditor, Deloitte, filing a "going concern" notice on GM. That was not the news, though, we knew that last week. What was is that GM itself for the first time posed questions about its own viability. The company sold 53% less vehicles in the past year, and all the managers know 2009 sales numbers will be much worse than that. Chrysler is as dead as GM, and Ford may or may not hang in there, in a much leaner form than it had today. This will add anywhere between 2 and 3 million lost jobs to the already shocking totals we'll see by Christmas.
I for one wouldn't be surprised if that number would approach 15 or even 20 million. I just can't see any savior on the streets of the country. I do know that the Obama plans will fail. These plans are still geared towards the same unobtainable goals that were in place under previous administrations: saving what exists, and turning a blind eye to what might replace it. The idea that for Joe and Jane to be saved, you first have to ravage their savings in order to save the ruling classes. It's not that I don't understand the train of thought, it's that it's so obviously utterly misguided. In a house that falls to pieces, you don't try to fix the roof first. What is breaking down Citi and GM, and countless other corporations that are following on their heels, GE, Bank of America, Morgan Stanley, Chrysler, is not that the consumer markets don‘t function as they did before, that people spend less money. What is tearing these companies to shreds is the excessive debts and obligations they have loaded on their once-invincible but now aching backs.
They would have ceased to exist even if our modern times of exuberance would have lasted and endured. There is a point where, when you need to grow faster and faster just to meet your payments and other needs, you can't grow enough anymore. That's not just the problem for banks and carmakers, it's the underlying issue for our entire economic system. A constant growth rate will never be sufficient down the line, you need your growth rate itself to grow. Our society depends on exponential growth. And that process stops somewhere. It's the same as the reason why your body stops growing around age 20. If you would grow to be 10 feet tall, your bones would break under your own weight.
There are limits inherent in any and all systems, and ignoring laws of physics doesn't mean they go away. When Glass-Steagall was repealed, and when Larry Summers, Tim Geithner, Phil Gramm and Robert Rubin managed to stop regulation of securities, Wall Street banks in effect obtained permission to grow as in the physical world only malignant tumors do and can. And we all know from observing that physical world that these tumors, if left untreated, will grow until they kill their host. America is the host to General Motors and Citigroup, to Chrysler and Bank of America. Instead of seeking treatment, the country seeks to deny the harmful and lethal effects, or even the very existence, of the cancerous growths in its body politic. And economic.
If we stick to this metaphor, it's not that hard to see where it goes. At some point, you, or we if you will, need to make a choice. You either choose to lose your life, as when you don't seek treatment, or you choose to risk losing your hair and feeling real sick for a time, as when you go in for radiation and chemo-therapy. Our societies as a whole are stuck in denial mode so far. Looking at the Obama, Geithner, Gordon Brown et al responses, all I see is an attitude that says: we don't need treatment, we can beat this by ourselves, on our own.
And while miracles may have happened at times while humans have roamed this earth, it's an insane and irresponsible gamble to take when you are a President or Prime Minister or Treasury Secretary and you hold the welfare and potentially the very lives of millions of people in your hands. That's simply inexcusable. Still, looking at what happens to our economies and the actions, worth trillions of dollars, that are being taken, all I see is continued denial. It's impossible to let GM and Citi go, we can't live without them, that's the prevailing drive.
Well, they're going no matter how fiercely you try to deny it, like so many organs being amputated from your disease-riddled body. Toxic assets cause diseases. It's up to us to decide whether they will finish us off as nations and societies. So far, we have made all the wrong decisions. We couldn't have been more wrong if we had tried. It's time to get a true diagnosis, and stop listening to faith based quacks and tea-leaf healers, to rid ourselves of Geithner and Rubin and Summers and Bernanke. Unless we have a death wish. Do we? Do you? It's time to face that question for real.
Mortgage Delinquencies in U.S. Increase to Record as Homeowners Lose Jobs
Americans fell behind on their mortgages and banks seized homes at a record pace in the fourth quarter as unemployment rose to a 15-year high and real estate values tumbled. Mortgage delinquencies increased to a seasonally adjusted 7.88 percent of all loans, the highest in records going back to 1972, the Mortgage Bankers Association said today. Loans in foreclosure rose to 3.30 percent, also an all-time high. The U.S. real estate market lost $2.4 trillion in value last year, according to First American CoreLogic, and unemployment jumped to 6.9 percent in the fourth quarter, the highest since 1993. As the recession enters a second year, unemployment is becoming a major cause of delinquencies, said Jay Brinkmann, the Washington-based trade group’s chief economist.
“When it’s a loan structure issue, you can deal with that, but when it’s an unemployment issue, unless you go out and find them a job there’s not much you can do,” Brinkmann said in an interview. “Eventually that loan will go into foreclosure.” The combined percentage of loans in foreclosure and at least one past due was 11.18 percent, the highest ever recorded by the Mortgage Bankers. The percentage of loans 60 days past due and 90 days or more past due all broke records set last quarter. The median U.S. home price plummeted 12 percent in the fourth quarter from a year earlier, with almost half the transactions foreclosures, according to the National Association of Realtors.
President Barack Obama introduced a plan to use $75 billion to entice lenders to modify or refinance home loans, stem foreclosures and rescue delinquent homeowners. Obama also said the Treasury Department will double stock purchases of Fannie Mae and Freddie Mac to as much as $200 billion to expand the availability of mortgages. To qualify for a refinanced loan applicants will have to fully document their income with pay stubs and tax returns, and sign an affidavit attesting to “financial hardship,” according to documents released by the U.S. Treasury in Washington yesterday. More than 8.3 million U.S. mortgage holders owed more on their loans in the fourth quarter than their property was worth as the recession cut home values by $2.4 trillion in 2008, First American CoreLogic said in a report yesterday. An additional 2.2 million borrowers will be underwater if home prices decline another 5 percent, according to First American, a Santa Ana, California-based seller of mortgage and economic data.
“There’s no doubt that declining house prices have been a major driver of mortgage delinquencies, defaults and foreclosures,” Federal Reserve Bank of Atlanta President Dennis Lockhart said yesterday during a speech in Miami. “Efforts to prevent foreclosures appear to have had only modest success so far.” A third of owners will stop making mortgage payments if the value of their homes drop 20 percent or more below what they owe, a situation known as “rational default,” said Norm Miller, director of real estate programs at the University of San Diego School of Business Administration. The jump in late payments from the prior quarter for all types of mortgages was 0.9 percent, the largest gain ever recorded by the Washington-based trade group.
The delinquency rate for prime mortgages rose to 5.06 percent from 4.34 percent in the third quarter and the foreclosure inventory increased to 1.88 percent from 1.58 percent, the Mortgage Bankers report said. The share of so-called seriously delinquent prime mortgages, a number that combines payments 90 days or more overdue and loans in foreclosures, was 3.74 percent, up from 2.87 percent. Subprime delinquencies rose to 21.88 percent from 20.03 percent, the foreclosure inventory grew to 13.71 percent from 12.55 percent, and seriously delinquent subprime loans increased to 23.11 percent from 19.56 percent. The Mortgage Bankers report is based on a survey of 45.4 million loans by mortgage companies, commercial banks, thrifts, credit unions and other financial institutions.
Citigroup, Once World’s Biggest Bank, Sees Stock Drop Below $1
Citigroup Inc. dropped below $1 in New York trading for the first time, the latest sign that stock investors are losing confidence in a company that was once the world’s biggest bank by market value. The stock fell to 99 cents at 11:22 a.m. on the New York Stock Exchange, marking an 85 percent decline this year and giving the company a market value of $5.5 billion. At its peak in late 2006, Citigroup stock was worth $55.70, giving the company a market value of $277.2 billion. Citigroup has reported more than $37.5 billion in net losses during the last five quarters and the U.S. government has provided the company with $45 billion. Last week, the government agreed to convert the preferred stock it owned in Citigroup to common shares, gaining a 36 percent stake in the company and boosting its buffer against future losses.
NYSE Euronext, which owns the New York Stock Exchange, has suspended until June 30 a rule that delisted companies trading below $1 after six months. The change was made to help prevent a wave of delistings after the Standard & Poor’s 500 Index fell to a 12-year low. Citigroup was created by the 1998 combination of Citicorp and Travelers Group Inc., which with a value of $85 billion was the largest merger in history at the time. The transaction helped persuade the U.S. government to repeal a Great Depression-era law, the Glass-Steagall Act, that prohibited banks that took consumer deposits from engaging in investment-banking activities.
Twelve Year Lows Are Extremely Rare
Thomas Lee, US Equity Strategy at JPMorgan writes: "Believe or not, retracing 12-year lows for the Dow is an incredibly rare event. Besides the retest of 1997 lows seen on Monday, this has only happened two other times, on April 8, 1932, and December 6, 1974." Given the rarity of the event, it is worth taking a closer look at the past instances: The 12 year low in 1932 was ~three months before the end of the bear market. In 1974, it was exactly the low for that bear market. Dan Greenhaus of Miller Tabak adds, in both cases, "the economy continued contracting beyond the bear market bottoms; this is typical of rrecessions. Unemployment continued rising and GDP remained weak.
The 1974 Bear market ended in December, but GDP contracted even in the Q1 1975 at a 4.7% clip — the worst GDP Q of that entire recession. Despite this, the Dow managed to rally 24.65%." Hitting a twelve year low is by no means is proof the bear market is over. And, two prior examples does not a sufficient sample make. Financial and housing sectors remain in a state of paralysis, and while substantial levels of stimulus are coming, eveer larger deficits are coming too. Regardless, the oversold nature of the market, as well as the virtual straight down drop that brought us here, does present a real possibility of a strong market rally.
U.S. Jobless Claims Exceed 600,000 for a Fifth Week
More than 600,000 Americans filed first-time claims for unemployment benefits last week for a fifth straight time as companies kept trimming costs. First-time unemployment applications decreased by 31,000 to 639,000 in the week that ended Feb. 28, less than anticipated, from a 26-year high of 670,000 the prior week, the Labor Department said today in Washington. The number of people staying on benefit rolls eased from a record. Companies such as J.Crew Inc. have stepped up the pace of firings as sales slump, contributing to a worsening recession. The Obama administration is counting on a series of stimulus efforts to jolt the economy and create or save 3.5 million jobs.
"The labor market is awful," Christopher Low, chief economist at FTN Financial in New York, said before the report. Economists forecast claims would fall to 650,000, from an originally reported 667,000 a week earlier, according to the median of 43 estimates in a Bloomberg News survey. Projections ranged from 620,000 to 680,000. Stock-index futures slid and Treasuries advanced. Contracts on the Standard & Poor’s 500 Stock Index dropped 1.8 percent to 695.70 at 8:35 a.m. in New York. Benchmark 10-year note yields fell to 2.88 percent from 2.98 percent late yesterday. Worker productivity in the fourth quarter fell for the first time in a year as output dropped even faster than companies cut jobs, another report from Labor also showed.
Productivity, a measure of employee output per hour, decreased at a 0.4 percent annual rate, down from the 3.2 percent gain Labor estimated last month. Labor costs jumped at a 5.7 percent pace, more than first estimated and the biggest gain in two years. The four-week moving average of initial claims, a less volatile measure, climbed to 641,750, the highest level since October 1982. The unemployment rate among people eligible for benefits, which tends to track the jobless rate, held at 3.8 percent in the week ended Feb. 21. Fifteen states and territories reported an increase in new claims for that same period, while 38 reported a decrease. The total number of people receiving benefits decreased to 5.106 million in the week ended Feb. 21 from a record 5.12 million the prior week. Initial claims reflect weekly firings and tend to rise as job growth slows.
Labor is expected to report tomorrow that February payrolls fell 650,000, the most since 1949, according to a Bloomberg News survey. The unemployment rate probably surged to 7.9 percent. A report from ADP Employer Services yesterday showed U.S. companies cut an estimated 667,000 jobs in February, up from 614,000 the month before. The ADP figures include only private employment and do not take into account hiring by government agencies. Already the 3.6 million jobs lost since the U.S. recession began in December 2007 mark the biggest employment slump of any economic contraction in the postwar period. The faltering labor market has caused consumer sentiment to plummet and crippled spending. Purchases dropped at a 4.3 percent rate in the fourth quarter, the most since 1980, according to Commerce Department figures.
The Reuters/University of Michigan’s sentiment index measuring Americans’ outlook over the next six months, which tends to track consumer spending, fell to 50.5 in February. The group’s measure of current conditions, which reflects Americans’ perceptions of their financial situation and whether it’s a good time to buy expensive items such as cars, fell to 65.5. Federal Reserve Chairman Ben S. Bernanke this week told the Senate Budget Committee that policy makers may need to expand aid to the banking system and take other aggressive measures even at the cost of soaring fiscal deficits. "Without a reasonable degree of financial stability, a sustainable recovery will not occur," the Fed chairman said.
J.Crew Group Inc., a U.S. clothing retailer, said Feb. 27 it is cutting about 95 jobs and suspending matching contributions to employee retirement-savings plans. Its announcement followed similar ones from Saks Inc., Macy’s Inc. and Limited Brands Inc. that they would reduce employment to control costs. "We are operating in a very tough economic environment," J.Crew Chief Executive Officer Millard Drexler said in a statement. Cornell University said Feb. 27 it is offering buyouts to more than 1,300 non-faculty employees and fired 68 staff members to reduce costs. The university is facing a 10 percent budget shortfall, which amounts to a deficit of more than $200 million. "Certainly, there will be more layoffs," President David Skorton said in an interview in New York.
US factory orders fall for 6th straight month
Demand for U.S.-made factory goods fell for the sixth straight month in January, dropping 1.9% on weakness in durable goods orders, the Commerce Department reported Thursday. Orders are down 20% in the past six months, a reflection of how deeply the recession is hitting U.S. manufacturers. Orders have never fallen for six months in a row since the government began collecting the data in 1992. Economists surveyed by MarketWatch expected orders to fall 3.5%. However, factory orders for December were revised one percentage point lower than previously reported.
Orders for durable goods fell 4.5% in January, revised higher from the 5.2% drop estimated a week ago. Orders for civilian aircraft and computers were revised up sharply. Civilian aircraft orders increased 168%, not 82% as reported last week. Computer orders fell 4.1%, not 16%. The first report is based on a smaller sample and large revisions are common. However, orders for core capital goods equipment - the kind of things companies use to expand or upgrade their productive capacity - were revised lower to a 5.7% decline. Orders for nondurable goods rose 0.4%, as prices rose for commodities such as petroleum. Orders for petroleum increased 9.8%. Shipments of factory goods fell 1.7%, a record sixth-straight decline.
Inventories of factory goods fell 0.8%, the fifth straight decline. The inventory-to-shipments ratio rose to 1.46 from 1.44, showing that manufacturers' stocks are too high compared to sales. Orders and shipments declined for every major durable-goods industry. Among nondurable industries, only food, petroleum and printing saw higher demand in January. In other reports released Thursday, the Labor Department reported first-time filings for unemployment benefits declined by 31,000 to 639,000 last week, but the smoothed trend continued to move higher. Also, the Labor Department reported that productivity fell 0.4% in the fourth quarter as output plunged faster than companies could cut jobs.
US Job Data Expected to Point to a Deeper Recession
February's payroll decline will likely confirm fears of a prolonged recession. Some economists say stronger government action may be needed. February is the shortest month, but it was a brutal one this year: Economists are predicting that on Mar. 6, the government will report that payroll employment declined in February by the most in 60 years. The continued job losses—about 2.5 million in just four months—are evidence that the private sector is having a hard time pulling itself out of recession. Even stronger government intervention may be required, several economists said on Mar. 4. "I've gone through a number of cycles as an economist on Wall Street, but this one's different," says Brian Fabbri, chief economist for BNP Paribas. "This one's scary different." Consumers and businesses are locked into a dysfunctional relationship, dragging each other down. Fearful and overindebted consumers are spending less, forcing businesses to cut jobs. That is causing consumers to spend even less, further squeezing businesses, and so on downward. Fabbri estimates that the unemployment rate hit 8% in February and will rise to 10.7% sometime in 2010.
Fabbri, who says he considers himself a small-government conservative, argues that in these extreme circumstances, the only way to break the vicious cycle is for Uncle Sam to launch a massive jobs program. "What got us out of the Depression? World War II," says Fabbri. "I'm not saying we need a war to get out of this one, but we need to start the jobs engine. No one else can do it." Until recently, economists were hoping that the 598,000 jobs lost in January would end up being the worst decline of this recession, which began in December 2007. But most now believe that February was worse, based on fresh data including the swelling number of people filing initial claims for unemployment insurance and a gloomy survey of private-sector employment by ADP (ADP). The median forecast in a Bloomberg survey of economists is that payrolls fell by 650,000 this past month. "The corporate sector is moving very preemptively" to shed jobs and cut costs, having realized that the recession is more severe than originally believed, says Lou Crandall, chief economist of Wrightson ICAP.
Only two months in U.S. history have seen bigger job losses than the ones that are estimated to have occurred in February. In September 1945, as armed forces were decommissioned after World War II, employment fell by nearly 2 million. In October 1949, a nationwide steelworkers' strike reduced total payrolls by a little more than 800,000. A decline of 650,000 would be the third-biggest absolute number. It would, however, barely crack the top 30 when measured as a percentage of total payrolls, since the economy is much bigger now than in the 1940s and 1950s. Ordinarily the U.S. economy is resilient and shrugs off recessions fairly quickly. This one is harder to shake in part because the excesses of the boom were greater and the financial system has been damaged worse. That's why many economists predict that the recession may last until the end of 2009, if not longer. And employment usually keeps falling even after output begins to grow because employers remain nervous about the recovery's durability.
Government will probably have to play a major role in getting the private sector functioning again, say Fabbri, Crandall, and other economists. It's already doing a lot, of course. The Federal Reserve has cut short-term interest rates essentially to zero, and the Obama Administration is pouring hundreds of billions of dollars into economic stimulus and repairing the crippled financial system. The question is whether the treatment will work quickly enough. Much of the infrastructure spending in the Obama stimulus plan doesn't hit until 2010, and efforts to buy toxic assets from banks to clean up their balance sheets are moving slowly as well. Dean Maki, co-head of U.S. economic research at Barclays Capital (BCS), is more optimistic than some other economists, predicting that the economy will begin growing in the fourth quarter of 2009 and the unemployment rate will top out that quarter at around 9%. He says the government is already managing to dampen the vicious cycle of cutting by consumers and businesses through transfer payments. Bigger Social Security checks and smaller payroll tax withholding are buoying incomes, helping the consumer sector keep spending despite job losses, Maki says. Certainly, says Maki, "recovery would take longer without the government stimulus."
US Q4 business productivity revised sharply down
U.S. non-farm productivity was much weaker than initially estimated in the fourth quarter as output contracted at its steepest pace since 1982, according to a government report on Thursday that underscored the deteriorating economic climate. The Labor Department said non-farm productivity fell at a revised 0.4 percent annual rate, sharply below initial estimates of a 3.2 percent advance published last month and 2.2 percent rise in the third quarter. Analysts polled by Reuters had forecast productivity increasing at a 1.5 percent rate.
Output was revised to show a steep 8.7 percent decline in the fourth quarter, the sharpest decline since the first quarter of 1982. It was initially estimated as a 5.5 percent fall. For 2008, productivity rose 2.8 percent, unchanged from last month's estimate. Unit labor costs, a gauge of inflation and profit pressures closely watched by the Federal Reserve, were revised up to a 5.7 percent increase in the fourth quarter, above Wall Street's estimates for a 3.4 percent increase. The number of hours worked dropped at an 8.3 percent annual rate during the fourth quarter, the biggest decline since the first quarter of 1975.
Europe's banks face a $2 trillion shortage
European banks face a US dollar "funding gap" of almost $2 trillion as a result of aggressive expansion around the world and may have difficulties rolling over debts, according to a report by the Bank for International Settlements. The BIS said European and British banks have relied on an "unstable" source of funding, borrowing in their local currencies to finance "long positions in US dollars". Much of this has to be rolled over in short-term debt markets. "The build-up of large net US dollar positions exposed these banks to funding risk, or the risk that their funding positions could not be rolled over," said the BIS.
The report, entitled "US dollar shortage in global banking", helps explain why there has been such a frantic scramble for dollars each time the credit crisis takes a turn for the worse. Many investors have been wrong-footed by the powerful rally in the dollar against almost all currencies, except the yen. British banks had accumulated a dollar "funding gap" of $300bn by mid 2007. The latest BIS data up to the third quarter of 2008 shows that this exposure has been trimmed by "deleveraging" but it still largely hanging over the UK financial institutions. Swiss banks had a funding gap of $300bn at the onset of the credit crunch, an extremely high figure relative to Swiss GDP. German banks were $300bn short, and Dutch banks were $150bn short.
Belgian and French banks were neutral. The BIS said the total "funding gap" in dollars was around $2.2 trillion at the peak, when money market liabilities are included. This had fallen to around $2 trillion by the time of the Lehman Brothers collapse. The data is collected with a lag but it appears that there are still huge dollar liabilities to be covered. Simon Derrick, currency chief at the Bank of New York Mellon, said the implications are obvious. "The global bullion of the last eight years was funded on dollar balance sheets, so the capital destruction we're seeing leaves banks starved for dollars. The dollar is clearly going to appreciate a lot further," he said.
Bank of England Cuts Rate to Record Low 0.5%, Will Buy $105 Billion Assets
The Bank of England reduced the benchmark interest rate to the lowest ever and said it would start purchasing 75 billion pounds ($105 billion) in assets, printing money to fight the recession. The bank’s nine-member panel, led by Governor Mervyn King, cut the rate a half point to 0.5 percent, the lowest since the bank was founded in 1694. The decision matched the median forecast of 60 economists in a Bloomberg News survey. King’s Monetary Policy Committee wants to pump newly printed money into the economy to alleviate a worsening recession as interest rates approach zero and lose their potency. Prime Minister Gordon Brown yesterday called on nations around the world to follow the U.S. and U.K. lead by cutting borrowing costs and spending more to battle the recession.
"We’re moving into a new world in the U.K. from interest- rate adjustment to quantitative easing," said Charles Goodhart, a former Bank of England policy maker. "It’s a great deal more uncertain how things will be done. This month what the MPC says is going to be much more important than what they do." In a statement accompanying the decision, the bank said it may take up to three months to carry out the asset purchases. Most of the assets will be U.K. government bonds known as gilts. The bank will hold a open market operation tomorrow. The Bank of England has now reduced the key rate 4.5 percentage points since October. The U.S. Federal Reserve kept its benchmark at a range of zero to 0.25 percent last month. The European Central Bank will probably cut its rate a half- point to 1.5 percent at 1:45 p.m. in Frankfurt, according to all 55 economists in a Bloomberg News survey.
Chancellor of the Exchequer Alistair Darling said in a March 3 newspaper interview that the central bank has the necessary "levers" to print money and may decide this month that it needs to use them. The Bank of England has already begun buying commercial paper through its 50 billion-pound ($71 billion) asset purchase facility, financed with Treasury bill sales. Policy makers unanimously decided last month that King should seek authority from Darling for quantitative easing by buying government bonds and other securities without funding through debt sales to raise the money supply. The bank didn’t release details of its plans before the decision and an exchange of letters is expected today between King and Darling.
"It seems to be much more messy than simply voting on the bank rate," David Tinsley, an economist at National Australia Bank in London, said before today’s announcement. "I’d expect to see a much more concrete outline of what they’ll do along with the rate decision." Along with the central bank’s measures, Brown’s government has pledged billion of pounds to shore up Britain’s banking system. Last week he promised 325 billion pounds of support for Royal Bank of Scotland Group Plc’s investments, while Lloyds Banking Group Plc is also in talks on a government asset insurance program. "Let us work together for a worldwide reduction of interest rates and a scale of stimulus round the world equal to the depth of the recession and the dimensions of the recovery we must make," Brown told Congress in Washington yesterday.
The U.K. economy contracted 1.5 percent in the fourth quarter, the most since 1980, as consumers curtailed spending. Former central bank Deputy Governor John Gieve said Feb. 20 the nation faces a "serious risk" of a decade-long depression as the credit squeeze hampers growth. Manufacturers and service industries shrank for a 10th month in February, according to surveys by the Chartered Institute of Purchasing and Supply and Market research. Net consumer lending rose by 1.1 billion pounds on the month, the least since at least 1993, the central bank said March 2. Michael Page International Plc, the U.K.’s second-largest recruitment company, said today that full-year profit dropped 4.3 percent as it was hurt by the global recession. IMI Plc, the world’s biggest maker of pneumatic controls, said yesterday it has cut its global workforce by 10 percent and plans further reductions in coming weeks to weather falling demand. Central bank forecasts published last month show economic growth will resume in the second quarter of next year while inflation will slow to 0.3 percent in early 2011, below the bank’s 2 percent goal. "The bank’s forecasts on the speed of the recovery seem to be extremely optimistic," said Jonathan Loynes, an economist at Capital Economics Ltd. in London. "It’s going to be some time before growth returns."
European, British central banks cut half a point
The European Central Bank on Thursday cut its main interest rate by a half percentage point to 1.5 percent, dropping the cost of borrowing in the 16 countries that use the euro to a new record low amid grim economic news. The ECB's decision to slash the main refinancing rate for the euro zone, which has 330 million people and accounts for more than 15 percent of the world's gross domestic product, was in line with expectations. The Bank of England earlier Thursday also cut its rates by a half percentage point, to a new low of 0.5 percent, and announced measures to go further in stimulating the sagging economy by expanding the money supply. The ECB made a half-point cut in January to 2 percent -- its previous record low -- but left rates unchanged last month.
ECB President Jean-Claude Trichet was to discuss the latest decision at a news conference later Thursday. The euro zone fell into recession last year. The gloom deepened in the fourth quarter, when its economy shrank by 1.5 percent compared with the previous three months. Business and consumer confidence in the euro zone hit a new low in February, a sign that the recession will deepen again in the current quarter. Unemployment has been rising. An estimate released Monday showed that euro-zone inflation crept up to 1.2 percent in February from a near 10-year low of 1.1 percent the previous month, but that was still well below the ECB's target rate of "close to but below" 2 percent. That fueled expectations that the ECB would cut rates on Thursday. Both the euro and the pound were down after the decisions by nearly one percent against the dollar at $1.2542 and $1.4065.
Bank of New York Mellon currency strategist Neil Mellor said there's "little upside" for the pound on the basis of the Bank of England's rate cut and its announcement that it is getting ready to pump 75 billion pounds into the economy. "If investors are to become in any way optimistic that this policy will work, it will only come at the cost of growing concern over the long-term inflationary implications of the policy," he said. "As such, in conjunction with ongoing frailty in the banking sector and an ongoing economic downturn of unknown proportions, an era of quantitative easing is one more thing for investors to worry about," he added. Markets are keenly awaiting the upcoming press conference from Trichet and what he says about the prospect for further interest rate reductions and quantitative easing, the technical term for increasing the supply of money in the economy.
ECB Interest-Rate Cuts May Fail to Rescue Crumbling Economy
The European Central Bank is struggling to keep up with the region’s plunging economy. Even as President Jean-Claude Trichet and his colleagues prepare to cut interest rates to a record low today, the 16 nations that share the euro are mired in a recession deeper than envisioned in their worst-case scenario just three months ago. The pain is building as companies including chemical-maker BASF SE cut investment and jobs, Spain and Ireland run an increasing risk of default and trade partners to the east crumble. Meanwhile, a growing number of economists say the ECB risks becoming more a part of the problem than the solution as officials squabble over how much they can cut rates and whether to use more unorthodox methods to revive growth.
"The ECB remains vastly behind the curve," said Erik Nielsen, chief European economist at Goldman Sachs Group Inc. in London, who estimates the ECB has cost the economy as much as 100 billion euros ($126 billion) by failing to act as fast as the Federal Reserve. "There’s no reason to waste any more time." Trichet’s dilemma is that dropping borrowing costs too low may sow the seeds of future crises. Having cut its benchmark rate by 2.25 percentage points since early October, the ECB will today lower it a further half point to 1.5 percent, according to all 55 economists surveyed by Bloomberg News. It announces its decision at 1:45 p.m. in Frankfurt, and Trichet holds a press conference 45 minutes later.
The economy shrank 1.5 percent last quarter, and the latest data suggest the recession is deepening. Manufacturing contracted at a record pace last month, confidence is at an all-time low, unemployment is climbing toward 10 percent for the first time in 11 years and inflation, at 1.1 percent, is the weakest since 1999. Eastern European nations such as Poland and Hungary are suffering, too, jeopardizing a third of the euro area’s exports and $1.25 trillion in bank loans. Europe’s economy has "come to a complete halt," said Robert Barrie, chief European economist at Credit Suisse Group in London. "There’s a concern that if policy doesn’t respond, it won’t get better."
The ECB in December forecast the euro-region economy would shrink 0.5 percent this year. Its worst-case scenario was a 1 percent contraction. Today, the bank will likely predict a 2.2 percent slump, said Aurelio Maccario, chief European economist at UniCredit MIB in Milan. By comparison, the International Monetary Fund predicts the U.S. economy will shrink 1.6 percent this year. Trichet entered 2009 signaling reluctance to keep cutting rates for fear of feeding future asset bubbles and inflation. Those qualms remain, putting the ECB at odds with the aggressiveness shown by central banks in Washington and London. The Fed has cut its benchmark to as low as zero. The Bank of England may today lower its key rate to 0.5 percent and say it has been given authority by the government to print money.
The ECB is determined that the mistakes of the past "should not be repeated," said David Mackie, chief European economist at JPMorgan Chase & Co. At the same time, inflation is set to remain below the bank’s 2 percent goal "for an extended period," and "it is not clear that the ECB is ready to acknowledge this." Bundesbank President Axel Weber said last week that 1 percent is his "lowest limit" for the ECB’s benchmark. Executive Board member Juergen Stark, who expects a recovery in 2010, said Feb. 14 that the bank will proceed with "appropriate caution." Other policy makers including Finland’s Erkki Liikanen, Holland’s Nout Wellink and ECB Vice President Lucas Papademos have spoken of the potential for the economy to deteriorate further, indicating the bank’s 22-member Governing Council is divided. Athanasios Orphanides from Cyprus has argued that the bank could go so far as to take rates toward zero.
While officials debate, the obstacles to recovery are building as companies reduce budgets and payrolls, threatening investment and consumer spending. The pain was evident in recent days as European companies from Porsche SE to Munich Re reported their businesses were suffering. Munich Re, the world’s biggest reinsurer, on March 3 scrapped a profit goal for 2010, while Porsche, maker of the 911 sports car, said U.S. sales in February sank 36 percent. BASF, the world’s largest chemicals company, marked its first quarterly loss in seven years by saying Feb. 26 that it will accelerate plant closures and eliminate at least 1,500 jobs. Air France-KLM Group, the region’s biggest airline, and Volkswagen AG, its largest carmaker, are also paring staff. "The situation in our sales markets is worsening," said BASF’s Chief Executive Officer Juergen Hambrecht.
Gilles Moec, an economist at Bank of America Merrill Lynch, said European companies may retrench more than foreign rivals as they try to reduce debt levels that are almost twice as high as those of their U.S. counterparts. "Refinancing costs for businesses are increasing," said Moec. "Corporate-sector debt is now a key vulnerability for the euro zone." Some governments are also being punished for the debts they generated during the boom or the budget deficits they’re running up now, curbing their ability to help growth and even raising questions about whether the euro area will maintain its current form. The cost of insuring Irish, Greek and Spanish debt against default has risen to records and bond spreads have widened to the most since the euro began.
The problem for the ECB as it seeks to help its economy is that it’s hemmed in by European Union rules that forbid it from buying bonds from governments. Any decision to use the open market may spark a dispute over which country’s securities to purchase. Options are also limited by the lack of a region-wide finance authority that would underwrite any losses it may incur. "I can understand why the ECB hasn’t released the handbrake yet," said Rainer Sartoris, an economist at HSBC Trinkaus & Burkhardt in Dusseldorf, Germany. "They’re in a much more difficult situation than the Fed or the Bank of England." Trichet made that point this week, saying the ECB has "all the challenges the U.S. Fed has" and "additional challenges as well."
Julian Callow, chief European economist at Barclays Capital, nevertheless expects the ECB to start buying corporate securities soon to lower borrowing costs and push money into the economy. The effect may be smaller than in the U.S., where the market for commercial paper is bigger, said Callow. The ECB could also follow the Swiss National Bank by trying to reduce three- and six-month interest rates in the money markets, said Martin van Vliet, an economist at ING Bank in Amsterdam. Whatever it decides to do, the central bank can’t afford to put its head in the sand, said Thomas Mayer, chief European economist at Deutsche Bank AG in London. "You suspect the ECB just wants to close its eyes to what’s going on," he said. "That’s not good for the economy."
Trichet Indicates ECB May Cut Rates Further in Next Months
European Central Bank President Jean-Claude Trichet indicated policy makers will reduce their benchmark interest rate further to combat a deepening recession after cutting it to a record low of 1.5 percent today. “We didn’t decide ex-ante that this was the lowest point that we could attain,” Trichet said during a press conference in Frankfurt today after the ECB lowered its main rate by half a point. “Further decisions will depend on the judgment of the governing council discussion.” The economy of the 16 euro nations is shrinking faster than the ECB expected just three months ago as the global slowdown curbs export demand and companies lay off workers. Trichet said today the central bank has cut its economic forecasts again and expects inflation to stay “well below” its 2 percent ceiling this year and next. The euro fell as much as 0.6 percent to $1.2481 after his remarks.
Trichet has so far been reluctant to follow the Federal Reserve and the Bank of England, which have cut rates toward zero and started using other policy tools, for fear that will sow the seeds of future crises. Trichet said today the ECB hasn’t yet decided whether to deploy new monetary tools. The central bank has lowered its main rate by a total of 275 basis points since early October. The euro-region economy shrank 1.5 percent last quarter and latest data suggest the recession is deepening. “Both global and euro-area demand are likely to be weak in 2009,” Trichet said. “Over the course of 2010, the economy is expected to gradually recover.”
The ECB cut its growth and inflation forecasts today. The central bank expects the economy to contract between 3.2 percent and 2.2 percent this year after earlier forecasting a range of minus 1 percent to zero. Next year, the ECB said the range will be between a contraction of 0.7 percent and growth of the same margin. “Overall, inflation rates have decreased significantly and are expected to remain well below 2 percent in 2009 and 2010,” Trichet said. “That’s due to the fall in commodity prices and diminishing cost pressures reflecting the severe downturn in economic activity.” The central bank expects inflation of between 0.1 percent and 0.7 percent this year, compared with a previous range of 1.1 percent to 1.7 percent. Next year, inflation will be between 0.6 percent and 1.4 percent, the ECB said.
JPMorgan, Wells Fargo, Bank of America Face Ratings Cuts
JPMorgan Chase & Co., Wells Fargo & Co. and Bank of America Corp., the three largest U.S. banks by market value, may face credit-rating downgrades by Moody’s Investors Service amid signs they’ll set aside additional cash for loan losses. JPMorgan, the largest U.S. bank by market value, had its ratings outlook cut by Moody’s to negative from stable. Moody’s said it will review the long-term debt ratings of Wells Fargo, the second-largest U.S. bank, and Bank of America, ranked third, on concern that higher credit costs may damage capital ratios. The U.S. economy "deteriorated further" in almost all corners of the nation in the past two months as consumer spending slumped and manufacturing declined, the Federal Reserve said in its regional business survey this week. Ten of 12 Fed district banks reported worsening conditions in their regional economies and respondents didn’t expect a "significant pickup" until late 2009 or early 2010.
"This is pulling them in line with their peers," Jeffery Harte, a banking analyst at Sandler O’Neill & Partners LP in Chicago, said of Moody’s new outlook on New York-based JPMorgan. JPMorgan’s profit fell 76 percent in the fourth quarter as rising defaults and the U.S. recession forced the bank to write down $2.9 billion of assets and boost reserves for bad loans. The bank’s market value of $72.5 billion is more than Wells Fargo, Bank of America and Citigroup Inc. combined. New York-based Citigroup is the fourth-largest U.S. bank by market value. Bank of America in Charlotte, North Carolina, posted its first loss in 17 years during the fourth quarter, while San Francisco-based Wells Fargo reported its first deficit since 2001. The two banks are the largest U.S. home lenders, according to the Inside Mortgage Finance newsletter.
Moody’s said yesterday it expects JPMorgan’s credit card portfolio to have fewer losses than other banks its size. The firm has a Tier 1 ratio of 10.2 percent and tangible equity ratio of 7.9 percent, Moody’s said. "This level of capital gives JPMorgan flexibility to take heightened credit costs and still maintain good capital ratios," Moody’s Senior Vice President Sean Jones said in the statement. Bank of America’s credit rating was lowered to A from A+ earlier this week by Standard & Poor’s Corp. Moody’s cut Wells Fargo’s rating two levels on Jan. 6, citing the company’s weakened capital position after its acquisition of Wachovia Corp. Wells Fargo fell 8 cents to $9.58 in Germany, after declining 9.5 percent in New York Stock Exchange composite trading yesterday. JPMorgan was down 20 cents at $19.10 in German trading today and Bank of America lost 6 cents to $3.53.
GM warns it may be forced into bankruptcy
General Motors Corp on Thursday said its auditors had raised "substantial doubt" about its ability to survive outside bankruptcy if it fails to stem its losses and stop burning cash. The "going concern" warning from the struggling U.S. automaker had been expected, but underscored the stakes for GM as it seeks up to $30 billion in U.S. government aid to restructure outside a court-supervised bankruptcy process. GM's shares dropped 15 percent to $1.87 in premarket trading. GM said its creditors had agreed to waive a requirement that could have allowed them to force the automaker to repay more than $6 billion in loans because of the warning in order to allow GM to press its case for government aid.
The automaker had warned late last month that it expected auditors Deloitte & Touche would question its viability after it reported a loss of nearly $31 billion for 2008. The disclosures came in GM's delayed annual report to U.S. Securities Regulators and a 25-page discussion of the growing risks facing the automaker ranging from tight credit and troubled suppliers to slumping demand for new cars around the globe. GM has about $1 billion in convertible debentures that mature on June 1. Absent a deal to restructure its debt, that looming payment could force GM into bankruptcy, it said. The automaker also said repeatedly that a bankruptcy filing could force a liquidation because of the lack of financing its reorganization would require and consumer reluctance to buy vehicles from a bankrupt automaker.
GM faces an end of March deadline to complete concession talks with the United Auto Workers and bondholders to reduce its debt load as part of a bid to convince the autos task force assembled by U.S. President Barack Obama that it can be made viable with a new round of government help. "Our future is dependent on our ability to execute our viability plan," GM said in its annual report filed with U.S. securities regulators. "If we fail to do so for any reason, we would not be able to continue as a going concern and could potentially be forced to seek relief through a filing under the U.S. bankruptcy code," it said. Some analysts have said that the "going concern" warning from GM's auditors could risk cutting the credit available to its suppliers just as many of those smaller companies face a deepening cash crisis of their own.
Representatives of GM's bondholders were scheduled to meet on Thursday with the U.S. autos task force. Under GM's bailout, its debt holders have been asked to take a payout of one-third of the $27 billion GM owes through a debt-for-equity swap. Bondholders have balked at those terms and are asking Washington to guarantee their remaining debt in the automaker. Separately, GM said in its SEC filing that its lenders had waived "call" provisions that could have forced early payment of its $4.5 billion secured revolving credit facility, a $1.5 billion term loan and a $125-million inventory financing facility. The new waivers allow GM's lenders to call those loans if the U.S. Treasury rejects GM's restructuring plan and request for additional aid and forces it to repay the $13.4 billion it has already borrowed from the U.S. government.
GM has lost some $82 billion since 2005 and has been hit hard by the steep drop in global auto sales in the past year. Industry-wide U.S. auto sales have fallen 40 percent from their 2007 peak. Sales globally are down about 24 percent from a peak in January 2008, GM said. GM said it expected to post a loss that could top $1 billion in the current quarter as it begins to report results separately for its troubled Saab unit. The Swedish auto brand is up for sale and attempting to reorganize under new ownership and with aid from the Swedish government.
As Car Sales Collapse, GM and Chrysler Grow Desperate
Under pressure to demonstrate their viability in order to qualify for more government loans, General Motors and Chrysler couldn't produce any additional evidence on Tuesday. If they were taking physical exams, they both would have flunked. As February sales were reported, GM owned up to selling 53% fewer cars and trucks than a year ago, while Chrysler admitted that its total fell 44%. Slow sales means slow production, which is where automakers get their revenue, so the results put a real dent in cash flow. At the beginning of the month, GM and Chrysler both had more than five months' supply of unsold cars.
Both companies are running low on the money they need to operate. GM ended the year with $14 billion, about what it needs to keep the lights on. Chrysler was forecasting that it would start March with just $2.4 billion. Without a boost from the government, GM and Chrysler could each be forced into bankruptcy or liquidation by the time the crocuses bloom. Adding injury to insult, Standard and Poor's reiterated its sell opinion on shares of GM, which are commanding a mere $2.04 a share — about the price of a subway ride in New York City. Observing that the industry is gripped by an "automotive depression," S&P's Efraim Levy added, "We do not foresee an uptick in industry demand before Q4 '09 at the earliest." Chrysler was spared a similar indignity because it is privately held.
The two companies are seeking $21.6 billion in emergency loans on top of the $17.4 billion they have already received. But both are missing two pieces they must have by March 31 to convince the government that they are viable: approval from bondholders to restructure their debt and approval from the United Auto Workers to restructure their health-care agreement. Complicating the problem, the bondholders and the UAW are keeping a close eye on each other to make sure that neither side gets a better deal. With the Obama Administration taking heat for enormous deficits in the budget it is proposing, this automotive impasse can only increase the pressure on the Treasury Department to forget about further loans, pull the plug on the two companies and force them into bankruptcy.
In bankruptcy court, a judge could impose terms on both the bondholders and the autoworkers. In addition, the judge could renegotiate contracts with suppliers and ignore state franchise laws that protect dealers from termination. The automakers complain bitterly that bankruptcy would destroy their corporate reputations, turn off customers and be ruinously expensive as well. But as the March deadline gets closer and matters remain unresolved, it increasingly looks like a straightforward if brutal solution. It isn't as if the auto companies have a huge reservoir of public affection from which to draw. Outside of some Congress members from Michigan, Ohio and Indiana, there haven't been many voices speaking out with any variation of "Save Detroit."
GM auditors raise the specter of Chapter 11
General Motors Corp.'s auditors have raised "substantial doubt" about the troubled automaker's ability to continue operations, and the company said it may have to seek bankruptcy protection if it can't execute a huge restructuring plan. The automaker revealed the concerns Thursday in an annual report filed with the U.S. Securities and Exchange Commission. "The corporation's recurring losses from operations, stockholders' deficit, and inability to generate sufficient cash flow to meet its obligations and sustain its operations raise substantial doubt about its ability to continue as a going concern," auditors for the accounting firm Deloitte & Touche LLP wrote in the report. GM has received $13.4 billion in federal loans as it tries to survive the worst auto sales climate in 27 years. It is seeking a total of $30 billion from the government.
During the past three years it has piled up $82 billion in losses, including $30.9 billion in 2008. The company faces a March 31 deadline to have signed agreements of concessions from debtholders and the United Auto Workers union to show the government it can become viable again. On Feb. 17 it submitted the restructuring plan to the Treasury Department that includes laying off 47,000 workers worldwide by the end of the year and closing five more U.S. factories. GM said in its filing that its future depends on successfully executing the plan. "If we fail to do so for any reason, we would not be able to continue as a going concern and could potentially be forced to seek relief through a filing under the U.S. Bankruptcy Code," the Detroit-based automaker said in the annual report. GM, the report said, is highly dependent on auto sales volume, which dropped rapidly last year.
"There is no assurance that the global automobile market will recover or that it will not suffer a significant further downturn," the company wrote. GM warned last month that its auditors may raise the doubts, and industry analysts said auditors' statements may trigger clauses in some of GM's loans, placing them in default. But the company said in its filing that it has received waivers of the clauses for its $4.5 billion secured revolving credit facility, a $1.5 billion term loan and a $125 million secured credit facility. "Consequently, we are not in default of our covenants," the report said. "If we conclude that there is substantial doubt about our ability to continue as a going concern for the year ending Dec. 31, 2009, we will have to seek similar amendments or waivers at that time." GM spokeswoman Julie Gibson said there is no clause in the terms of the government loans that places them in default if the auditors raise doubts about GM's ability to keep operating. "That was not a condition of the loan. It's not in the agreement," she said.
Ford Will Retire $10.4 Billion of Debt Using Cash, Stock
Ford Motor Co., the only U.S. automaker not surviving on government loans, plans to offer cash and shares to retire as much as $10.4 billion in debt. After ending last year with $25.8 billion in debt, Ford is seeking to reduce its liabilities in three transactions. The plans includes a cash-and-stock proposal where Ford offers a cash premium to induce holders of $4.9 billion in convertible bonds to trade for Ford common shares, according to a regulatory filing today. Two other transactions involve Ford Credit. Standard & Poor’s lowered Ford’s rating to CC, from CCC+. Ford shares fell 16 cents, or 8.6 percent, to $1.71 at 6:42 p.m. after the close of regular New York Stock Exchange trading. Earlier, the shares gained 6 cents to $1.87. The plan was announced in a filing about 4:30 p.m.
"Ford seems to be in better shape than GM but nevertheless it’s tough out there," said Andrew Feltus, who oversees about $8 billion in high-yield debt at Pioneer Investment Management Co. in Boston. He doesn’t own any Ford bonds. "It’s a tough industry. Ford’s a better company than GM, but if you’re even Mercedes it’s tough making cars right now." Ford Credit is offering to spend $1.3 billion buying back Ford Motor notes for as little as 30 cents on the dollar, according to the filing. Ford Credit is also offering to spend $500 million buying back Ford Motor’s term loans due in 2013 through a so-called Dutch auction. The company will accept bids in a range of 38 cents to 47 cents on the dollar. About $6.9 billion of the loan is outstanding and it was quoted at 31 cents on the dollar before the offer, according to London-based pricing service Markit.
Ford said the debt restructuring may allow it to use stock for as much as 50 percent of its cash-payment obligations to a union-run trust known as a voluntary employee beneficiary association, or VEBA. Dearborn, Michigan-based Ford and the United Auto Workers agreed in 2007 that such a trust would assume responsibility for retiree health care starting in 2010. The automaker and the UAW recently reached another accord intended to reduce Ford’s labor costs. Ford’s 7.375 percent notes due 2011 gained 4.5 cents on the dollar to 62 cents, to yield 37 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Traders of credit-default swaps are demanding a mid-price of 84 percent upfront, in addition to 5 percent a year, to protect against a Ford default for five years, according to CMA DataVision. The price, unchanged from yesterday, means it would cost $8.4 million initially and $500,000 annually to protect $10 million of Ford debt for five years. Contracts protecting against a default by Ford Motor Credit are trading at about 45 percent upfront, in addition to 5 percent a year, CMA data show. This means it would cost $4.5 million and then $500,000 annually to protect the motor credit unit debt for five years.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities or the cash equivalent should the company fail to adhere to its debt agreements. Ford’s 4.25 percent convertible note due in December 2036 traded at 20 cents on the dollar as of 3:53 p.m. in New York, unchanged from yesterday, according to Trace. "This is an enormously leveraged company, so if you reduce the debt, you reduce the company’s risk profile," said auto analyst John Casesa of Casesa Shapiro Group in New York. "The company faces tremendous operating risk so reducing the financial risk is welcome."
Fitch maintained its CCC rating on Ford’s debt and said the transactions would be a "mild positive" if executed. Ford borrowed $23.4 billion in late 2006, a move that gave it more cash than struggling competitors General Motors Corp. and Chrysler LLC, both of which received U.S. loans late last year. To secure the 2006 financing, Ford had to put up all its major assets, such as its headquarters and Ford blue oval logo, as collateral. The company’s $14.6 billion loss in 2008 was the worst in its history, exceeding a $12.6 billion loss in 2006. The automaker said it had total liquidity of $24 billion at the end of 2008.
No Bailout For You
The Obama administration released more details Wednesday on its $275 billion foreclosure prevention plan. The administration hopes 9 million homeowners will have the opportunity to refinance or modify their mortgages, helping to dam the flood of foreclosures currently drowning real estate markets But there are 112 million households in the U.S. What about the other 103 million? For most of those people, the modification plan has only indirect benefits: fewer foreclosures in their towns and, if all goes well, stabilizing housing markets. Those are hardly trivial benefits, but some taxpayers might feel sore about footing the bill for everybody else. A look at who's left out:
Jumbo mortgage holders: Anyone with a mortgage on a single-family residence over $729,750 is ineligible for modification. In most parts of the country, $729,750 will buy you a huge house, but back in 2007 it was the median home price in places like San Francisco and San Jose, Calif.
Investors and speculators: Remember when it seemed like a great idea to buy and flip as many homes as possible? Oops. The foreclosure prevention programs are only for owner-occupied homes, as verified by a tax return, credit report and other documentation such as a utility bill. Some people were, no doubt, essentially speculating on their primary residence, hoping to flip the home they lived in. These people would be eligible for these programs. People who bought multiple-unit condos and currently live in one of the units are eligible too. But by and large, investors, speculators and vacationers will be unable to come up with documentation proving the home is owner-occupied.
People who can't document their income: Borrowers who took out so-called "liar loans" are going to have trouble fibbing their way through this round of underwriting. The government is requiring servicers to run a credit check and verify income before modifying loans. This means that a dog walker who bought a McMansion during the bubble will have a much harder time proving he or she can afford a discounted mortgage now.
Renters: Obviously, a mortgage modification plan wouldn't help people without mortgages. Still, the more than 37 million households in the U.S. that rent (some of whom were priced out of owning a home during the bubble) can't be too happy about subsidizing belly-up borrowers. Renters looking to own their own homes have a particularly difficult pill to swallow: The plan is aimed at stopping home prices from correcting to affordable levels, pricing out many would-be buyers. Obama's stimulus plan does, however, have an $8,000 first-time home buyer tax credit. But imagine the plight of renters who live in a four-unit condo they share with their landlord. The landlord is eligible for a modification (for four-unit properties, the cap is $1.4 million), potentially saving thousands a month, but he's under no obligation to reduce the rent for his tenants.
Recent borrowers without Fannie Mae and Freddie Mac loans: The biggest part of the government's plan allows people with Fannie Mae or Freddie Mac mortgages to refinance to a better rate, even if their mortgage is as much as 5% underwater--for example, if you owed $105,000 but your house was only worth $100,000. Under the old rules, a homeowner needed 20% equity to refinance. Thus, many recent buyers who have seen their homes lose value have been unable to refinance at today's low rates. The government is quick to point out that this program is for responsible home buyers who haven't missed payments. OK, but what about responsible buyers who haven't missed payments but have little or slightly negative home equity and just happen not to have a Fannie or Freddie loan? Tough luck.
Holders of older mortgages: If you bought your house years ago and have been quietly paying your mortgage on time ever since, there's nothing here for you. Even the government's efforts to keep mortgage rates low are possibly of little benefit to these homeowners, many of whom refinanced into similarly low rates in 2003 and 2004. People with great credit scores who already have a large stake of equity in their homes can refinance under conventional programs.
Second-mortgage holders:Many borrowers might still be in trouble if they took out second mortgages (they were usually called home equity loans at the time--something of a misnomer as most of that equity from the boom years is gone now). But there's no modification plan for people in trouble on second mortgages unless they're also eligible for modification with their first mortgage. For second-mortgage holders also in trouble on their first mortgage, the Treasury says it will eventually unveil some incentives to extinguish that second mortgage.
Obama Mortgage Plan Lacks Safe Harbor Against Investor Suits
The success of the Obama administration's plan to cut mortgage payments for millions of at-risk homeowners hinges on congressional action to shield mortgage servicers against lawsuits from investors, a top mortgage industry official said. The plan, which the administration kicked off Wednesday, is heavy on incentives for mortgage servicers and borrowers, but provides no protection for servicers against lawsuits from mortgage investors who might become angry about the modifications.
Roughly 60% of seriously delinquent U.S. mortgage loans are concentrated in " private label" mortgage-backed securities, or MBS, which are not issued by Fannie Mae and Freddie Mac. Such mortgages "probably won't be modified until there's a safe harbor," David G. Kittle, the chairman of the Mortgage Bankers Association, said. "The incentives are not enough to protect anyone from a lawsuit." Under the program, the government would pay mortgage servicers a $1,000 one- time fee to reduce borrowers' mortgage payments to 38% of their income for five years. The government would then match the cost of further interest rate reductions or other measures intended to bring mortgage payments down to 31% of borrowers' income.
The government would make generous annual payments to servicers and borrowers if the loan stays current. The only incentive for mortgage investors is a $1,500 payment for modifying loans that are not yet delinquent. The program does nothing to address what has been one of the biggest impediments to loan modifications during the housing crisis - the misalignment of the interests of mortgage servicers and mortgage investors in private-label securities. Companies servicing pools of mortgages packaged as private-label securities are bound by contracts with investors in the securities. The contracts vary, but typically require servicers to act in the best interest of the investors. That is often not a simple calculation. For example, a loss modification action by a servicer could potentially benefit some investors of the pool at the expense of others.
Mortgage investors have mounted lawsuits against servicers who have performed loan modifications they deemed against their interest. Under the administration's program, participating mortgage servicers are required to "use reasonable efforts" to waive the contracts where they bar modification. However, the program does not override the contracts. The administration, which estimates its program could help as many as 3-4 million people obtain more affordable mortgage payments, supports legislation pending in the U.S. House that would give mortgage servicers a safe harbor against investor lawsuits. "We would expect the legislation process to continue, " a senior White House official told reporters during a background briefing Wednesday.
Some housing experts said the program is likely to reach its targets despite the lack of a safe harbor because the payments to servicers are so generous they will tip the scales in favor of modifying a loan. "They need the servicers to cooperate. They've sweetened the pot enough that that's going to happen to a large degree," National Community Reinvestment Coalition President John Taylor said. He called the lawsuit issue an " exaggerated problem." Thomas Lawler, a housing economist from Leesburg, Va., said the incentives would spur mortgage servicers to modify loans by giving them the funds to staff up. Servicers haven't been aggressive "because they haven't been adequately staffed and they haven't been incentivized to do so" in a tanking housing market, he argued.
A feature of the program that would institute a "net present value" test could also help spur more loan modifications by giving mortgage servicers some cover from investors, Taylor said. Participating servicers must run all loans that are at least 60 days delinquent or deemed at risk of imminent default through the test. They are required to modify loans where the net present value of the cash flows under a modification scenario exceed the net present value of the cash flows in the absence of modification. The mortgage industry offered praise for the plan. Officials have exhorted borrowers to be patient with lenders as they cope with an expected deluge of modification requests. "The plan appropriately balances the interest of homeowners, mortgage servicers and investors," Jamie Dimon, chief executive of JPMorgan Chase & Co., one of the largest servicers, said in a statement.
The Poseidon Mortgage Adventure
As housing prices slide, one in five Americans find their home loans under water, with more likely to take a bath. There seems to be a long road between here and a healthy American housing market. According to a study by First American CoreLogic released Wednesday, one in five homeowners with mortgages owe more to their lenders than their homes are worth. Compounding the problem, is that that rate will increase as housing prices drop in states that have so far avoided the worst of the crisis. About 8.31 million properties had negative equity at the end of the year, up 9.0% from 7.63 million at the end of September. The percentage of these underwater borrowers rose to 20.0% from 18.0% over that time. There are currently 60.0 million homeowners in the United States, putting the total percentage of underwater homes at 13.9%.
The study covered 43 U.S. states and the District of Columbia. Seven states -- Maine, Mississippi, North and South Dakota, Vermont, Wisconsin and Wyoming -- were left out because they lagged in reporting data. States such as California, Florida and Nevada were particularly stressed. Along with Arizona, Georgia, Michigan, and Ohio they accounted for 62.0% of underwater borrowers but just 41.0% of mortgages. Other areas, however, are deteriorating. Connecticut, for example, saw a 25.0% increase in homes with negative equity, while the District of Columbia had a 44.0% rise.
New York fared best, with just 4.7% of borrowers with negative equity and an average 48.0% loan-to-value ratio. This, however, couild change as employment and bonuses slide in the financial-services industry. In related news, applications for loans to buy U.S. homes and to refinance existing mortgages fell for the second straight week, the Mortgage Bankers Association said. The news comes on the heels of President Barack Obama's $275.0 billion program to reduce mortgage rates and stem the foreclosures that have dragged home prices down nearly 27.0% from their mid-2006 peak. Some are questioning whether Obama's plan will work.
The Mortgage Bankers Association's seasonally adjusted mortgage applications index, comprising purchase and refinance loans, fell 12.6%, to 649.7 last week. That was about half the level posted early this year, when average 30-year mortgage rates fell as low as 4.89%, according to the trade group. Mortgage rates rose to 5.14% last week from 5.07%. On Tuesday, data on the secondary market for U.S. homes showed conditions were far worse than had been expected, with sales sliding in January. One ray of light: luxury homebuilder Toll Brothers indicated in its first-quarter earnings report that home prices could be near a bottom.
U.S. Sets Big Incentives to Head Off Foreclosures
The Obama administration on Wednesday began the most ambitious effort since the 1930s to help troubled homeowners, offering lenders and borrowers big incentives and subsidies to try to stem the wave of foreclosures. People with mortgages as high as $729,750 could qualify for help, and there is no ceiling on how high their income can be as long as they are in danger of losing their homes. Interest rates on loans could go as low as 2 percent for some. Many homeowners could see their mortgage payments drop by several hundred dollars a month, and some could save more than $1,000 a month.
Administration officials estimate that the plan will help as many as four million people avoid foreclosure, at a cost to taxpayers of about $75 billion. In addition, the Treasury Department said it intended to follow up with a plan to help troubled borrowers with second mortgages, which many homebuyers used as "piggyback" loans to buy houses with no money down. The plan is bolder and more expensive than any of the Bush administration’s programs, which were based almost entirely on coaxing lenders to voluntarily modify loans. While the number of loan modifications has climbed sharply, the number of foreclosures skyrocketed to 2.2 million at the end of 2008, a record.
The new plan, which takes effect immediately, is intended to win much bigger concessions from lenders by offering a mix of generous financial incentives and regulatory arm-twisting. The final impact will depend on how both lenders and the investors who own mortgages respond, but housing experts said the administration had a good chance of achieving its goal. The eagerness with which lenders agree to modify loans is likely to be affected by a bill that the House is expected to take up on Thursday. It would give bankruptcy judges the power to order changes in mortgages on primary residences and would protect loan-servicing companies from lawsuits by investors.
Several of the nation’s biggest mortgage-servicing companies, overseeing two-thirds of all home loans in the country — Citigroup, JPMorgan Chase, Bank of America and Wells Fargo are expected to participate in the plan. In addition, any bank that receives additional federal money under the Treasury Department’s $700 billion financial rescue program will be required to take part. But many lenders are expected to participate voluntarily, because the government would be absorbing much of the cost of resolving their bad loans. "I predict this program will be extremely effective at reducing foreclosures," said Eric Stein, senior vice president at the Center for Responsible Lending, a nonprofit advocacy group for homeowners.
Administration officials have similar expectations. "It is imperative that we continue to move with speed to help make housing more affordable and help arrest the damaging spiral in our housing markets," said Timothy F. Geithner, the Treasury secretary. In releasing detailed guidelines on the plan, first unveiled Feb. 17, the Treasury Department made it clear that the program would not help every homeowner in trouble. It will do little to help families whose income has evaporated because one or more breadwinners have lost their jobs, nor will it save those swamped by big debts beyond their mortgages. It will not do much for homeowners who are current on their loans but "upside down" — owing more than their houses are worth.
Still, the program, when combined with a separate effort to help homeowners refinance their loans even if they are not in distress, could help put a floor under home prices. The Treasury has instructed Fannie Mae and Freddie Mac, the two government-controlled mortgage-finance companies, to refinance homeowners at today’s low market rates even if the owners have less than the standard 20 percent equity that is usually required. This second program applies to about 30 million people with mortgages owned or guaranteed by Fannie or Freddie, but will not be available to people whose mortgages are much higher than their home’s market value.
Administration officials said it could lower monthly payments for as many as five million homeowners. To finance that effort, the Treasury is providing the two companies with up to $200 billion in additional capital, on top of $200 billion that it had already pledged to them. Under the new loan modification guidelines, the Treasury will offer mortgage-servicing companies upfront incentive payments of $1,000 for every loan they modify and additional payments of $1,000 a year for the first three years if the borrower remains current. The Treasury will also chip in $1,000 a year to directly reduce the borrower’s loan amount, if the borrower stays up to date on payments.
But the biggest subsidies are in reducing the size of a person’s monthly payment. If the lender reduced the borrower’s monthly housing payment to 38 percent of the household’s gross monthly income, the Treasury Department would match, dollar for dollar, the lender’s cost in reducing payments down to 31 percent of monthly household income. The program calls on lenders first to reduce interest rates to as low at 2 percent for the next five years to hit the monthly income target. After five years, some borrowers would start to pay gradually higher rates, but their rates could not exceed the market rate at the time they renegotiated. That would be a favorable deal for many people. At the moment, the market rate for such loans is just over 5 percent — very low by historical standards.
The key to determining whether a person receives help will be a so-called net present value calculation by the mortgage company. In essence, a lender will first have to calculate how much it would cost to reduce a person’s monthly payments to an "affordable" range, 31 to 38 percent of the borrower’s monthly income. If the calculation shows that the lender’s cost in modifying the loan, after receiving the taxpayer subsidy, would be lower than the cost of foreclosing, the lender would be required to offer a borrower the new deal. If the estimated cost of the concessions appeared to be higher than the cost of foreclosure, the decision would be voluntary. Housing experts have estimated that lenders lose about half the outstanding loan amount if they pursue foreclosure, and those losses are climbing because the resale value of houses continues to fall. As a result, the program could indeed lead to millions of loan modifications.
Borrowers cannot be charged any modification fees, the Treasury Department said. Lenders will have to bear the administrative expense of reviewing the loans and making their cost estimates. Treasury officials said they were trying to warn consumers against fraud artists and consultants who are seeking to collect fees for helping homeowners negotiate with lenders. There is no ceiling on how much a person can earn and still qualify for help, but the size of the mortgage to be modified cannot be higher than $729,750 for a single-family home, or $1.4 million for the mortgage on a four-unit condominium or cooperative. The program is open only to borrowers who live in the homes at issue, and not to investors or people with mortgages on second or third homes. It is open to people who obtained a mortgage before Jan. 1, 2009. Borrowers can apply for loan modifications until the end of 2012.
Jon Stewart kills off CNBC and all their idiot pundits
Default-Swap Clearinghouse Proposal Wins Fed Approval
The Federal Reserve Board approved Intercontinental Exchange Inc. proposal to clear trades in the $27 trillion credit-default swap market. Atlanta-based Intercontinental still needs the Securities and Exchange Commission to sign off on its plan. Intercontinental spokeswoman Sarah Stashak declined to comment on when the company may receive SEC approval. The Intercontinental plan has the backing of eight major dealers including JPMorgan Chase & Co. and UBS AG. It will compete with plans by four other clearinghouse owners in the U.S. and Europe. Regulators on both sides of the Atlantic are driving separate plans to stabilize the market after American International Group Inc., once the world’s largest insurer, almost went bankrupt last year from its use of credit-default swaps. The unregulated, privately traded contracts stymied government efforts to assess bank credit risk because the full range of trades between dealers was unknown.
"For the Fed it’s a great step," said Mark Williams, a finance professor at Boston University. "It’s another brick to rebuild credibility in the credit markets so we don’t have a future AIG." North American indexes on credit-default swaps will be the first to be cleared by Intercontinental, the company said in a statement today. Intercontinental will compete with similar proposals to guarantee credit-default swaps by CME Group Inc., NYSE Euronext, Eurex AG and LCH.Clearnet Ltd. Credit-default swaps are derivatives used to hedge against losses or to speculate on the ability of companies to repay their debt. Members of the Intercontinental clearinghouse such as banks will have to have a net worth of at least $5 billion and a credit rating of A or better to clear their credit-default swap trades, the Federal Reserve said in its approval. Each clearing member will have to contribute at least $20 million to the clearinghouse’s guarantee fund, which is used in case of a trader default.
Intercontinental Chief Executive Officer Jeff Sprecher has said he eventually wants the guarantee fund to be in the range of $1 billion. A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of a counterparty defaulting on a transaction. In the over-the-counter market, where credit-default swaps are currently traded, participants are exposed to each other in case of a default. A clearinghouse also provides one location for regulators to view positions and prices. The Federal Reserve decision comes a day after the Federal Trade Commission and the Justice Department granted approval to Intercontinental to buy the Clearing Corp., a Chicago-based clearinghouse owned by eight major dealers in the credit-default swap market. That deal gives Intercontinental the support of the largest users of the credit-default swap market.
Intercontinental said in its statement today that it expects to close the Clearing Corp. purchase within a week. The regulatory efforts to guarantee credit-default swaps with a clearinghouse may be hampered by a shrinking market and a limited number of participants, according to Stanford University finance professor Darrell Duffie. The comparable size of the credit-default swap market to other over-the-counter derivatives is too small to justify separating the contracts from the bilateral market for clearing, Duffie wrote in a Feb. 19 research paper with graduate student Haoxiang Zhu. Also, having more than one clearinghouse for credit-default swaps would reduce the netting benefits, Duffie said in an interview yesterday. "Two is worse than one, three is worse than two and so on," he said.
Credit default swaps and amplified losses
by Satyajit Das
At the quantum level, the laws of classical physics alter in intriguing ways. At the derivative level, the rules of finance also operate differently.
In October 2008, Alan Greenspan, acknowledged he was “partially” wrong to oppose regulation of CDS. “Credit default swaps, I think, have serious problems associated with them,” he admitted to a Congressional hearing. CDS contracts on Freddie Mac and Fannie Mae were “technically” triggered as a result of the conservatorship necessitating settlement of around $500bn in CDS contracts with losses totalling $25bn-$40bn. Government actions were specifically designed to allow the companies to continue to fully honour their obligations. The triggering of these contracts poses questions on the effectiveness of CDS contracts in transferring risk of default.
Practical restrictions on settling CDS contracts has forced the use of “protocols” – where the seller makes a payment to the buyer of protection to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through an “auction” system. For Freddie and Fannie, the auction prices resulted in the following settlements by sellers of protection: Fannie – about 8.49 per cent for senior debt and 0.01 per cent for subordinated debt. Freddie – about 6 per cent for senior debt and 2 per cent for subordinated debt. Subordinated debt ranks behind senior debt and is expected to suffer larger losses in bankruptcy. The lower pay-out on subordinated debt probably resulted from subordinated protection buyers suffering in a short squeeze, resulting in their contracts expiring virtually worthless. Differences in the pay-outs are also puzzling given that they are both under identical “conservatorship” arrangements.
In other CDS settlements in 2008 and 2009, the pay-outs required from sellers of protection have been highly variable and large relative to historical default loss statistics. This is driven by technical issues related to the CDS market. The auction settlement of Lyondell (around 80-85 per cent) reflected complications from the role of debtor in possession financing and complex collateral allocation mechanisms. Skewed pay-outs do not assist confidence in CDS contracts as a mechanism for hedging. The large pay-outs are placing a material pressure on the price of existing bonds and loans exacerbating broader credit problems.
Low overall net settlement amounts may also be misleading. In practice, there is the “real” settlement where genuine hedgers and investors deliver bonds under the physical settlement rules and the “auction” where dealers who have both bought and sold protection and have small net positions settled via the auction. In the case of Lehman, the net settlement figure of $6bn that was quoted refers to the auction. Some banks and investors that had sold protection on Lehmans did not participate in the auction choosing to take delivery of defaulted Lehman debt resulting in losses of almost the entire face value. CDS contracts can amplify losses in credit markets.
Lehman Brothers defaulted with around $600bn in debt implying a maximum loss to creditors of that amount. In addition, according to market estimates, there were CDS contracts of around $400bn-$500bn where Lehmans was the reference entity. Market estimates suggest only about $150bn of the CDS contracts were hedges. The remaining $250bn-$350bn of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200bn-$300bn) are additional to the $600bn. The CDS contracts amplified the losses as a result of the bankruptcy of Lehmans by up to 50 per cent.
Ludwig von Mises, the Austrian economist, said: “It may be expedient for a man to heat the stove with his furniture; but he should not delude himself by believing that he has discovered a wonderful new method of heating.” As the global economy slows and the risk of corporate default increases, the identified issues are likely to complicate the problems of credit markets and banks generally. Most worryingly, recent proposals to regulate CDS markets show limited awareness of these issues.
US Lawmakers Clash With Fed Over Strategy On AIG Rescue
U.S. lawmakers questioned the strategy behind the government's rescue of embattled insurer American International Group Inc. (AIG) on Thursday, even as the Federal Reserve said the company was so big and interconnected they couldn't - and still can't - allow the company to fail. "It's not clear who we're rescuing - whether it is whatever remains of AIG or its trading partners," U.S. Sen. Christopher Dodd, D-Conn. said. "AIG's trading partners were not 'innocent victims' here - they were sophisticated investors who took enormous, irresponsible risks." Dodd, who chairs the Senate Banking Committee, was echoed by the panel's ranking Republican, U.S. Sen. Richard Shelby of Alabama. He called the September collapse of AIG the "greatest corporate failure in American history" and described the recent history of the company a "very disturbing story of malfeasance, incompetence and greed."
There has been increasing unrest on Capitol Hill about the Fed and U.S. Treasury Department's move earlier this week to once again rework the government's bailout of AIG and give $30 billion of additional capital to the company. As voiced by Dodd, there is a growing concern that AIG is being propped up to protect the counterparties on billions of dollars of credit default swaps and derivatives where investors should expect to take some losses. "It's reasonable to ask why holders, who would have received only pennies on the dollar for their credit default swaps absent any government intervention, would expect or deserve payments for what essentially is a bankrupt company," Dodd asked.
Federal Reserve Vice Chairman Donald Kohn, repeating the frequent argument heard from Treasury and Fed officials explaining their actions, on Thursday said a "disorderly" collapse of the firm would have disastrous economic effects. "The failure of AIG would impose unnecessary and burdensome losses on many individuals, households and businesses, disrupt financial markets, and greatly increase fear and uncertainty about the viability of our financial institutions, " Kohn told the Senate Banking Committee. He said AIG's Financial Products division, the source of much of the company's problems, still has a "very large notional amount" of derivatives contracts that touch a variety of counterparties throughout the financial system. For that reason, Kohn said, "we believe we had no choice if we are to pursue our responsibility for protecting financial stability.
Kohn was joined at the hearing by, Scott Polakoff, acting director of the Office of Thrift Supervision, and New York Insurance Superintendent Eric Dinallo. All three cited obvious problems at AIG's financial products division as responsible for the company's collapse last September. They painted a picture of a division facing too little oversight as it used AIG's financial strength ratings to build an increasingly complex and financially dangerous credit- default swaps business. "Financial Products did not adequately protect itself against the effects of a declining economy or the loss of the highest ratings from the credit rating agencies," Kohn said. The Office of Thrift Supervision was able to partially regulate AIG after the company applied to start a federal savings bank in 1999. Though the OTS did bring a variety of issues to the attention of AIG's board, Polakoff acknowledged the agency didn't foresee the "profound systemic impact" credit-default swap products caused within the broader insurance company.
"Where the OTS fell short, as did others, was in the failure to recognize in time the extent of the liquidity risk to AIG of the 'super senior' credit default swaps," he said. If regulators had recognized the risk, he said, they could have forced AIG to reduce its exposure to the complex financial instruments, as well as require the company to stop originating new credit default swaps before the end of 2005. "In hindsight, we focused too narrowly on the perceived creditworthiness of the underlying securities and did not sufficiently assess the susceptibility of highly illiquid, complex instruments to downgrades in the ratings of the company or the underlying securities," Polakoff said. And even though the U.S. government, through Fed lending facilities and the Treasury's $700 billion financial rescue plan, has committed trillions to try to stabilize the financial system, Kohn said the existing uncertainty has made it impossible for AIG to complete an effort to sell off parts of its business.
"These extreme financial and economic conditions have greatly complicated the plans for divestiture of significant parts of the company in order to repay the U.S. government for its previous support," he said. Dinallo, whose office has come under fire from some congressional quarters for not regulating AIG appropriately, fired back in his testimony, stressing that the New York Insurance Department "is not and never has been" the primary regulator for AIG. Instead, he said, his office only oversees the individual insurance companies domiciled in New York, which includes some of AIG's numerous insurance subsidiaries but didn't include the Financial Products division.
"The crisis for AIG did not come from its state regulated insurance companies, " Dinallo said, adding the insurance subsidiaries "were not the purchasers of AIG's toxic credit default swaps." Looking ahead, Polakoff said federal and state policy makers need a better understanding of the credit-default swaps market, which he said needs more consistent terms and conditions, as well as more market participants. "Congress should consider legislation to bring CDS under regulatory oversight, " he said.
Bair Says FDIC Insurance Fund Could Be Insolvent This Year
Federal Deposit Insurance Corp. Chairman Sheila Bair said the fund it uses to protect customer deposits at U.S. banks could dry up amid a surge in bank failures, as she responded to an industry outcry against new fees approved by the agency. "Without these assessments, the deposit insurance fund could become insolvent this year," Bair wrote in a March 2 letter to the industry. U.S. community banks plan to flood the FDIC with about 5,000 letters in protest of the fees, according to a trade group. "A large number" of bank failures may occur through 2010 because of "rapidly deteriorating economic conditions," Bair said in the letter. "Without substantial amounts of additional assessment revenue in the near future, current projections indicate that the fund balance will approach zero or even become negative."
The FDIC last week approved a one-time "emergency" fee and other assessment increases on the industry to rebuild a fund to repay customers for deposits of as much as $250,000 when a bank fails. The fees, opposed by the industry, may generate $27 billion this year after the fund fell to $18.9 billion in the fourth quarter from $34.6 billion in the previous period, the FDIC said. The fund, which lost $33.5 billion in 2008, was drained by 25 bank failures last year. Sixteen banks have failed so far this year, further straining the fund. Smaller banks are outraged over the one-time fee, which could wipe out 50 percent to 100 percent of a bank’s 2009 earnings, Camden Fine, president of the Independent Community Bankers of America, said yesterday in a telephone interview.
"I’ve never seen emotions like this," said Fine, adding that he’s received more than 1,000 e-mails and telephone messages from angry bankers. "The FDIC realizes that these assessments are a significant expense, particularly during a financial crisis and recession when bank earnings are under pressure," Bair wrote. "We did not want to impose large assessments when the industry and economy are struggling. We searched for alternatives but found none better." The agency, which has released the change for 30 days of public comment, could modify the assessment to shift the burden to the large banks "that caused this train wreck," Fine said. "Community bankers are feeling like they are paying for the incompetence and greed of Wall Street," he said.
Bair dismissed that suggestion. "For risk-based assessments, our statute restricts us from discriminating against an institution because of size," Bair wrote. The deposit insurance fund won’t dry up because the government can get funds from the industry and congressional appropriations, and borrow from the Treasury, Chip MacDonald, a partner specializing in financial services at law firm Jones Day, said today in a telephone interview. "As a depositor, I am not worried in the least," MacDonald said. "No one is going to let the FDIC go without any money." Consumers should watch this issue closely, said Edmund Mierzwinski, consumer program director at U.S. PIRG, a Boston- based consumer-watchdog group.
"I wouldn’t take their money out of the bank yet," Mierzwinski said. "If the FDIC is saying that there is this serious problem, then we should all be concerned. I think there is a chance the FDIC is going to have to ask taxpayers for money in the future." Bair rejected arguments that the agency should use government aid to rebuild the fund. The FDIC has authority to tap a $30 billion line of credit at the Treasury Department and legislation pending in Congress would boost the amount to $100 billion. "Banks, not taxpayers, are expected to fund the system," Bair said. Asking for taxpayer support "could paint all banks with the ‘bailout’ brush." The FDIC "will revise the interim rule, if appropriate, in light of the comments received," the agency said in a Federal Register notice.
Cuomo Said to Subpoena Seven Merrill Executives
New York Attorney General Andrew Cuomo subpoenaed seven people who received bonuses at Merrill Lynch & Co., said a person familiar with the matter. Cuomo is probing $3.6 billion in bonuses given Merrill employees just before the firm merged with Bank of America Corp. on Jan. 1. Former Merrill Chief Executive Officer John Thain and Bank of America CEO Kenneth D. Lewis previously testified in Cuomo’s office about the bonuses. The seven executives will be asked questions about their individual bonuses, their communications with Thain and the timing of the bonuses, the person said. The person said the seven bonus recipients who were subpoenaed were Andrea Orcel, David Sobotka, Peter Kraus, Thomas Montag, David Gu, David Goodman and Fares Noujaim.
The Man Who Destroyed GE
As GE's stock struggles to hold
$7$6, a level at which it is still arguably expensive (17X cash flow), shareholders are calling for CEO Jeff Immelt's head. And it's true: Jeff has had 7 years to reduce GE's dependence on the business that is sinking the ship--GE Capital--and he has chosen not to do so. Until last fall. When it was too late. But let's not forget who built GE Capital in the first place: GE's legendary CEO, Jack Welch.
True, Jack Welch left the company eight years ago, but his legend--and legacy--live on. Thanks to Jack, Jeff inherited a company that was highly dependent on a financing business, one that already carried more than $300 billion in debt (The total is now more than $500 billion). It was in no small part this debt load that allowed Jack Welch to post his legendary (and eerily consistent) earnings numbers over his 20 years at GE's helm. It is also this debt load that is crushing GE shareholders today.
GE's round-trip from $7 to $40+ to $7 has now eliminated much of GE's stock appreciation during the legendary Welch's reign. If GE were valued at a more reasonable multiple of free cash flow (say 10X), all of the stock's appreciation during Welch's tenure would be wiped out (and then some). So as GE shareholders gaze in disbelief at the stock's shriveled remains, they should direct at least some of their frustration at the man who transformed GE from an industrial company to a bank in the first place.
GE Treated Like a 'Leper' as Investors Punish Shares
General Electric Co. investors are treating the company as though it’s on the verge of failing ahead of a potential cut in its top-level AAA rating.
"It’s a leper right now," said Marilyn Cohen, president of Envision Capital Management Inc. in Los Angeles, who oversees $180 million in fixed-income assets and no longer owns GE bonds. Bankruptcy "seems improbable, but we’ve seen improbable things happen," Cohen said. GE, which just posted its third-highest annual profit ever, has lost about $264 billion in market value in 12 months. Yesterday it fell a fourth straight day to the lowest closing price since November 1992, feeding a surge in options volume and credit-default swaps. Investors are punishing the shares on a presumption, which the company disputes, that GE Capital will need more outside funding to cover potential writedowns and losses in real estate, consumer credit cards and leasing.
The run underscores how stock investors may have lost confidence in companies with finance operations -- even those like GE that own industrial businesses, still predict a profit, and operate with some degree of backing from the U.S. government. While federal commercial paper liquidity backstops and debt guarantees since October have prevented the type of creditor panics that sank Bear Stearns Cos. and Lehman Brothers Holdings Inc., a former Federal Reserve official says the programs haven’t made a convincing case for stock investors. "Creditors are being bailed out everywhere but equity owners are not," said William Poole, president of the St. Louis Federal Reserve Bank until March 2008. "What that does is create cascading weakness because you can’t raise any equity capital." GE fell 2 cents to $6.67 at 8:10 a.m., before the regular open of New York Stock Exchange composite trading, and has dropped 80 percent in a year.
The stock decline doesn’t represent the true value of the company or the finance arm, which will be profitable again this quarter, Chief Financial Officer Keith Sherin said today. "I think it’s overdone," Sherin, 50, said in an interview on the company-owned CNBC television network. "I don’t see a need to put additional capital into GE Capital." Investors unwilling to be calmed by the federal guarantees so far haven’t taken much comfort from managers. Chief Executive Officer Jeffrey Immelt, Vice Chairman Michael Neal and other directors bought stock as a show of faith this week. Immelt bought 50,000 shares and Neal, who also oversees GE Capital as its chief executive, bought 125,000 two days. Each day the stock closed lower. "Our company’s reputation was tarnished because we weren’t the ‘safe and reliable’ growth company that is our aspiration," Immelt, 53, said in his yearly letter to shareholders dated Feb. 6. "I accept responsibility for this. But, I think the environment presents an opportunity of a lifetime." GE, the biggest maker of jet engines and power turbines, cut its dividend Feb. 27 for the first time since 1938 to save $9 billion a year. Lowering the dividend was necessary but also "a reputational blow to GE and an income hit to long suffering shareholders," wrote Citigroup Inc. analyst Jeffrey Sprague, who has a "hold" rating on the stock, in a March 1 note to clients.
GE may soon lose the top-level AAA debt ratings it has held for decades. Standard & Poor’s Corp. in December said GE had a 1-in-3 chance of losing its top designation within two years, and S&P kept GE’s "negative" outlook unchanged after the dividend reduction. Moody’s Investors Service put GE on review in January and, after the dividend cut, said it would keep studying GE’s debt for a possible lower rating. While Immelt has said he’s prepared to run GE with less than a AAA, analysts including Richard Hofmann of CreditSights Inc. in London say bondholders are concerned that the company may split off all of GE Capital, sending the unit’s ratings lower and causing them to lose money. GE spokesman Russell Wilkerson repeated yesterday that there are no plans to separate GE Capital, and the company dismissed as "pure speculation" that there is any need to raise outside funding for the finance arm for now. "It’s a spiral happening here both on the stock and credit side that could spur more dramatic strategic action, and a lot of bondholders are concerned that action could be a spinoff of GE Capital," Hofmann said. "We’ve weighed the pros and cons and think the window has passed for that and it’s unlikely."
The parent company carried GE Capital on its books at about $53 billion at the end of 2008, its annual filing with the U.S. Securities and Exchange Commission shows. GE Capital may be required to post as much as $12 billion if the long-term ratings are reduced four to six levels into the single-A category and short-term ratings fall below A1/P-1, Hofmann estimates based on GE’s filings. Nicholas Heymann, an analyst with Sterne Agee & Leach Inc. in New York, estimated in a note March 3 that GE may need more capital to cover losses of between $21 billion to $54 billion in the next several years. Investors also are worried about the quality of GE Capital’s $637 billion in debt, particularly loans at its real estate division and in slowing economies such as Eastern Europe. GE’s Wilkerson said total financial assets in Eastern and Central Europe are about $26 billion. GE says it’s adequately reserved. The finance arm has assumed $10 billion in credit losses for 2009 and has set aside $7.2 billion in reserves, mostly in consumer finance, as it slows underwriting, the company said Feb. 10.
"GE has taken aggressive steps to strengthen the capital base and liquidity of GE Capital, weather the current economic storm and be well positioned for long-term growth," Wilkerson said. "GE Capital’s loan loss reserves are at historic highs in absolute dollar terms." For stock investors, who are first in line to bear losses on bad credits, the question is how much the finance assets are worth. The recession continues to drag on, making any estimates difficult, so investors assume the worst-case scenario. "The market is increasingly pricing these assets at liquidation values," said Dino Kos, managing director at the New York research firm Portales Partners and a former vice president at the New York Fed. "You can’t have a financial system valued at that price." The equity market has become convinced that GE Capital is under-capitalized, wrote Deutsche Bank analyst Nigel Coe today in a note to investors. GE’s industrial businesses alone are worth $12 a share, wrote Coe, who is based in New York and rates the company a "hold."
The run on GE has continued even as Immelt says he’s improving the balance sheet and shrinking the finance arm to 30 percent of total earnings this year compared with about half in 2007. GE’s profit from continuing operations was $18.1 billion last year as its finance arm made $8.6 billion. The company has projected the unit will have a profit of $5 billion this year, above most analysts’ estimates. After injecting $9.5 billion this quarter, GE will have added $15 billion of capital to the finance unit in the past six months to reduce its debt-to-equity ratio to 6-to-1 net of cash. In total, GE Capital now has $63 billion in equity, $34 billion of tangible equity, and $36 billion of cash, GE said yesterday. That gives GE Capital a 5.3 percent ratio of tangible common equity to assets, it said. GE is included in the Fed’s commercial-paper backstop program, has $70 billion remaining in federal bond-insurance guarantees, and has repeatedly said in presentations that it’s lending more conservatively. The company says it’s funded 71 percent of the $45 billion in long-term debt maturing this year, more than $4 billion of that without the federal insurance. Commercial paper balances have been reduced to $60 billion.
Sellers of GE Capital credit-default swap contracts yesterday demanded 15.5 percent upfront in addition to 5 percent a year as of 4:30 p.m. in New York, according to broker Phoenix Partners Group. That means it would cost $1.5 million initially and $500,000 annually to protect $10 million of the unit’s debt from default. The price fell from a record 20 percent upfront in earlier trading. The recent increase in credit swaps may have been exacerbated because contracts on GE Capital were often loaded up in so-called synthetic collateralized debt obligations that bet on the creditworthiness of companies, Tim Backshall, chief strategist at Credit Derivatives Research LLC, said in a March 2 note to clients. As underlying swaps increase, dealers who sold those deals need to hedge their exposure by buying protection against a sudden default, he said. Concern that GE Capital could be downgraded also may trigger unwinds of the CDOs, he said. The Standard & Poor’s Financials index has dropped about twice as much as the 21 percent decline for the S&P 500 index this year through yesterday. "Investors aren’t willing to give any company the benefit of the doubt," said Joel Conn, who manages $100 million at Lakeshore Capital LLC in Birmingham, Alabama, and doesn’t own GE stock. "It isn’t even trust-but-verify. It is verify all up front, and maybe we will believe you."
Laughable Rating Agencies Still Say GE Is AAA
Things have gotten so bad for GE that the Wall Street Journal is openly contemplating what will happen if GE Capital is bankrupt. GE's stock is now below $7, with the company having shed $300 billion of market cap since the peak. GE's CEO is explaining that the company didn't anticipate a global financial meltdown. And yet our rating agencies, Moody's and Standard & Poors, still rate GE AAA. After the horror of being publicly humiliated in the subprime collapse, you'd think that the rating agencies might want to demonstrate that they do, in fact, do some analysis before giving client companies the ratings they want and expect. Apparently not. (A reader speculates that the rating agencies are actually having their arms twisted by the government in addition to GE on this one, because of all the hell that will break loose if the agencies actually admit what kind of shape GE is in. This sounds far-fetched, but you never know.)
Okay, one more dig at the rating agencies, while we're at it. The truth, of course, is that the rating agencies already have downgraded GE. S&P did so in December, when it put the company on "watch," or whatever it is it calls the "get-the-hell-out-now-before-we-tell-everyone-how-bad-things-are" rating. And Moody's followed in January. These were ratings downgrades. The moment they appeared, GE had, to all reasonable people, lost its AAA rating. But because GE pays the bills, and because the future of civilization apparently rests on a 20-something analyst at S&P continuing to profess that GE is a Rock of Gibraltar, the legal rating hasn't actually been downgraded. And so we continue to hope, pretend, and deny instead of taking our medicine and getting on with recovery.
Fed Refuses to Release Bank Lending Data, Insists on Secrecy
The Federal Reserve Board of Governors receives daily reports on loans to banks and securities firms, the institution said in response to a Freedom of Information Act lawsuit filed by Bloomberg News. The Fed refused yesterday to disclose the names of the borrowers and the loans, alleging that it would cast "a stigma" on recipients of more than $1.9 trillion of emergency credit from U.S. taxpayers and the assets the central bank is accepting as collateral. The bank provides "select members and staff of the Board of Governors with daily and weekly reports" on Primary Dealer Credit Facility borrowing, said Susan E. McLaughlin, a senior vice president in the markets group of the Federal Reserve Bank of New York in a deposition for the Fed. The documents "include the names of the primary dealers that have borrowed from the PDCF, individual loan amounts, composition of securities pledged and rates for specific loans."
The Board of Governors contends that it’s separate from its member banks, including the Federal Reserve Bank of New York which runs the lending programs. Most documents relevant to the Bloomberg suit are at the Federal Reserve Bank of New York, which the Fed contends isn’t subject to FOIA law. The Board of Governors has 231 pages of documents, which it is denying access to under an exemption under trade secrets. "I would assume that information would be shared by the Fed and the New York Fed," said U.S. Representative Scott Garrett, a New Jersey Republican. "At some point, the demand for transparency is paramount to any demand that they have for secrecy." Bloomberg sued Nov. 7 under the U.S. Freedom of Information Act requesting details about the terms of 11 Fed lending programs.
The Bloomberg lawsuit said the collateral lists "are central to understanding and assessing the government’s response to the most cataclysmic financial crisis in America since the Great Depression." The Fed stepped into a rescue role that was the original purpose of the Treasury’s $700 billion Troubled Asset Relief Program. The central bank loans don’t have the oversight safeguards that Congress imposed upon the TARP. Total Fed lending exceeded $2 trillion for the first time Nov. 6 after rising by 138 percent, or $1.23 trillion, in the 12 weeks since Sept. 14, when central bank governors relaxed collateral standards to accept securities that weren’t rated AAA. Fed lending as of Feb. 25 was $1.92 billion.
Bloomberg News, a unit of New York-based Bloomberg LP, on May 21 asked the Fed to provide data on collateral posted from April 4 to May 20. The central bank said June 19 that it needed until July 3 to search documents and determine whether it would make them public. Bloomberg didn’t receive a formal response that would let it file an appeal within the legal time limit. On Oct. 25, Bloomberg filed another request, expanding the range of when the collateral was posted. It sued Nov. 7. In response to Bloomberg’s request, the Fed said the U.S. is facing "an unprecedented crisis" in which "loss in confidence in and between financial institutions can occur with lightning speed and devastating effects."
Fed Chairman Ben S. Bernanke and then Treasury Secretary Henry Paulson said in September they would meet congressional demands for transparency in a $700 billion bailout of the banking system. The Freedom of Information Act obliges federal agencies to make government documents available to the press and public. The Bloomberg lawsuit, filed in New York, doesn’t seek money damages. Banks oppose any release of information because that might signal weakness and spur short-selling or a run by depositors, the Fed argued in its response. "You could make everything a trade secret," said Lucy Dalglish, executive director of the Arlington, Virginia-based Reporters Committee for Freedom of the Press.
S&P Calls for Greater Regulation on Credit Ratings
Standard & Poor’s called for more regulation of credit-rating companies, recommending a global framework that would eliminate potential conflicts of interest, increase transparency and create an industry code of ethics. New rules should ensure ratings are independently derived and unbiased, the methods they use are disclosed and regulators are given the authority to sanction companies if they fail to comply with "appropriate policies," the unit of New York-based McGraw-Hill Cos. said today in a white paper outlining 10 goals for policymakers. Ratings firms including S&P and Moody’s Investors Service, the two biggest, have been blamed by regulators and investors for giving top AAA ratings to structured securities that later defaulted.
In the paper, S&P tries to get ahead of efforts in Congress and Europe to regulate its industry by laying out its own terms. S&P acknowledged assumptions haven’t held up in evaluating structured securities backed by subprime mortgages. "These guys messed up big time," Lawrence White, professor of economics at New York University’s Stern School of Business, said in an interview. "The initial ratings for mortgage-related securities, especially in the 2005, 2006 period, were horribly overly optimistic. And we the general public, we the U.S. economy, we the global economy are paying a big price because of that over-optimism."
Greater regulation will help restore investor confidence in the credit markets and ratings companies as long as the rules are applied consistently worldwide and the analysts remain independent, Rita Bolger, head of global regulatory affairs at S&P, said in an interview. Other goals outlined in the white paper include making public some information that issuers confidentially disclose to credit analysts, encouraging periodic inspections by regulators and requiring formal registration of ratings companies. "We welcome initiatives that enhance ratings quality and improve transparency," said Anthony Mirenda, a Moody’s spokesman in New York. "We remain committed to the dialogue we established with the regulatory community."
The U.S. Securities and Exchange Commission has criticized the ratings companies for conflicts of interest that may have led to excessively high bond ratings and a failure to warn investors about default risks. Financial institutions worldwide have taken almost $1.2 trillion in writedowns and credit losses since the beginning of 2007 as the subprime mortgage market collapsed, weakening the global economy. Most of the 27 European Union member nations have tentatively backed a proposal to regulate S&P, Moody’s and other credit-rating companies, requiring them to register with the authorities within a year, according to the Czech government, which holds the EU’s rotating presidency. EU Financial Services Commissioner Charlie McCreevy proposed the initiative in November as part of the union’s response to the financial crisis. McCreevy blamed the rating companies for underestimating the risks of mortgage-backed securities that touched off broader turmoil in credit markets.
The key problem is the SEC requirement since 1975 that certain funds and financial firms can only invest in debt ranked investment grade by companies considered nationally recognized statistical ratings organizations, which helped give Moody’s and S&P a stranglehold over the industry, White said. Removing that requirement would do more to engender competition than additional regulation, he said. The group’s designation should be revoked for investments in structured products because credit ratings are unreliable in determining the risk of securitized assets, said Janet Tavakoli, founder and president of Chicago-based Tavakoli Structured Finance Inc., which advises banks and hedge funds. "Standard & Poor’s completely dodges addressing this issue" in the white paper, she said in an interview. "They’re kicking sand in the face of investors and regulators."
States Want To Use Infrastructure Bonds To Refinance Old Debt
Last year, Congress authorized states and local governments to issue a new type of taxable muni bonds that would be subsidized by the federal government as long as they were used to finance capital expenditures. The idea behind the program was to encourage new capital spending as part of the government’s effort to stimulate the economy out of the recession. States and local governments, however, want to use a new bond program authorized by Congress to refinance debt used for old programs, according to the industry paper Bond Buyer.
Many states and municipalities continue to have auction rate securities—some $78 billion are outstanding—and now bond attorneys are asking the IRS and the Treasury Department to clarify whether ambiguities in the law will allow them to issue the bonds to refinance old spending rather than pay for new spending.The bond program, called Build America Bonds, allow the state or local government to elect between receiving a cash subsidy from the federal government or have it provide bondholders with a tax credit. Either would essentially make the bond issuance cheaper for state and local governments. The hope was that this would prompt new issues that would fund new projects, which would in turn result in spending, jobs, stimulus.
In a move that is now familiar to anyone paying attention, it seems that the state governments might prefer to use the subsidy to help them pay off old debt rather than borrow and spend on new projects. It’s the photographic negative of banks receiving bailout funds but then electing to use the funds to shore up their balance sheets rather than lend it out. At the heart of both is the fact of too much bad debt that must be addressed before new lending, borrowing or spending will occur. The bailout law was so hastily drafted that it may have left this option open to state and local governments by accident. "Legally there's a good argument that a refunding would be okay if the old bond financed capital expenditures," an attorney who asked not to be identified tells Bond Buyer. "It does not say the capital expenditures must be incurred on a specific date or after a specific date."
Bear Stearns’ Jimmy Cayne’s Profane Tirade Against Treasury’s Geithner
The Wall Street stages of grief go something like this: Anger, bargaining, acceptance, tell-all biography. Deal Journal exclusively brings you two detailed excerpts from House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan, to be published in March, 2009 by Doubleday, a division of Random House, Inc. Cohan brings lively quotes about the tensions surrounding the death of Bear Stearns. Consider, for instance, this rant that Cohan describes from bridge-playing Bear Stearns CEO Jimmy Cayne describing his feelings on Geithner’s decision to sell Bear Stearns: Asked about Geithner’s comments and his decision regarding opening the discount window to Wall Street after Bear had been sold for $2 a share and not earlier, Jimmy Cayne became spitting angry."The audacity of that p—k in front of the American people announcing he was deciding whether or not a firm of this stature and this whatever was good enough to get a loan," he said. "Like he was the determining factor, and it’s like a flea on his back, floating down underneath the Golden Gate Bridge, getting a h–d-on, saying, ‘Raise the bridge.’ This guy thinks he’s got a big d–k. He’s got nothing, except maybe a boyfriend. I’m not a good enemy. I’m a very bad enemy. But certain things really—that bothered me plenty. It’s just that for some clerk to make a decision based on what, your own personal feeling about whether or not they’re a good credit? Who the f–k asked you? You’re not an elected officer. You’re a clerk. Believe me, you’re a clerk. I want to open up on this f—-r, that’s all I can tell you."
The rest of the excerpt is below:
During congressional hearings on April 3 that followed the events of March, just as certainly as little boys on sleds follow a winter snowfall, Bernanke and Geithner further explained their thinking at this crucial moment in the history of American capitalism. "We made the decision to [open the discount window] on Sunday," Bernanke said. "At the time we did it, we didn’t know whether the Bear Stearns deal would be consummated or not, and we wanted to be prepared in case it wasn’t consummated, that we would need to have this facility in order to protect what we imagined would be pressure on the other dealers subsequently to that. Whether opening up earlier would have helped or not is very difficult to say. Perhaps President Geithner can add to this. But Bear Stearns was losing customers and counterparties very quickly. They were downgraded on Friday. And we did lend them money, of course, to keep them [going] into the weekend, but it’s not at all obvious to me that it would have been sufficient to prevent their bankruptcy."
Like Bernanke, Geithner also defended the decision to open the discount window on Sunday evening based upon the events that occurred at Bear Stearns on Friday. "Friday morning we took the exceptional step, with extreme reluctance, with support of the Board of Governors and the Treasury, to structure a way to get them to the weekend, so that we could buy some time to explore whether there was a possible solution that would have them acquired and guaranteed," he said, noting that "the scale of the loss of confidence" in Bear Stearns was extraordinary. "The number of customers and counterparties that sought to withdraw funds" and the "actions by rating agencies" to downgrade Bear’s credit "accelerated that dynamic, despite the access to liquidity and despite the hope that that might buy some time."
Geithner also defended the Fed’s decision not to open the discount window until Sunday night, after Bear could have benefited from it. "The way the Federal Reserve Act is designed, and the way we think about the discount window for banks, is we only allow sound institutions to borrow against collateral in that context," he said. "I can only speak personally for this, but I would have been very uncomfortable lending to Bear, given what we knew at that time." He said that both the opening of the Fed window and the earlier creation of the facility "were exceptionally consequential acts, taken with extreme reluctance and care, because of the substantial consequences it would have for moral hazard in the financial system going forward. And I do not believe it would have been appropriate for us to take that act Sunday night if we had not been faced with the dynamics that were precipitated by, accelerated by, the looming prospect of a Bear default."
In a separate interview a few months later, Geithner again defended his decision not to open the discount window to Bear Stearns. He said he would not have taken that extraordinary step three months earlier, as Schwartz, Dodd, and others had been hoping. "People had been pushing us to do it for a long time," he said. "We consciously chose not to do it, and I think rightly so, because it is a consequential act. You don’t want to do it unless you think there’s no other option available to mitigate the risks of the system."
He reiterated the fact that Bear Stearns was no longer creditworthy on Sunday night. "We don’t lend to banks if we’re not pretty comfortable with their financial position and how prudent they are," he said. "These facilities were not giving the dealers the same protections banks have. My own personal view is it would not have mitigated significantly the risk that Bear faced because they were in a position where they were uniquely vulnerable to the same kind of loss of confidence they faced and we would not have been lending freely to them no matter what. Who knows, you can’t wind back the clock.
"But I don’t have any regrets about not opening the window earlier. In fact, I think it’s kind of unfortunate in some ways we did do it. We’re trying in some ways to let the air out of this thing gradually and mitigate the risk [of] too much damage to the economy. We’re not trying to put a floor under stuff artificially. We can’t protect people from the risks they took in the boom. We just want to protect the economy to some extent from the damage that can come if the air gets let out too traumatically. It’s not our job to come keep the air in there and let people operate at a level of leverage and risk that was true before this thing. So there were a huge number of people that were pushing us from the beginning to put a bigger safety net under everything and we chose consciously not to do that, and I think for good reasons. We want the system to be stronger coming out of this, not weaker. It will be weaker if all we do is give people a whole bunch of comfort that we protect them on the other side. Very hard line to draw, though. This is a pretty wrenching thing."
Geithner said he knew he and Paulson would be criticized no matter what the regulatory decision. "We’re going to get two types of criticism," he continued. "Some people will say, ‘Oh, my God, you guys way overdid it. That wasn’t necessary. You should have let all this damage happen. You gave too much away to the priority of the adverse outcome.’ And a bunch of other people say, ‘If only you had been more aggressive earlier, it would have been terrific.’ But frankly, we’ve been way aggressive on monetary policy and on a bunch of other fronts, and even before this we had a bunch of people saying to us we had overdone it. We’re operating in difficult judgments, fog of war, and so we’re going to be second–guessed by a bunch of people." One early critic was Paul Volcker, the former chairman of the Federal Reserve, who told the Economic Club of New York on April 8, "Sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank." Wall Street executives immediately appreciated the import of the Fed’s decision. "This is a five-vodka event," one said. "Liquidity is no longer an issue."
But, by and large, the Bear Stearns executives were furious. They had been lobbying the Fed for months to take this very action. Just fifteen minutes after the firm had been dispatched, for a pittance, into the waiting arms of JPMorgan, the Fed moved at last. Only the most diplomatic among them, such as Alan Schwartz, were able to convey a professional understanding of how their competitors would benefit at Bear Stearns’s expense, and claim to be okay with it. "One part of me was thrilled they were opening the window," one executive said. "I didn’t want Lehman to be next. The other part was . . . it feels a little raw to say, ‘It’s really complicated, it’s really complicated, oh, okay, done, stroke of the pen.’ But you’re so strung out by then you don’t know how you feel."
The others were simply appalled and were willing to say so. Fred Salerno heard about it from a friend who called him in the airport after the Bear board had signed the deal. "What upset me the most was . . . they opened the window a half hour after they told us we had to sign," Salerno said with some anger. "No excuse for that. . . . I’ll never forget about that. I found out about out all those people? Now, maybe it wouldn’t have made a difference, maybe we’re so far gone that when we really looked at the numbers we had to take the deal anyhow, but they should have told us. I was sick. . . . Not because of me, but because of the fourteen thousand people that got disadvantaged by some political play, in my mind. I’ll never forget that. No excuse. You talk about transparency. You talk about disclosure. You can’t play a game like that, not with people’s lives."
Understaffed Geithner can't keep up, critics say
For five weeks, Treasury Secretary Timothy Geithner has battled the worst economic crisis in generations with no key deputies in place. That's made for a rocky debut for the man President Barack Obama put in charge of addressing the financial crisis. With an awkward first television appearance, a bank rescue plan that lacked promised specifics and two restructured bailouts that raised taxpayer risk, Geithner has failed to calm financial markets desperate for answers. Critics say part of the problem is that Geithner is flying solo: Not one of his top 17 deputies has been named, let alone confirmed. And without senior leadership, lower-level Treasury employees can't make decisions or represent the government in crucial conversations with banks and others.
As Geithner strives to address the financial crisis, advance Obama's agenda and work with foreign leaders to stave off economic disaster, he's assembled a 50-person "shadow cabinet" of would-be appointees. Those people have received hall passes and can advise Geithner, but they lack any authority. "Everyone would think it's a travesty if the Defense Department didn't have a lot of their people in place, because you're in a crisis fighting a couple of wars," said Tony Fratto, who was a Treasury spokesman under President George W. Bush. "But Tim Geithner is fighting wars on a few fronts himself, and he doesn't have the generals there to help him."
Treasury officials contend that Geithner is receiving plenty of good advice, much of it from the 50 advisers already working there. But until Treasury gets some Senate-confirmed leaders, these people can't sign documents or make policy decisions. They can't even sit in their future offices. To be sure, a great deal has happened at Treasury since Geithner assumed his post. The department has rolled out a few details of its much-maligned financial stability program, new programs to aid homeowners and has started assessing the strength of major financial institutions. And one official, Under Secretary for Terrorism and Financial Intelligence Stuart Levey, has been asked to stay on.
The problem, critics say, is that many of these initiatives would have gone more smoothly if Geithner had a full complement of senior staffers to work with. Among the harshest critics of Treasury's leadership vacuum is Paul Volcker, an Obama economic adviser and former Federal Reserve chairman who last week called the situation "shameful." "The secretary of the treasury is sitting there without a deputy, without any undersecretaries, without any, as far as I know, assistant secretaries responsible in substantive areas at a time of very severe crisis," Volcker said. "He shouldn't be sitting there alone." The White House took issue with Volcker's statement, saying Geithner has plenty of able staffers. Former Treasury Secretary Lawrence Summers, Obama's chief economic adviser, has worked closely with Geithner for years.
Treasury officials say the administration is taking extra care to vet possible appointees after embarrassing revelations about tax problems for Geithner, former Health and Human Services Secretary-designate Tom Daschle and others. One likely nominee to a top Treasury post has not heard from the department for weeks, the person said, speaking anonymously because there has been no official offer. The person submitted voluminous information about taxes, domestic help and the like more than a month ago. Former Treasury employees said that even the best lower-level staffers and top advisers can't do the work required of Treasury's top ranks. They can't explain Treasury's policies to a nervous public or give a fair hearing to stakeholders in the crucial decisions the department must make.
Fratto said Wall Street bankers complained to him recently that meeting with lower-level Treasury staff, rather than with senior appointees, wouldn't address their issues. "They know that only the political appointees are the decision-makers," he said. "You can share information and work with people at the deputy assistant level, but the bosses just aren't there." Meeting with Geithner could have satisfied the bankers, Fratto said, but the secretary has been stretched thin with congressional testimony, aid to automakers, restructuring the bailouts for Citigroup Inc. and American International Group Inc., reforming the regulatory system and developing a revamped bank rescue plan. "They have a lot on their plate and more staff will help handle the work," said Scott Talbott, a lobbyist with the Financial Services Roundtable.
Perhaps Treasury's highest-profile effort -- its management of the $700 billion financial system bailout -- is still led by Neel Kashkari, a Bush administration holdover who officials said is on his way out. Fratto said that makes it impossible for Kashkari to engage in real negotiations with banks. He said the bailout has been hurt by "uncertainty over what the policy is, the details, whether they're going to stick, whether the programs are going to change again -- and these are all things that Neel probably can't answer for them, and no one can answer for them." The concerns are gaining momentum in advance of next week's meeting in London with finance ministers of 20 major countries. Without political appointees to negotiate discussion points or the texts of public statements, the White House will have to take a larger role, former Treasury officials said.
For the first such meeting, in November, Deputy Treasury Secretary Robert Kimmitt traveled to Australia while then-Treasury Secretary Henry Paulson stayed in Washington. Geithner, overseeing bailouts that have ballooned in size and scope, has no such deputy. Treasury's lack of official leadership created an opening for the State Department to assume a major role in economic dialogue with China, which had been a Treasury initiative, Fratto and others said. Treasury doesn't "have the people at that table who can carry the weight in a fight with the State Department," Fratto said. Treasury officials say they are very close to announcing their first slate of appointees, which will include some top-level officials outside the 50-person team now advising Geithner. The current team includes about half the appointees Treasury will have to name.
Trading Places: China and the U.S.
It would not be fair to compare Mao Zedong to either President Bush or President Obama. Neither has swum the Yangtze River and neither was a rabid communist. Mao created the central government system that is currently being dismantled. Bush and Obama may be remembered by historians as the American leaders who centralized much of the financial and industrial portions of the U.S. economy. China and the U.S. are passing one another going in opposite directions. Deng Xiaoping, who ran China after Mao had become a tourist attraction lying in a glass box in Beijing, began moving the country to a capitalist economy. By the time he died in 1997, China had begun vigorous trade with the outside world leading to remarkable years of GDP growth.
China now allows most of it major companies to be privatized and traded on public stock exchanges. It is the largest owner of U.S. Treasuries in the world and a major investor in private businesses through its sovereign wealth fund. The Chinese banking system has clearly been developed by the government to encourage the creation of private enterprise. Parts of the financial and commercial structure of China are still owned by the state, but the government's once-famous totalitarian grip on the economy appears to be loosening some each year. The liberalization of China's business may recede to some extent because the recession will cause the level of government support for the economy to grow to keep GDP from contracting.
The nation's prime minister says GDP will grow 8% this year, which seems nearly impossible. But if the government does have to offer financial support to the banks and industry, it will certainly come with some strings attached and may even cause the central government to take larger shares in businesses that it had planed to privatize. But, the move in China seems to be relentlessly toward a free market economy. Because China has a rich treasury, it can afford to support a rotation to privatization without the immediate concern that its government will be troubled by huge deficits. The U.S. faces both large deficits and the need to take de facto control of parts of the credit, financial, and industrial sectors. In effect, the amount of the nation's economic activity controlled by the government will rise to a level which would have been unimaginable even months ago.
There is no way to predict what the American or Chinese system will look like in ten years. If the recession in the U.S. lasts another two years, the amount of GDP that is effectively under government control will increase rapidly as the Administration and Congress do whatever they can to keep large industries from collapsing. On the other side of the Pacific, China may have the luxury of having an economy that continues to expand, even if it is at a much slower rate than at any time over the last decade. China can bankroll privatizations without worrying that the wealthy residents of the country will fight it in the legislature. By the end of the downturn, the U.S. may look more like China than China does, at least economically.
Ilargi: In the face of their societies crumbling, those in power across the world, from China to Russia to Nowheristan, will resort to lying to their people no matter what the odds. Wen Jiabao is no different from Obama. China's economy is already shrinking instead of growing, but that doesn't matter. Tomorrow's another day. A whole new one.
China eyes 8% growth despite grim economic tide
Premier Wen Jiabao assured on Thursday that China will achieve 8 percent growth this year despite a deepening financial crisis, setting out export support and spending programmes to shore up the economy. In the text of his annual work report to the National People's Congress, the nation's largely ceremonial parliament, Wen said the 8 percent goal was a realistic one. "It needs to be stressed that in projecting the GDP growth target at 8 percent, we have taken into consideration both our need and ability to sustain development in China," he said. "As long as we adopt the right policies and appropriate measures and implement them effectively, we will be able to achieve this target."
Global markets soared on Wednesday on speculation that Wen would add to a 4 trillion yuan ($585 billion) stimulus plan unveiled in November to head off a rise in unemployment that could threaten the social stability prized by the ruling Communist party. But while he projected a leap in China's budget deficit this year to 950 billion yuan, Wen announced no increase in the headline cost of the pump-priming package to revive the world's third largest economy, which has been hit by a slump in demand for its exports. The expected 2009 budget deficit would be less than 3 percent of national income -- a quarter of what the United States is planning for. Balancing optimism with caution, Wen said China faced unprecedented difficulties and challenges due to the worldwide financial crisis.
"Demand continues to shrink on international markets; the trend toward global deflation is obvious; and trade protectionism is resurging. The external economic environment has become more serious, and uncertainties have increased significantly." Wen said the government would use tax incentives and fiscal policies to support exports, while reaffirming Beijing's long-standing policy if keeping the exchange rate of the yuan, China's currency, "basically stable". Wen has said he is encouraged by the economy's response to the blueprint, which envisages massive spending on infrastructure, affordable housing and the environment. Bank lending has surged -- Wen set an ambitious target of 5 trillion yuan in new loans this year, just above last year's level -- and surveys of manufacturers have perked up.
But exports have collapsed and a recovery in steel prices that was triggered by the stimulus plan has gone into reverse, suggesting to many economists that China is not out of the woods yet. "The global financial crisis continues to spread and get worse," Wen said in his speech. He said his government would seek to prevent any threats from social unrest, which officials have warned could flare up as workers and farmers confront unemployment and income cuts. Officials estimate about 20 million migrant workers have already lost their jobs due to the closure of export-dependent factories and a downturn in the construction industry. "We will improve the early warning system for social stability to actively prevent and properly handle all types of mass incidents," he said, using the government's euphemism for riots, protests and demonstrations.
China says ready to talk peace with Taiwan
China is ready to talk peace with Taiwan, Premier Wen Jiabao said on Thursday in a new overture to the neighbouring self-ruled island it claims as its own. China was "ready to create conditions for ending the state of hostility" with Taiwan, Wen said in the text of his work report, given on the first day of the annual session of parliament. Any peace pact would benefit both sides, Taiwan’s government said, but added that the recession-hit island wanted economic deals before political ones. "A peace deal has advantages for both sides," said Tony Wang, a spokesman for Taiwan President Ma Ying-jeou. "But our thought is first to seek economic deals and political ones later."
China has claimed sovereignty over Taiwan since the end of the Chinese civil war in 1949, when defeated Nationalist forces fled to the island. Beijing has vowed to bring the island under mainland rule, by force if necessary. But ties have warmed since mainland-friendly Ma took office in May and the two sides have signed deals to enhance tourist and business flows. "Cross-strait relations have embarked on the track of peaceful development," Wen said in the text.
- "... We will work on the basis of the one-China principle to enhance mutual political trust between the two sides.
- "... We are also ready to hold talks on cross-strait political and military issues and create conditions for ending the state of hostility and concluding a peace agreement between the two sides of the Taiwan Strait."
Wen did not elaborate on talks on political and military issues, but they could include military confidence building, Chinese military vessels making port calls on Taiwan ports and vice versa. Wen’s remarks come when Taiwan is increasingly reliant on China amid the global economic slump, which has also sapped trade and investment. China is the island’s largest trading partner and their two-way trade is worth more than $130bn a year. China’s Communist Party-controlled parliament is set to approve military spending for 2009 of 480.7bn yuan ($70.2bn), up 14.9 per cent on 2008, and a lot of that spending is focused on Taiwan. China raised the number of short-range missiles aimed at the island off its coast to about 1,500, Taiwanese officials and experts said last month, a sign of continued distrust despite the recent warming of ties.
China to Sell 200 Billion Yuan of Bonds for Local Governments
China’s finance ministry plans to sell 200 billion yuan ($29 billion) of bonds on behalf of local governments to stimulate economic growth, Premier Wen Jiabao said. The State Council allows local governments to sell 200 billion yuan of bonds, which will be issued by the Ministry of Finance," Wen said in his work report, presented to the National People’s Congress in Beijing today. "The bonds will be under provincial budget supervision."
China is building more homes, roads and railways as part of a 4 trillion yuan fiscal stimulus plan to revive the economy, which expanded 6.8 percent in the fourth quarter, less than this year’s 8 percent goal. The 2009 budget deficit was 750 billion yuan, rising to 950 billion yuan including local-government bonds, as the slowdown cuts revenue and the government spends to revive the economy. "The outstanding government debt in 2009 will be about 20 percent of gross domestic product, which is tolerable and generally safe," Wen said.
China backs Sudan leader wanted for war crimes
China urged the International Criminal Court Thursday to drop its arrest warrant for Sudan's leader on war crimes, saying it won't help stabilize the war-scarred Darfur region. "China opposes anything that could disrupt efforts to realize peace in Darfur and in Sudan," said Foreign Ministry spokesman Qin Gang in a statement posted to the ministry's official Web site. Qin also backed a call by African and Arab countries to have the warrant dropped.
The court on Wednesday charged President Omar al-Bashir with war crimes and crimes against humanity in Darfur — its first action against a sitting head of state. China, which buys two-thirds of Sudan's petroleum exports, has been repeatedly criticized for not using its economic leverage to apply more pressure on Bashir's government to end a civil war in his country's Darfur region. At least 300,000 people have been killed. Beijing is believed to be the provider of most of Sudan's small arms, many of which are used in Darfur.
A chance to remake the global financial system
Global financial confidence, once destroyed, requires myr?iad positive events and a heavy convergence of them to counter ambient pessimism and gloom. The recent series of government packages, notwithstanding their scale and speed, has had little demonstrable effect on the level of confidence or the outlook for ongoing activity. Indeed the number of new and significant packages may begin to peter out out as the public accounts of most countries can no longer cope with the growing burden of insolvency or assume further private sector risk. This context underlines the urgent need for the Group of 20 industrialised and developing nations meeting in London to construct a new paradigm to resuscitate the world financial and economic system.
What is needed is a new global economic and political settlement. The first priority should be to make the G20 a permanent gathering. The leaders should meet at least once a year and, in current circumstances , twice. A permanent G20 structure, representative of the major debtor and creditor countries and the most strategically powerful ones, will sound the death knell of the Group of Seven leading industrialised nations. This is two decades too late, but better late than never. The second priority should be for future international economic policy co-ordination to be conducted by the G20 – its leaders, finance ministers and central bankers – not by the International Monetary Fund, which has failed so miserably in this task.
The third priority should be radically to restructure the IMF, disbanding its board and replacing it with a governance structure that truly represents the wider world it claims to serve. The Fund should still manage its balance of payments emergency facility but under the general supervision of the G20. The Washington establishment may resist such changes while the European members of the G7 will do all they can to hang on to the old postwar structure. Yet the utility of those arrangements began to erode when the cold war ended and China began its rise to the powerhouse it is today. The pump-priming of government budgets through deficits and recapitalisation of banks offers only a temporary respite to the crisis. Fiscal policy has its limits. President Barack Obama is already portending a US federal deficit of $1,700bn (€1,354bn) this year, or about 13 per cent of gross domestic product and told the US public to expect deficits in the trillions for years.
In the short term the world needs the US stimulus but the longer term antecedents of the crisis can only be dealt with when deficit countries save more and spend less and surplus countries do the opposite. This savings imbalance will not be remedied while the larger creditor states are locked out of the hierarchy of global institutions. Left to themselves, they will go back to their own defensive game. Brought into the fold, on a credible basis, they may think it is safe to change habits. For instance, the government of China has no intention of dealing with its surpluses by letting its real exchange rate redirect national resources, especially when such action risks putting it into the hands of the IMF. Following the crisis of 1997, what every Asian government fears is the political consequence of capital outflow – to wit President Suharto of Indonesia, who was forced out of office in 1998.
Until international monetary governance is democratised, or at least is more representative, no major developing country, creditor or otherwise, is going to put its head into the IMF cum US Treasury noose. But to make a G20 structure that is truly dynamic, the US must answer two strategic questions. Is China a commercial competitor that has to be strategically watched or is it a building block in a new multi-faceted world? Should Russia have an organic place in a more representative world system or should it continue to be regarded as incurably untrustworthy? A positive resolution of these questions along with reform of the old Bretton Woods arrangements can usher in a more workable world structure. The question is whether Mr Obama will recognise this opportunity at the coming G20 meeting or whether the advice of old advisers will keep him, and the rest of us, in the current economic and strategic rut. A burst of inclusion is the only way to make the world anew. If it happens, the impact on confidence will be profound – outweighing all the packages put on the table to date.
The writer is a former Australian prime minister
Martin Feldstein and Simon Johnson on the U.S.'s Lost Decade
From a recent MIT get-together, economists Martin Feldstein and Simon Johnson trying to out-dire one another on the outlook for the U.S. economy, China, India and the busted global banking system.
UBS Tells Senate It Won't Turn Over More Names in IRS Tax-Evasion Lawsuit
UBS AG, Switzerland’s largest bank, said today it won’t turn over any more of the 52,000 customer identities being sought by the U.S. in a lawsuit that seeks to crack down on tax evaders. UBS agreed Feb. 19 to pay $780 million and disclose some client names to avoid prosecution for helping wealthy Americans avoid taxes. The bank has agreed to turn over about 300 names, said Senator Carl Levin, chairman of a Senate panel that held a hearing in Washington today on offshore tax havens. The U.S. lawsuit seeks to force UBS to provide the names of 52,000 current and former U.S. clients it believes evaded taxes. The Swiss government recognizes only tax fraud, not tax evasion, as a crime. UBS contends the dispute should be resolved through diplomacy and not the U.S. lawsuit in federal court in Miami.
"We believe that UBS has now complied with the summons to the fullest extent possible without subjecting its employees to criminal prosecution in Switzerland" under bank-secrecy laws, UBS executive Mark Branson told a hearing held by Levin’s Permanent Subcommittee on Investigations. Branson is chief financial officer of global wealth management at UBS. Levin, a Michigan Democrat, said offshore tax abuses cost the U.S. $100 billion a year and that Switzerland bears much of the blame because of its support of bank secrecy. "The rest of the world is getting fed up with offshore tax havens that turn a blind eye to tax evasion and allow their financial institutions, lawyers, accountants and others to profit from tax-dodging," Levin said. "It is absurd that any country wants to make money off our loss of tax revenue," the senator said.
Levin said UBS agreed to turn over the names of about 300 U.S. clients as a part of its so-called deferred prosecution agreement with the U.S. Justice Department. Separately, the Swiss government agreed to turn over the names of 12 U.S. customers under a U.S.-Swiss tax treaty. "The Swiss hold out bank secrecy as a national value, in the same way Americans prize freedom and democracy," Levin said. "The Swiss claim bank secrecy is essential to protecting individual privacy and is more important than any law in the United States requiring the payment of taxes." Treasury Secretary Timothy Geithner also told the Senate Finance Committee today that the government will mount an "ambitious" program to crack down on companies that use offshore locales to avoid paying taxes.
In 2007, 83 of the 100 largest publicly traded U.S. companies had units in low-tax or no-tax jurisdictions such as the Cayman Islands or the Isle of Man, according to a congressional report released in January. They included American International Group Inc., Citigroup Inc., Bank of America Corp. and Morgan Stanley, all of which were given taxpayer money through the $700 billion financial rescue. British Prime Minister Gordon Brown, speaking to a joint session of Congress today, urged world governments to "outlaw shadow banking systems and offshore tax havens." Internal Revenue Service Commissioner Doug Shulman testified at Levin’s hearing. "The U.S. is taking unprecedented measures and there is much more in the works," Shulman said. "You can expect to see a multi-year effort to beef up our resources."
Zurich-based UBS has said it will close its cross-border banking business and strengthen its internal controls. Since last summer, the bank has closed more than 14,000 accounts, Branson said. Under questioning by Levin, Branson said UBS has about 46,000 accounts held by U.S. taxpayers. Of those, Levin said, 30,000 were accounts held by Americans who live in the U.S. and 16,000 by taxpayers outside the U.S. "All securities accounts of both residents and non- residents will be closed," Branson told the panel. He said the bank will not close cash accounts for non-U.S. residents. Branson said the value of those cash accounts is less than $1 billion.
Levin asked if UBS would disclose information on those accounts to the IRS. "We’ll make sure there are appropriate controls over those accounts," Branson said. "Controls so there is no tax evasion?" Levin asked. "All appropriate controls," Branson said. Levin expressed frustration after asking Branson about participants in the bank’s attempt to defraud the IRS. "I don’t know why I can’t get direct answers here," Levin said. "Your answers seem needlessly evasive."
Why the Swiss are Questioning their Once Proud Banks
Swiss banking giant UBS takes its name from the first initials of the company's original moniker Union Bank of Switzerland. But over the past few months the Swiss have begun to joke that the acronym should stand for United Bandits of Switzerland. Fury over a tax scandal and massive losses thanks to UBS's exposure to the toxic subprime market in the U.S. is growing fast. "Those arrogant and greedy bankers are tarnishing our image," says Marie-Claire Favre between sips of her cappuccino in a Lausanne cafe. Standing in front of UBS's Lausanne office, Bernard Thevenoz can't hide his outrage. "Those thugs, they are dragging our country through the mud," the octogenarian hisses, waving his cane towards the palatial building. "How can we ever regain our dignity?"
Banks are the backbone of Switzerland's economy, accounting for 12% of national GDP, and for decades they have been central to the Swiss view of themselves. But the past few months have not been good for the industry, and in particular UBS, which has been under a cloud since last summer. That was when news broke that U.S. authorities were investigating the world's largest manager of private wealth for its role in helping rich Americans hide $200 billion in undisclosed offshore accounts to avoid taxes. Last month UBS agreed to pay the U.S. a $780 million penalty to absolve itself of criminal fraud charges. It also agreed to release the names of 250 clients whom the U.S. suspects of evading taxes. Two weeks ago, as UBS shares plummeted to a new low, the bank's chief executive Marcel Rohner resigned. All that and the bank recently announced a $17 billion loss, the biggest in Swiss corporate history. (See pictures of the global financial crisis.)
All that news does not please the fiscally conservative and risk-averse Swiss. A $60 billion government rescue package for banks wasn't too welcome, either. Nor was UBS's announcement that it will pay out an estimated $1.77 billion in bonuses this year. As Zurich's daily newspaper, Tages-Anzeiger, observed, "Mr. and Mrs. Swiss will never understand that." They don't. "It's a disgrace," says Favre, a retired teacher who is planning to withdraw her investments from UBS when they come to term this summer. "We always believed our country and institutions were superior to anyone else's because they were honest and transparent. But this makes me think we are really no different and no better, so it's time we got off our high horse." That's a sentiment that chimes with UBS shareholder Thomas Minder. "To say that I and many other shareholders lost confidence in UBS would be an understatement," says the CEO of Trybol, a small cosmetics company in the town of Neuhausen. At this point, I am not surprised by anything they do."
Financial analysts say those strong feelings are beginning to translate into financial decision making. The number of UBS customers closing their accounts is on the rise. Panagiotis Spiliopoulos, head of investment banking research at Switzerland's Vontobel bank, estimates that $15-20 billion in domestic funds were moved from UBS to smaller banks in recent months. In normal times, one bank expert says, withdrawals would be next to nothing. "We are fed up because UBS has betrayed all the values that make us uniquely Swiss: fiscal responsibility, stability and international credibility," says Samuel Bretholz, a Geneva sociology student who is writing a thesis about the banks' impact on society. "No wonder our perception of ourselves as decent people has taken a beating." Credit Suisse, Switzerland's second largest bank, posted a $7 billion loss in 2008 and slashed thousands of jobs. But so far it has not suffered from the loss of client confidence that UBS faces. The biggest winners are small banks because "they keep their noses clean and stay out of the United States," Bretholz says. "The Swiss want their money to be safe, and they can no longer find security in big banks that operate internationally and are exposed to global risks."
Prompted by the tax evasion scandal, the Swiss are now in the middle of a national re-examination of banking industry regulations. An increasing number of voices are speaking up against banking secrecy, which, under the current law, can only be lifted if a client is suspected of defrauding tax authorities, rather than merely not declaring all assets. Recent polls show that 56% of Swiss now support helping foreign countries identify tax evaders, up from just 20% last year. Even some ministers and bankers agree that changes to the 75-year-old law might be necessary to avoid continued pressure from abroad. "The fact that the Swiss no longer fervently defend this treasured tradition also shows a change in how they view the banking industry now," Bretholz says. "They don't want to be seen as a nation that hides other people's money."
But whether the current uproar will permanently tarnish the citizens' image of their country or diminish the confidence in the banking sector remains to be seen. "Right now, everybody is upset because UBS messed up," says Georg Lutz, a political scientist at Lausanne's Foundation for Research in Social Sciences. But Lutz points out that the Swiss had rebounded from scandals and corporate downfalls before, such as the controversy in the 1990s surrounding the dormant Holocaust bank accounts, or the collapse, in 2001, of Switzerland's former national airline. "At that time we were upset too, but we got over it and moved on," Lutz says. "So in the end the UBS fiasco will not have a lasting negative effect on the national psyche." Perhaps. For now, though, Swiss citizens have decided that their financial institutions are no longer something they can bank on. In Switzerland, that's revolutionary.
Putin Threatens to Cut Ukraine Gas Flow in Two Days
Prime Minister Vladimir Putin threatened to cut Russian gas flows to Ukraine, the main transit route for a quarter of Europe’s supply, in two days if February supplies aren’t paid for. "If, as a result of the use of the security services and the arrest of company officials, the payment isn’t made, it will lead to a stoppage of our deliveries," Putin said during a government meeting broadcast on state television today. OAO Gazprom, Russia’s gas exporter, said today it has received $310 million of the $360 million that Ukrainian state energy company NAK Naftogaz Ukrainy owes for February. Naftogaz has until March 7 to pay the rest under a contract the two sides signed in January.
"The pending $50 million will be accumulated and sent to Russia either today or tomorrow," Ukrainian Deputy Chief of Presidential Staff Oleksandr Shlapak said by e-mail. Ukraine’s state security service yesterday raided Naftogaz’s Kiev offices as part of a probe into company’s acquisition of 7.4 billion hrynias ($884 million) worth of gas meant for shipment to Europe. The security service failed today to enter the offices of Naftogaz’s pipeline unit DK UkrTransGaz. "They wanted to get in and get access to documents but we prevented them," Naftogaz spokesman Ilya Savvin said by phone. Gazprom and Naftogaz signed accords on Jan. 19 that ended a dispute that disrupted deliveries from Russia via Ukraine to the European Union for about two weeks. Moscow-based Gazprom reduced deliveries to Ukraine by half last March because of nonpayment.
Oil producers running out of storage space
Supertankers that once raced around the world to satisfy an unquenchable thirst for oil are now parked offshore, fully loaded, anchors down, their crews killing time. In the United States, vast storage farms for oil are almost out of room. As demand for crude has plummeted, the world suddenly finds itself awash in oil that has nowhere to go. It’s been less than a year since oil prices hit record highs. But now producers and traders are struggling with the new reality: The world wants less oil, not more. And turning off the spigot is about as easy as turning around one of those tankers.
So oil companies and investors are stashing crude, waiting for demand to rise and the bear market to end so they can turn a profit later. Meanwhile, oil-producing countries such as Iran have pumped millions of barrels of their own crude into idle tankers, effectively taking crude off the market to halt declining prices that are devastating their economies. Traders have always played a game of store and sell, bringing oil to market when it can fetch the best price. They say this time is different because of how fast the bottom fell out of the oil market. "Nobody expected this," said Antoine Halff, an analyst with Newedge. "The majority of people out there thought the market would keep rising to $200, even $250, a barrel. They were tripping over each other to pick a higher forecast."
Now the strategy is storage. Anyone who can buy cheap oil and store it might be able to sell it at a premium later, when the global economy ramps up again. The oil tanks that surround Cushing, Okla., in a sprawling network that holds 10 percent of the nation’s oil, have been swelling for months. Exactly how close they are to full is a closely guarded secret, but analysts who cover the industry say Cushing is approaching capacity. There are other storage tanks in the country with plenty of extra room to take on oil, but Cushing is the delivery point for the oil traded on the New York Mercantile Exchange. So the closer Cushing gets to full, the lower the price of oil goes.
Some oil is ending up in giant ships and staying there. On these supertankers, rented by oil companies such as Royal Dutch Shell, there is little for crews to do but paint and repaint the decks to pass time. More than 30 tankers, each with the ability to move 2 million barrels of oil from port to port, now serve as little more than floating storage tanks. They are moored across the globe, from the Texas coast to the calm waters off Europe and Nigeria. "It gets expensive to do this," said Phil Flynn, an analyst at Alaron Trading Corp. "If you’re sitting on a bunch of oil and you’re stuck paying storage and insurance, and you can’t find a buyer, you may have to sell it at a discount just to get rid of it."
On the other hand, as storage units on land have filled up, the companies that own the tankers have profited. Tanker companies charge an average of $75,000 a day, three times as much as last summer, to hold crude, said Douglas Mavrinac, an analyst with Jefferies & Co. Demand for oil began to increase steadily in the early 1980s, and it went into overdrive in recent years as the Chinese economy surged and as producers pumped lakes of oil out of the ground to take advantage of a spike in prices. Then recession gripped the globe, frozen credit markets made things worse, and inventories swelled. Refineries in the U.S. have cut way back on production of gas as the economy weakens and millions of Americans, many of them laid off, keep their cars in the garage.
The latest government records show U.S. inventories are bloated with a virtual sea of surplus crude, enough to fuel 15 million cars for a year. Inventories have grown by 26 million barrels since the beginning of the year alone. Oil from Saudi Arabia, the United Arab Emirates and Nigeria is finding few takers, even though much of it is used to make gasoline in the United States. There are so many players in the international oil market that no one has enough control to sway prices. OPEC slashed production by more than 4 million barrels a day, and still the price of a barrel of crude languishes near $40. At its peak, it traded at $147 a barrel.
Experts aren’t sure what will happen when all that oil finally comes ashore. One fear is that with oil prices so low, companies will slash drilling and production, setting the world up for an energy crunch that would send prices soaring. The number of oil and gas rigs operating in the United States has fallen a staggering 39 percent since August. Others say prices would plummet if companies forced millions of barrels onto the market at once. "If everyone’s running for the exits at the same time, they’ll engineer a price collapse," Flynn said.
Chávez Targets Cargill Mills in Price-Control Move
President Hugo Chávez on Wednesday ordered the expropriation of the local rice operations of U.S. grain giant Cargill Inc., and threatened to take over beer and food manufacturer Polar, the country's largest private company. Mr. Chávez's move comes amid a growing battle between his populist government and private food companies, who are straining under strict price controls aimed at slowing down high inflation set off by Mr. Chávez's non-stop spending. The controls have led to shortages of staples like milk and rice. Mr. Chávez blames the companies; the companies say the prices are set too low to make a profit. Earlier this week, Mr. Chávez ordered army units to take over other rice mills belonging to Venezuelan companies whom the president accuses of causing shortages of rice. He also imposed new regulations forcing producers to devote at least 70% of their production to price-regulated products, including certain types of sugar, milk and vegetable oil.
The intervention is aimed at keeping companies from finding ways around the price controls, for example switching to value-added variations of goods such as low-fat milk or flavored rice, which aren't covered by the controls. For rice producers, this means that 90% of their production must be price-controlled white rice, which is consumed by the vast majority of Venezuelans. "We have state officials in our company now, observing production," said Frank Rojas, the sales and marketing manager for Arroz Mary, one of the leading rice producing companies in Venezuela. So far, government representatives aren't making any production decisions, he said. On Wednesday, Mr. Chávez went after Cargill, based in Minneapolis. "Prepare a decree and let's expropriate Cargill," Mr. Chávez told Agriculture minister Elias Jaua alter a meeting of his cabinet.
The former army officer also threatened to expropriate Polar, Venezuela's largest private company which makes a multitude of food products as well as the country's trademark Polar beer. "We will expropriate you Mr. Mendoza, I'm warning you," Mr. Chávez said, referring to the CEO of the family-owned company, Lorenzo Mendoza. "Get the decrees ready, one after the other." Mr. Chávez is renewing his push to create what he calls 21st Century socialism after winning a referendum last month eliminating term limits and permitting him to run for office as many times as he wants. In the past few years, he has nationalized broad swathes of the economy. But the outspoken leader faces a growing set of problems from the falling price of oil, which Venezuela relies on for 90% of its hard currency earnings. Venezuela's oil currently fetches about $36.80 a barrel, almost half the $60-a-barrel needed to finance this year's budget.
Unlike previous takeovers, Mr. Chávez doesn't have the money now to pay anything close to market prices for the assets. So far, he has been unable to pay for the last batch of company nationalizations from 2008 that included three cement makers, the country's top steel mill and a bank owned by Spain's Banco Santander SA. But the leader suggested that might not stop him from seizing assets. "I have no problem expropriating rice companies," Mr. Chávez told a crowd on Saturday. "And also I will pay [company owners] with paper. I won't pay them with cash, no."
As projects grind to a halt, home sites turn to wasteland
By day, it's far too quiet at the site of a planned housing and retail development on a former Navy base in Oakland. At night, neighbors can hear the thieves come out. They rip out copper wire, haul away pipes and take anything else they can steal from dozens of buildings on the site, abandoned after Irvine developer SunCal Cos. fell victim to the economy. It's a scene not uncommon throughout California, as residential construction grinds to a halt under the dual weight of the credit crunch and the housing crisis: a rusty chain the only barrier between the community and a half-built structure in Hollywood; a bare dirt lot in Pasadena; old stoves amid the trash at the site in Oakland.
"I hear hacking and see scary bonfires in the middle of the night," said Don Johnson, a retired Coast Guard employee who lives near the defunct Oak Knoll Naval Medical Center in Oakland. Nearly 250 residential developments with a combined total of 9,389 houses and condominiums have been halted in California, according to research firm Hanley Wood Market Intelligence. The units, worth close to $3.5 billion, were in various stages of development. Now, many are in bankruptcy or have been foreclosed by lenders. Developers have halted sales on an additional 370 new-home developments -- about 30,000 units worth $11.9 billion. "It's a sad state of affairs," said Greg Doyle, regional director of Hanley Wood.
LandSource Communities Development, the parent company of the developer building the 21,000-home Newhall Ranch community near Santa Clarita, filed for Chapter 11 in June. In Hollywood, a chain secures a seven-story building still sheathed in yellow insulation panels and surrounded by steel scaffolding. The Madrone condominium and retail complex at Hollywood Boulevard and La Brea Avenue had been scheduled for completion this spring. But the developer, John Laing Homes, stopped answering its phones weeks ago and on Feb. 19 filed for Chapter 11 bankruptcy protection. Across the street, Tony Boon worried about the effect on Pink Pepper, a Thai restaurant he manages. He had hoped that residents, shoppers and employees at the complex would stop in for meals. Now his customers gaze out on the stagnant site.
"It should have been a beautiful building, but it's just kind of an eyesore," he said. Similar sites abound. On the edge of Old Pasadena, the Pasadena Athletic Club and an office building on Fair Oaks Avenue were demolished to prepare for a six-story hotel, condominium and retail project. Work halted last year when financing fell through, the developer's attorney said. The dirt lot sits empty, surrounded by a chain link fence and green plastic netting. In the Lincoln Heights neighborhood of Los Angeles, the contractor stopped work more than a year ago on Fuller Lofts, a $20-million transformation of a 1920s-era Fuller Paint warehouse into condos on San Fernando Road. The developer, Livable Places, has gone out of business and blames high construction costs, tightening credit for home buyers and a glut of competition.
Walking away from partly completed projects is not unusual in a real estate downturn, said Don Walker, senior vice president of Irvine-based John Burns Real Estate Consulting. The difficulty, he said, is making sure health and safety issues are not ignored as the sites languish. SunCal, the company that was supposed to revitalize the former Navy site in Oakland, concedes that its abandoned projects could be dangerous. At its Oakland site, structures dating to World War II were to have been demolished by now to make way for 1,000 homes and a shopping center. But workers walked off the job when their payments stopped, leaving behind piles of debris. A nine-story hospital the developers planned to raze was invaded by squatters.
In the Sacramento River Delta area of Contra Costa County at SunCal's planned Delta Coves housing development, blowing sand is filling in a new lagoon, and crucial water pumping systems are unmonitored. "No one is manning those pumps," said Kevin Emigh, the county's assistant public works director. In theory, the pumps will operate without oversight, but no one will know whether they lose power or break, he said. Hard rains or rising groundwater could put the neighborhood next to Delta Coves at risk. "More than 100 homes would flood" if the pumps didn't function, Emigh said. Late last year, SunCal filed for Chapter 11 protection on more than 20 big real estate developments throughout the West, said Frank Faye, the developer's chief operating officer, although the company itself is not in bankruptcy.
At some of those projects, urgent problems include blowing dust and overgrown brush that could become a fire hazard. Busy public roads have been torn up and left that way, he said. Faye and other SunCal executives blame failed investment bank Lehman Bros., saying that when Lehman declared bankruptcy, all funds to the projects were cut off. SunCal has sued Lehman, hoping to persuade it to allow another investor to join the developments and restart the money spigot. The lawsuit, filed in January, accused Lehman of "hoarding billions in cash" that could be used to address safety and maintenance problems. A Lehman Bros. spokeswoman declined to comment on its role in Delta Coves or other SunCal projects, citing pending litigation between the two partners. But the company did file a motion to dismiss SunCal's bankruptcy suit.
Meanwhile, public officials and neighbors are losing heart -- and patience. In Oakland, civic leaders had hoped that Oak Knoll, the project at the former Navy facility, would generate tax revenue and improve a struggling neighborhood. "It would have changed the whole city," said Oakland City Councilman Larry Reid, who represents the area. San Clemente, the site of another abandoned SunCal project, is suing the bonding company that insured the developer's public works projects, said City Manager George Scarborough. Avenida Pico, one of the city's main thoroughfares, is now a partially paved street that ends in a jumble of sandbags and rutted dirt. "Pico has been that way for two years," he complained.
Some developers facing Chapter 11 have been able to complete public works or at least secure their sites. LandSource Communities Development, a Valencia company that prepares master-planned communities in north Los Angeles County, filed for bankruptcy protection but has moved ahead with improvements, spokeswoman Marlee Lauffer said. Among the projects partially funded by its lender Barclays are the Magic Mountain Parkway Interchange on Interstate 5 and a new elementary school in Valencia, Lauffer said. Others have not been so proactive. In Anaheim, there are dusty lots in the "Platinum Triangle" near Angel Stadium where a mixed-use development of thousands of homes, stores and offices was planned.
Work on the development of more than 10,000 homes and 7 million square feet of commercial and office space stalled more than a year ago. Chain-link fencing and cloth mark the boundary between the street and two chunks of land where Lennar Corp. has demolished buildings and built streets and other infrastructure. Lennar is under orders from the Anaheim City Council to build a wall between the project and the street, and landscape it with trees and clinging vines. But work on the improvements has yet to start. "It's going to be a long time before they have the economic strength to start again," Councilwoman Lorri Galloway said.
Wall Street on the Tundra
Just after October 6, 2008, when Iceland effectively went bust, I spoke to a man at the International Monetary Fund who had been flown in to Reykjavík to determine if money might responsibly be lent to such a spectacularly bankrupt nation. He’d never been to Iceland, knew nothing about the place, and said he needed a map to find it. He has spent his life dealing with famously distressed countries, usually in Africa, perpetually in one kind of financial trouble or another. Iceland was entirely new to his experience: a nation of extremely well-to-do (No. 1 in the United Nations’ 2008 Human Development Index), well-educated, historically rational human beings who had organized themselves to commit one of the single greatest acts of madness in financial history. "You have to understand," he told me, "Iceland is no longer a country. It is a hedge fund."
An entire nation without immediate experience or even distant memory of high finance had gazed upon the example of Wall Street and said, "We can do that." For a brief moment it appeared that they could. In 2003, Iceland’s three biggest banks had assets of only a few billion dollars, about 100 percent of its gross domestic product. Over the next three and a half years they grew to over $140 billion and were so much greater than Iceland’s G.D.P. that it made no sense to calculate the percentage of it they accounted for. It was, as one economist put it to me, "the most rapid expansion of a banking system in the history of mankind." At the same time, in part because the banks were also lending Icelanders money to buy stocks and real estate, the value of Icelandic stocks and real estate went through the roof. From 2003 to 2007, while the U.S. stock market was doubling, the Icelandic stock market multiplied by nine times. Reykjavík real-estate prices tripled. By 2006 the average Icelandic family was three times as wealthy as it had been in 2003, and virtually all of this new wealth was one way or another tied to the new investment-banking industry.
"Everyone was learning Black-Scholes" (the option-pricing model), says Ragnar Arnason, a professor of fishing economics at the University of Iceland, who watched students flee the economics of fishing for the economics of money. "The schools of engineering and math were offering courses on financial engineering. We had hundreds and hundreds of people studying finance." This in a country the size of Kentucky, but with fewer citizens than greater Peoria, Illinois. Peoria, Illinois, doesn’t have global financial institutions, or a university devoting itself to training many hundreds of financiers, or its own currency. And yet the world was taking Iceland seriously. (March 2006 Bloomberg News headline: iceland’s billionaire tycoon "thor" braves u.s. with hedge fund.)
Global financial ambition turned out to have a downside. When their three brand-new global-size banks collapsed, last October, Iceland’s 300,000 citizens found that they bore some kind of responsibility for $100 billion of banking losses—which works out to roughly $330,000 for every Icelandic man, woman, and child. On top of that they had tens of billions of dollars in personal losses from their own bizarre private foreign-currency speculations, and even more from the 85 percent collapse in the Icelandic stock market. The exact dollar amount of Iceland’s financial hole was essentially unknowable, as it depended on the value of the generally stable Icelandic krona, which had also crashed and was removed from the market by the Icelandic government. But it was a lot.
Iceland instantly became the only nation on earth that Americans could point to and say, "Well, at least we didn’t do that." In the end, Icelanders amassed debts amounting to 850 percent of their G.D.P. (The debt-drowned United States has reached just 350 percent.) As absurdly big and important as Wall Street became in the U.S. economy, it never grew so large that the rest of the population could not, in a pinch, bail it out. Any one of the three Icelandic banks suffered losses too large for the nation to bear; taken together they were so ridiculously out of proportion that, within weeks of the collapse, a third of the population told pollsters that they were considering emigration. In just three or four years an entirely new way of economic life had been grafted onto the side of this stable, collectivist society, and the graft had overwhelmed the host. "It was just a group of young kids," said the man from the I.M.F. "In this egalitarian society, they came in, dressed in black, and started doing business."
Five hundred miles northwest of Scotland the Icelandair flight lands and taxis to a terminal still painted with Landsbanki logos—Landsbanki being one of Iceland’s three bankrupt banks, along with Kaupthing and Glitnir. I try to think up a metaphor for the world’s expanding reservoir of defunct financial corporate sponsorships—water left in the garden hose after you’ve switched off the pressure?—but before I can finish, the man in the seat behind me reaches for his bag in the overhead bin and knocks the crap out of me. I will soon learn that Icelandic males, like moose, rams, and other horned mammals, see these collisions as necessary in their struggle for survival. I will also learn that this particular Icelandic male is a senior official at the Icelandic stock exchange. At this moment, however, all I know is that a middle-aged man in an expensive suit has gone out of his way to bash bodies without apology or explanation. I stew on this apparently wanton act of hostility all the way to passport control.
You can tell a lot about a country by how much better they treat themselves than foreigners at the point of entry. Let it be known that Icelanders make no distinction at all. Over the control booth they’ve hung a charming sign that reads simply, all citizens, and what they mean by that is not "All Icelandic Citizens" but "All Citizens of Anywhere." Everyone is from somewhere, and so we all wind up in the same line, leading to the guy behind the glass. Before you can say, "Land of contradictions," he has pretended to examine your passport and waved you on through.
Next, through a dark landscape of snow-spackled black volcanic rock that may or may not be lunar, but that looks so much as you would expect the moon to look that nasa scientists used it to acclimate the astronauts before the first moon mission. An hour later we arrive at the 101 Hotel, owned by the wife of one of Iceland’s most famous failed bankers. It’s cryptically named (101 is the city’s richest postal code), but instantly recognizable: hip Manhattan hotel. Staff dressed in black, incomprehensible art on the walls, unread books about fashion on unused coffee tables—everything to heighten the social anxiety of a rube from the sticks but the latest edition of The New York Observer. It’s the sort of place bankers stay because they think it’s where the artists stay. Bear Stearns convened a meeting of British and American hedge-fund managers here, in January 2008, to figure out how much money there was to be made betting on Iceland’s collapse. (A lot.) The hotel, once jammed, is now empty, with only 6 of its 38 rooms occupied. The restaurant is empty, too, and so are the small tables and little nooks that once led the people who weren’t in them to marvel at those who were. A bankrupt Holiday Inn is just depressing; a bankrupt Ian Schrager hotel is tragic.
With the financiers who once paid a lot to stay here gone for good, I’m given a big room on the top floor with a view of the old city for half-price. I curl up in silky white sheets and reach for a book about the Icelandic economy—written in 1995, before the banking craze, when the country had little to sell to the outside world but fresh fish—and read this remarkable sentence: "Icelanders are rather suspicious of the market system as a cornerstone of economic organization, especially its distributive implications." First comes a screeching from the far side of the room. I leave the bed to examine the situation. It’s the heat, sounding like a teakettle left on the stove for too long, straining to control itself. Iceland’s heat isn’t heat as we know it, but heat drawn directly from the earth. The default temperature of the water is scalding. Every year workers engaged in street repairs shut down the cold-water intake used to temper the hot water and some poor Icelander is essentially boiled alive in his shower. So powerful is the heat being released from the earth into my room that some great grinding, wheezing engine must be employed to prevent it from cooking me.
Then, from outside, comes an explosion. Boom! Then another. Boom! As it is mid-December, the sun rises, barely, at 10:50 a.m. and sets with enthusiasm at 3:44 p.m. This is obviously better than no sun at all, but subtly worse, as it tempts you to believe you can simulate a normal life. And whatever else this place is, it isn’t normal. The point is reinforced by a 26-year-old Icelander I’ll call Magnus Olafsson, who, just a few weeks earlier, had been earning close to a million dollars a year trading currencies for one of the banks. Tall, white-blond, and handsome, Olafsson looks exactly as you’d expect an Icelander to look—which is to say that he looks not at all like most Icelanders, who are mousy-haired and lumpy. "My mother has enough food hoarded to open a grocery store," he says, then adds that ever since the crash Reykjavík has felt tense and uneasy.
Two months earlier, in early October, as the market for Icelandic kronur dried up, he’d sneaked away from his trading desk and gone down to the teller, where he’d extracted as much foreign cash as they’d give him and stuffed it into a sack. "All over downtown that day you saw people walking around with bags," he says. "No one ever carries bags around downtown." After work he’d gone home with his sack of cash and hidden roughly 30 grand in yen, dollars, euros, and pounds sterling inside a board game. Before October the big-name bankers were heroes; now they are abroad, or laying low. Before October Magnus thought of Iceland as essentially free of danger; now he imagines hordes of muggers en route from foreign nations to pillage his board-game safe—and thus refuses to allow me to use his real name. "You’d figure New York would hear about this and send over planeloads of muggers," he theorizes. "Most everyone has their savings at home." As he is already unsettled, I tell him about the unsettling explosions outside my hotel room. "Yes," he says with a smile, "there’s been a lot of Range Rovers catching fire lately." Then he explains.
For the past few years, some large number of Icelanders engaged in the same disastrous speculation. With local interest rates at 15.5 percent and the krona rising, they decided the smart thing to do, when they wanted to buy something they couldn’t afford, was to borrow not kronur but yen and Swiss francs. They paid 3 percent interest on the yen and in the bargain made a bundle on the currency trade, as the krona kept rising. "The fishing guys pretty much discovered the trade and made it huge," says Magnus. "But they made so much money on it that the financial stuff eventually overwhelmed the fish." They made so much money on it that the trade spread from the fishing guys to their friends. It must have seemed like a no-brainer: buy these ever more valuable houses and cars with money you are, in effect, paid to borrow. But, in October, after the krona collapsed, the yen and Swiss francs they must repay are many times more expensive. Now many Icelanders—especially young Icelanders—own $500,000 houses with $1.5 million mortgages, and $35,000 Range Rovers with $100,000 in loans against them. To the Range Rover problem there are two immediate solutions. One is to put it on a boat, ship it to Europe, and try to sell it for a currency that still has value. The other is set it on fire and collect the insurance: Boom!
The rocks beneath Reykjavík may be igneous, but the city feels sedimentary: on top of several thick strata of architecture that should be called Nordic Pragmatic lies a thin layer that will almost certainly one day be known as Asshole Capitalist. The hobbit-size buildings that house the Icelandic government are charming and scaled to the city. The half-built oceanfront glass towers meant to house newly rich financiers and, in the bargain, block everyone else’s view of the white bluffs across the harbor are not. The best way to see any city is to walk it, but everywhere I walk Icelandic men plow into me without so much as a by-your-leave. Just for fun I march up and down the main shopping drag, playing chicken, to see if any Icelandic male would rather divert his stride than bang shoulders. Nope. On party nights—Thursday, Friday, and Saturday—when half the country appears to take it as a professional obligation to drink themselves into oblivion and wander the streets until what should be sunrise, the problem is especially acute. The bars stay open until five a.m., and the frantic energy with which the people hit them seems more like work than work. Within minutes of entering a nightclub called Boston I get walloped, first by a bearded troll who, I’m told, ran an Icelandic hedge fund. Just as I’m recovering I get plowed over by a drunken senior staffer at the Central Bank. Perhaps because he is drunk, or perhaps because we had actually met a few hours earlier, he stops to tell me, "Vee try to tell them dat our problem was not a solfency problem but a likvitity problem, but they did not agree," then stumbles off. It’s exactly what Lehman Brothers and Citigroup said: If only you’d give us the money to tide us over, we’ll survive this little hiccup.
A nation so tiny and homogeneous that everyone in it knows pretty much everyone else is so fundamentally different from what one thinks of when one hears the word "nation" that it almost requires a new classification. Really, it’s less a nation than one big extended family. For instance, most Icelanders are by default members of the Lutheran Church. If they want to stop being Lutherans they must write to the government and quit; on the other hand, if they fill out a form, they can start their own cult and receive a subsidy. Another example: the Reykjavík phone book lists everyone by his first name, as there are only about nine surnames in Iceland, and they are derived by prefixing the father’s name to "son" or "dottir." It’s hard to see how this clarifies matters, as there seem to be only about nine first names in Iceland, too. But if you wish to reveal how little you know about Iceland, you need merely refer to someone named Siggor Sigfusson as "Mr. Sigfusson," or Kristin Petursdottir as "Ms. Petursdottir." At any rate, everyone in a conversation is just meant to know whomever you’re talking about, so you never hear anyone ask, "Which Siggor do you mean?"
Because Iceland is really just one big family, it’s simply annoying to go around asking Icelanders if they’ve met Björk. Of course they’ve met Björk; who hasn’t met Björk? Who, for that matter, didn’t know Björk when she was two? "Yes, I know Björk," a professor of finance at the University of Iceland says in reply to my question, in a weary tone. "She can’t sing, and I know her mother from childhood, and they were both crazy. That she is so well known outside of Iceland tells me more about the world than it does about Björk." One benefit of life inside a nation masking an extended family is that nothing needs to be explained; everyone already knows everything that needs to be known. I quickly find that it is an even greater than usual waste of time to ask directions, for instance. Just as you are meant to know which Bjornjolfer is being spoken of at any particular moment, you are meant to know where you are on the map. Two grown-ups—one a banker whose office is three blocks away—cannot tell me where to find the prime minister’s office. Three more grown-ups, all within three blocks of the National Gallery of Iceland, have no idea where to find the place. When I tell the sweet middle-aged lady behind the counter at the National Museum that no Icelander seems to know how to find it, she says, "No one actually knows anything about our country. Last week we had Icelandic high-school students here and their teacher asked them to name an Icelandic 19th-century painter. None of them could. Not a single one! One said, ‘Halldor Laxness?’!" (Laxness won the 1955 Nobel Prize in Literature, the greatest global honor for an Icelander until the 1980s, when two Icelandic women captured Miss World titles in rapid succession.)
The world is now pocked with cities that feel as if they are perched on top of bombs. The bombs have yet to explode, but the fuses have been lit, and there’s nothing anyone can do to extinguish them. Walk around Manhattan and you see empty stores, empty streets, and, even when it’s raining, empty taxis: people have fled before the bomb explodes. When I was there Reykjavík had the same feel of incipient doom, but the fuse burned strangely. The government mandates three months’ severance pay, and so the many laid-off bankers were paid until early February, when the government promptly fell. Against a basket of foreign currencies the krona is worth less than a third of its boom-time value. As Iceland imports everything but heat and fish, the price of just about everything is, in mid-December, about to skyrocket. A new friend who works for the government tells me that she went into a store to buy a lamp. The clerk told her he had sold the last of the lamps she was after, but offered to order it for her, from Sweden—at nearly three times the old price.
Still, a society that has been ruined overnight doesn’t look much different from how it did the day before, when it believed itself to be richer than ever. The Central Bank of Iceland is a case in point. Almost certainly Iceland will adopt the euro as its currency, and the krona will cease to exist. Without it there is no need for a central bank to maintain the stability of the local currency and control interest rates. Inside the place stews David Oddsson, the architect of Iceland’s rise and fall. Back in the 1980s, Oddsson had fallen under the spell of Milton Friedman, the brilliant economist who was able to persuade even those who spent their lives working for the government that government was a waste of life. So Oddsson went on a quest to give Icelandic people their freedom—by which he meant freedom from government controls of any sort. As prime minister he lowered taxes, privatized industry, freed up trade, and, finally, in 2002, privatized the banks. At length, weary of prime-ministering, he got himself appointed governor of the Central Bank—even though he was a poet without banking experience.
After the collapse he holed up in his office inside the bank, declining all requests for interviews. Senior government officials tell me, seriously, that they assume he spends most of his time writing poetry. (In February he would be asked by a new government to leave.) On the outside, however, the Central Bank of Iceland is still an elegant black temple set against the snowy bluffs across the harbor. Sober-looking men still enter and exit. Small boys on sleds rocket down the slope beside it, giving not a rat’s ass that they are playing at ground zero of the global calamity. It all looks the same as it did before the crash, even though it couldn’t be more different. The fuse is burning its way toward the bomb.
When Neil Armstrong took his small step from Apollo 11 and looked around, he probably thought, Wow, sort of like Iceland—even though the moon was nothing like Iceland. But then, he was a tourist, and a tourist can’t help but have a distorted opinion of a place: he meets unrepresentative people, has unrepresentative experiences, and runs around imposing upon the place the fantastic mental pictures he had in his head when he got there. When Iceland became a tourist in global high finance it had the same problem as Neil Armstrong. Icelanders are among the most inbred human beings on earth—geneticists often use them for research. They inhabited their remote island for 1,100 years without so much as dabbling in leveraged buyouts, hostile takeovers, derivatives trading, or even small-scale financial fraud. When, in 2003, they sat down at the same table with Goldman Sachs and Morgan Stanley, they had only the roughest idea of what an investment banker did and how he behaved—most of it gleaned from young Icelanders’ experiences at various American business schools. And so what they did with money probably says as much about the American soul, circa 2003, as it does about Icelanders. They understood instantly, for instance, that finance had less to do with productive enterprise than trading bits of paper among themselves. And when they lent money they didn’t simply facilitate enterprise but bankrolled friends and family, so that they might buy and own things, like real investment bankers: Beverly Hills condos, British soccer teams and department stores, Danish airlines and media companies, Norwegian banks, Indian power plants.
That was the biggest American financial lesson the Icelanders took to heart: the importance of buying as many assets as possible with borrowed money, as asset prices only rose. By 2007, Icelanders owned roughly 50 times more foreign assets than they had in 2002. They bought private jets and third homes in London and Copenhagen. They paid vast sums of money for services no one in Iceland had theretofore ever imagined wanting. "A guy had a birthday party, and he flew in Elton John for a million dollars to sing two songs," the head of the Left-Green Movement, Steingrimur Sigfusson, tells me with fresh incredulity. "And apparently not very well." They bought stakes in businesses they knew nothing about and told the people running them what to do—just like real American investment bankers! For instance, an investment company called FL Group—a major shareholder in Glitnir bank—bought an 8.25 percent stake in American Airlines’ parent corporation. No one inside FL Group had ever actually run an airline; no one in FL Group even had meaningful work experience at an airline. That didn’t stop FL Group from telling American Airlines how to run an airline. "After taking a close look at the company over an extended period of time," FL Group C.E.O. Hannes Smarason, graduate of M.I.T.’s Sloan School, got himself quoted saying, in his press release, not long after he bought his shares, "our suggestions include monetizing assets … that can be used to reduce debt or return capital to shareholders."
Nor were the Icelanders particularly choosy about what they bought. I spoke with a hedge fund in New York that, in late 2006, spotted what it took to be an easy mark: a weak Scandinavian bank getting weaker. It established a short position, and then, out of nowhere, came Kaupthing to take a 10 percent stake in this soon-to-be defunct enterprise—driving up the share price to absurd levels. I spoke to another hedge fund in London so perplexed by the many bad LBOs Icelandic banks were financing that it hired private investigators to figure out what was going on in the Icelandic financial system. The investigators produced a chart detailing a byzantine web of interlinked entities that boiled down to this: A handful of guys in Iceland, who had no experience of finance, were taking out tens of billions of dollars in short-term loans from abroad. They were then re-lending this money to themselves and their friends to buy assets—the banks, soccer teams, etc. Since the entire world’s assets were rising—thanks in part to people like these Icelandic lunatics paying crazy prices for them—they appeared to be making money. Yet another hedge-fund manager explained Icelandic banking to me this way: You have a dog, and I have a cat. We agree that they are each worth a billion dollars. You sell me the dog for a billion, and I sell you the cat for a billion. Now we are no longer pet owners, but Icelandic banks, with a billion dollars in new assets. "They created fake capital by trading assets amongst themselves at inflated values," says a London hedge-fund manager. "This was how the banks and investment companies grew and grew. But they were lightweights in the international markets."
On February 3, Tony Shearer, the former C.E.O. of a British merchant bank called Singer and Friedlander, offered a glimpse of the inside, when he appeared before a House of Commons committee to describe his bizarre experience of being acquired by an Icelandic bank. Singer and Friedlander had been around since 1907 and was famous for, among other things, giving George Soros his start. In November 2003, Shearer learned that Kaupthing, of whose existence he was totally unaware, had just taken a 9.5 percent stake in his bank. Normally, when a bank tries to buy another bank, it seeks to learn something about it. Shearer offered to meet with Kaupthing’s chairman, Sigurdur Einarsson; Einarsson had no interest. (Einarsson declined to be interviewed by Vanity Fair.) When Kaupthing raised its stake to 19.5 percent, Shearer finally flew to Reykjavík to see who on earth these Icelanders were. "They were very different," he told the House of Commons committee. "They ran their business in a very strange way. Everyone there was incredibly young. They were all from the same community in Reykjavík. And they had no idea what they were doing."
He examined Kaupthing’s annual reports and discovered some amazing facts: This giant international bank had only one board member who was not Icelandic, for instance. Its directors all had four-year contracts, and the bank had lent them £19 million to buy shares in Kaupthing, along with options to sell those shares back to the bank at a guaranteed profit. Virtually the entire bank’s stated profits were caused by its marking up assets it had bought at inflated prices. "The actual amount of profits that were coming from what I’d call banking was less than 10 percent," said Shearer. In a sane world the British regulators would have stopped the new Icelandic financiers from devouring the ancient British merchant bank. Instead, the regulators ignored a letter Shearer wrote to them. A year later, in January 2005, he received a phone call from the British takeover panel. "They wanted to know," says Shearer, "why our share price had risen so rapidly over the past couple of days. So I laughed and said, ‘I think you’ll find the reason is that Mr. Einarsson, the chairman of Kaupthing, said two days ago, like an idiot, that he was going to make a bid for Singer and Friedlander.’" In August 2005, Singer and Friedlander became Kaupthing Singer and Friedlander, and Shearer quit, he said, out of fear of what might happen to his reputation if he stayed. In October 2008, Kaupthing Singer and Friedlander went bust.
In spite of all this, when Tony Shearer was pressed by the House of Commons to characterize the Icelanders as mere street hustlers, he refused. "They were all highly educated people," he said in a tone of amazement. Here is yet another way in which Iceland echoed the American model: all sorts of people, none of them Icelandic, tried to tell them they had a problem. In early 2006, for instance, an analyst named Lars Christensen and three of his colleagues at Denmark’s biggest bank, Danske Bank, wrote a report that said Iceland’s financial system was growing at a mad pace, and was on a collision course with disaster. "We actually wrote the report because we were worried our clients were getting too interested in Iceland," he tells me. "Iceland was the most extreme of everything." Christensen then flew to Iceland and gave a speech to reinforce his point, only to be greeted with anger. "The Icelandic banks took it personally," he says. "We were being threatened with lawsuits. I was told, ‘You’re Danish, and you are angry with Iceland because Iceland is doing so well.’ Basically it all had to do with what happened in 1944," when Iceland declared its independence from Denmark. "The reaction wasn’t ‘These guys might be right.’ It was ‘No! It’s a conspiracy. They have bad motives.’" The Danish were just jealous!
The Danske Bank report alerted hedge funds in London to an opportunity: shorting Iceland. They investigated and found this incredible web of cronyism: bankers buying stuff from one another at inflated prices, borrowing tens of billions of dollars and re-lending it to the members of their little Icelandic tribe, who then used it to buy up a messy pile of foreign assets. "Like any new kid on the block," says Theo Phanos of Trafalgar Funds in London, "they were picked off by various people who sold them the lowest-quality assets—second-tier airlines, sub-scale retailers. They were in all the worst LBOs." But from the prime minister on down, Iceland’s leaders attacked the messenger. "The attacks … give off an unpleasant odor of unscrupulous dealers who have decided to make a last stab at breaking down the Icelandic financial system," said Central Bank chairman Oddsson in March of last year. The chairman of Kaupthing publicly fingered four hedge funds that he said were deliberately seeking to undermine Iceland’s financial miracle. "I don’t know where the Icelanders get this notion," says Paul Ruddock, of Lansdowne Partners, one of those fingered. "We only once traded in an Icelandic stock and it was a very short-term trade. We started to take legal action against the chairman of Kaupthing after he made public accusations against us that had no truth, and then he withdrew them."
One of the hidden causes of the current global financial crisis is that the people who saw it coming had more to gain from it by taking short positions than they did by trying to publicize the problem. Plus, most of the people who could credibly charge Iceland—or, for that matter, Lehman Brothers—with financial crimes could be dismissed as crass profiteers, talking their own book. Back in April 2006, however, an emeritus professor of economics at the University of Chicago named Bob Aliber took an interest in Iceland. Aliber found himself at the London Business School, listening to a talk on Iceland, about which he knew nothing. He recognized instantly the signs. Digging into the data, he found in Iceland the outlines of what was so clearly a historic act of financial madness that it belonged in a textbook. "The Perfect Bubble," Aliber calls Iceland’s financial rise, and he has the textbook in the works: an updated version of Charles Kindleberger’s 1978 classic, Manias, Panics, and Crashes, a new edition of which he’s currently editing. In it, Iceland, he decided back in 2006, would now have its own little box, along with the South Sea Bubble and the Tulip Craze—even though Iceland had yet to crash. For him the actual crash was a mere formality.
Word spread in Icelandic economic circles that this distinguished professor at Chicago had taken a special interest in Iceland. In May 2008, Aliber was invited by the University of Iceland’s economics department to give a speech. To an audience of students, bankers, and journalists, he explained that Iceland, far from having an innate talent for high finance, had all the markings of a giant bubble, but he spoke the technical language of academic economists. ("Monetary Turbulence and the Icelandic Economy," he called his speech.) In the following Q&A session someone asked him to predict the future, and he lapsed into plain English. As an audience member recalls, Aliber said, "I give you nine months. Your banks are dead. Your bankers are either stupid or greedy. And I’ll bet they are on planes trying to sell their assets right now."
The Icelandic bankers in the audience sought to prevent newspapers from reporting the speech. Several academics suggested that Aliber deliver his alarming analysis to Iceland’s Central Bank. Somehow that never happened. "The Central Bank said they were too busy to see him," says one of the professors who tried to arrange the meeting, "because they were preparing the Report on Financial Stability." For his part Aliber left Iceland thinking that he’d caused such a stir he might not be allowed back into the country. "I got the feeling," he told me, "that the only reason they brought me in was that they needed an outsider to say these things—that an insider wouldn’t say these things, because he’d be afraid of getting into trouble." And yet he remains extremely fond of his hosts. "They are a very curious people," he says, laughing. "I guess that’s the point, isn’t it?"
Icelanders—or at any rate Icelandic men—had their own explanations for why, when they leapt into global finance, they broke world records: the natural superiority of Icelanders. Because they were small and isolated it had taken 1,100 years for them—and the world—to understand and exploit their natural gifts, but now that the world was flat and money flowed freely, unfair disadvantages had vanished. Iceland’s president, Olafur Ragnar Grimsson, gave speeches abroad in which he explained why Icelanders were banking prodigies. "Our heritage and training, our culture and home market, have provided a valuable advantage," he said, then went on to list nine of these advantages, ending with how unthreatening to others Icelanders are. ("Some people even see us as fascinating eccentrics who can do no harm.") There were many, many expressions of this same sentiment, most of them in Icelandic. "There were research projects at the university to explain why the Icelandic business model was superior," says Gylfi Zoega, chairman of the economics department. "It was all about our informal channels of communication and ability to make quick decisions and so forth."
"We were always told that the Icelandic businessmen were so clever," says university finance professor and former banker Vilhjalmur Bjarnason. "They were very quick. And when they bought something they did it very quickly. Why was that? That is usually because the seller is very satisfied with the price." You didn’t need to be Icelandic to join the cult of the Icelandic banker. German banks put $21 billion into Icelandic banks. The Netherlands gave them $305 million, and Sweden kicked in $400 million. U.K. investors, lured by the eye-popping 14 percent annual returns, forked over $30 billion—$28 billion from companies and individuals and the rest from pension funds, hospitals, universities, and other public institutions. Oxford University alone lost $50 million. Maybe because there are so few Icelanders in the world, we know next to nothing about them. We assume they are more or less Scandinavian—a gentle people who just want everyone to have the same amount of everything. They are not. They have a feral streak in them, like a horse that’s just pretending to be broken.
After three days in Reykjavík, I receive, more or less out of the blue, two phone calls. The first is from a producer of a leading current-events TV show. All of Iceland watches her show, she says, then asks if I’d come on and be interviewed. "About what?" I ask. "We’d like you to explain our financial crisis," she says. "I’ve only been here three days!" I say. It doesn’t matter, she says, as no one in Iceland understands what’s happened. They’d enjoy hearing someone try to explain it, even if that person didn’t have any idea what he was talking about—which goes to show, I suppose, that not everything in Iceland is different from other places. As I demur, another call comes, from the prime minister’s office. Iceland’s then prime minister, Geir Haarde, is also the head of the Independence Party, which has governed the country since 1991. It ruled in loose coalition with the Social Democrats and the Progressive Party. (Iceland’s fourth major party is the Left-Green Movement.) That a nation of 300,000 people, all of whom are related by blood, needs four major political parties suggests either a talent for disagreement or an unwillingness to listen to one another. In any case, of the four parties, the Independents express the greatest faith in free markets. The Independence Party is the party of the fishermen. It is also, as an old schoolmate of the prime minister’s puts it to me, "all men, men, men. Not a woman in it."
Walking into the P.M.’s minute headquarters, I expect to be stopped and searched, or at least asked for photo identification. Instead I find a single policeman sitting behind a reception desk, feet up on the table, reading a newspaper. He glances up, bored. "I’m here to see the prime minister," I say for the first time in my life. He’s unimpressed. Anyone here can see the prime minister. Half a dozen people will tell me that one of the reasons Icelanders thought they would be taken seriously as global financiers is that all Icelanders feel important. One reason they all feel important is that they all can go see the prime minister anytime they like.
What he might say to them about their collapse is an open question. There’s a charming lack of financial experience in Icelandic financial-policymaking circles. The minister for business affairs is a philosopher. The finance minister is a veterinarian. The Central Bank governor is a poet. Haarde, though, is a trained economist—just not a very good one. The economics department at the University of Iceland has him pegged as a B-minus student. As a group, the Independence Party’s leaders have a reputation for not knowing much about finance and for refusing to avail themselves of experts who do. An Icelandic professor at the London School of Economics named Jon Danielsson, who specializes in financial panics, has had his offer to help spurned; so have several well-known financial economists at the University of Iceland. Even the advice of really smart central bankers from seriously big countries went ignored. It’s not hard to see why the Independence Party and its prime minister fail to appeal to Icelandic women: they are the guy driving his family around in search of some familiar landmark and refusing, over his wife’s complaints, to stop and ask directions. "Why is Vanity Fair interested in Iceland?" he asks as he strides into the room, with the force and authority of the leader of a much larger nation. And it’s a good question.
As it turns out, he’s not actually stupid, but political leaders seldom are, no matter how much the people who elected them insist that it must be so. He does indeed say things that could not possibly be true, but they are only the sorts of fibs that prime ministers are hired to tell. He claims that the krona is once again an essentially stable currency, for instance, when the truth is it doesn’t currently trade in international markets—it is assigned an arbitrary value by the government for select purposes. Icelanders abroad have already figured out not to use their Visa cards, for fear of being charged the real exchange rate, whatever that might be. The prime minister would like me to believe that he saw Iceland’s financial crisis taking shape but could do little about it. ("We could not say publicly our fears about the banks, because you create the very thing you are seeking to avoid: a panic.") By implication it was not politicians like him but financiers who were to blame. On some level the people agree: the guy who ran the Baugur investment group had snowballs chucked at him as he dashed from the 101 Hotel, which his wife owns, to his limo; the guy who ran Kaupthing Bank turned up at the National Theater and, as he took his seat, was booed. But, for the most part, the big shots have fled Iceland for London, or are lying low, leaving the poor prime minister to shoulder the blame and face the angry demonstrators, led by folksinging activist Hordur Torfason, who assemble every weekend outside Parliament. Haarde has his story, and he’s sticking to it: foreigners entrusted their capital to Iceland, and Iceland put it to good use, but then, last September 15, Lehman Brothers failed and foreigners panicked and demanded their capital back. Iceland was ruined not by its own recklessness but by a global tsunami. The problem with this story is that it fails to explain why the tsunami struck Iceland, as opposed to, say, Tonga.
But I didn’t come to Iceland to argue. I came to understand. "There’s something I really want to ask you," I say. "Yes?" "Is it true that you’ve been telling people that it’s time to stop banking and go fishing?" A great line, I thought. Succinct, true, and to the point. But I’d heard about it thirdhand, from a New York hedge-fund manager. The prime minister fixes me with a self-consciously stern gaze. "That’s a gross exaggeration," he says. "I thought it made sense," I say uneasily. "I never said that!" Obviously, I’ve hit some kind of nerve, but which kind I cannot tell. Is he worried that to have said such a thing would make him seem a fool? Or does he still think that fishing, as a profession, is somehow less dignified than banking? At length, I return to the hotel to find, for the first time in four nights, no empty champagne bottles outside my neighbors’ door. The Icelandic couple whom I had envisioned as being on one last blowout have packed and gone home. For four nights I have endured their Orc shrieks from the other side of the hotel wall; now all is silent. It’s now possible to curl up in bed with "The Economic Theory of a Common-Property Resource: The Fishery." One way or another, the wealth in Iceland comes from the fish, and if you want to understand what Icelanders did with their money you had better understand how they came into it in the first place.
The brilliant paper was written back in 1954 by H. Scott Gordon, a University of Indiana economist. It describes the plight of the fisherman—and seeks to explain "why fishermen are not wealthy, despite the fact that fishery resources of the sea are the richest and most indestructible available to man." The problem is that, because the fish are everybody’s property, they are nobody’s property. Anyone can catch as many fish as they like, so they fish right up to the point where fishing becomes unprofitable—for everybody. "There is in the spirit of every fisherman the hope of the ‘lucky catch,’" wrote Gordon. "As those who know fishermen well have often testified, they are gamblers and incurably optimistic." Fishermen, in other words, are a lot like American investment bankers. Their overconfidence leads them to impoverish not just themselves but also their fishing grounds. Simply limiting the number of fish caught won’t solve the problem; it will just heighten the competition for the fish and drive down profits. The goal isn’t to get fishermen to overspend on more nets or bigger boats. The goal is to catch the maximum number of fish with minimum effort. To attain it, you need government intervention.
This insight is what led Iceland to go from being one of the poorest countries in Europe circa 1900 to being one of the richest circa 2000. Iceland’s big change began in the early 1970s, after a couple of years when the fish catch was terrible. The best fishermen returned for a second year in a row without their usual haul of cod and haddock, so the Icelandic government took radical action: they privatized the fish. Each fisherman was assigned a quota, based roughly on his historical catches. If you were a big-time Icelandic fisherman you got this piece of paper that entitled you to, say, 1 percent of the total catch allowed to be pulled from Iceland’s waters that season. Before each season the scientists at the Marine Research Institute would determine the total number of cod or haddock that could be caught without damaging the long-term health of the fish population; from year to year, the numbers of fish you could catch changed. But your percentage of the annual haul was fixed, and this piece of paper entitled you to it in perpetuity.
Even better, if you didn’t want to fish you could sell your quota to someone who did. The quotas thus drifted into the hands of the people to whom they were of the greatest value, the best fishermen, who could extract the fish from the sea with maximum efficiency. You could also take your quota to the bank and borrow against it, and the bank had no trouble assigning a dollar value to your share of the cod pulled, without competition, from the richest cod-fishing grounds on earth. The fish had not only been privatized, they had been securitized. It was horribly unfair: a public resource—all the fish in the Icelandic sea—was simply turned over to a handful of lucky Icelanders. Overnight, Iceland had its first billionaires, and they were all fishermen. But as social policy it was ingenious: in a single stroke the fish became a source of real, sustainable wealth rather than shaky sustenance. Fewer people were spending less effort catching more or less precisely the right number of fish to maximize the long-term value of Iceland’s fishing grounds. The new wealth transformed Iceland—and turned it from the backwater it had been for 1,100 years to the place that spawned Björk. If Iceland has become famous for its musicians it’s because Icelanders now have time to play music, and much else. Iceland’s youth are paid to study abroad, for instance, and encouraged to cultivate themselves in all sorts of interesting ways. Since its fishing policy transformed Iceland, the place has become, in effect, a machine for turning cod into Ph.D.’s.
But this, of course, creates a new problem: people with Ph.D.’s don’t want to fish for a living. They need something else to do. And that something is probably not working in the industry that exploits Iceland’s other main natural resource: energy. The waterfalls and boiling lava generate vast amounts of cheap power, but, unlike oil, it cannot be profitably exported. Iceland’s power is trapped in Iceland, and if there is something poetic about the idea of trapped power, there is also something prosaic in how the Icelanders have come to terms with the problem. They asked themselves: What can we do that other people will pay money for that requires huge amounts of power? The answer was: smelt aluminum.
Notice that no one asked, What might Icelanders want to do? Or even: What might Icelanders be especially suited to do? No one thought that Icelanders might have some natural gift for smelting aluminum, and, if anything, the opposite proved true. Alcoa, the biggest aluminum company in the country, encountered two problems peculiar to Iceland when, in 2004, it set about erecting its giant smelting plant. The first was the so-called "hidden people"—or, to put it more plainly, elves—in whom some large number of Icelanders, steeped long and thoroughly in their rich folkloric culture, sincerely believe. Before Alcoa could build its smelter it had to defer to a government expert to scour the enclosed plant site and certify that no elves were on or under it. It was a delicate corporate situation, an Alcoa spokesman told me, because they had to pay hard cash to declare the site elf-free but, as he put it, "we couldn’t as a company be in a position of acknowledging the existence of hidden people." The other, more serious problem was the Icelandic male: he took more safety risks than aluminum workers in other nations did. "In manufacturing," says the spokesman, "you want people who follow the rules and fall in line. You don’t want them to be heroes. You don’t want them to try to fix something it’s not their job to fix, because they might blow up the place." The Icelandic male had a propensity to try to fix something it wasn’t his job to fix.
Back away from the Icelandic economy and you can’t help but notice something really strange about it: the people have cultivated themselves to the point where they are unsuited for the work available to them. All these exquisitely schooled, sophisticated people, each and every one of whom feels special, are presented with two mainly horrible ways to earn a living: trawler fishing and aluminum smelting. There are, of course, a few jobs in Iceland that any refined, educated person might like to do. Certifying the nonexistence of elves, for instance. ("This will take at least six months—it can be very tricky.") But not nearly so many as the place needs, given its talent for turning cod into Ph.D.’s. At the dawn of the 21st century, Icelanders were still waiting for some task more suited to their filigreed minds to turn up inside their economy so they might do it.
Enter investment banking. For the fifth time in as many days I note a slight tension at any table where Icelandic men and Icelandic women are both present. The male exhibits the global male tendency not to talk to the females—or, rather, not to include them in the conversation—unless there is some obvious sexual motive. But that’s not the problem, exactly. Watching Icelandic men and women together is like watching toddlers. They don’t play together but in parallel; they overlap even less organically than men and women in other developed countries, which is really saying something. It isn’t that the women are oppressed, exactly. On paper, by historical global standards, they have it about as good as women anywhere: good public health care, high participation in the workforce, equal rights. What Icelandic women appear to lack—at least to a tourist who has watched them for all of 10 days—is a genuine connection to Icelandic men. The Independence Party is mostly male; the Social Democrats, mostly female. (On February 1, when the reviled Geir Haarde finally stepped aside, he was replaced by Johanna Sigurdardottir, a Social Democrat, and Iceland got not just a lady prime minister but the modern world’s first openly gay head of state—she lives with another woman.) Everyone knows everyone else, but when I ask Icelanders for leads, the men always refer me to other men, and the women to other women. It was a man, for instance, who suggested I speak to Stefan Alfsson.
Lean and hungry-looking, wearing genuine rather than designer stubble, Alfsson still looks more like a trawler captain than a financier. He went to sea at 16, and, in the off-season, to school to study fishing. He was made captain of an Icelandic fishing trawler at the shockingly young age of 23 and was regarded, I learned from other men, as something of a fishing prodigy—which is to say he had a gift for catching his quota of cod and haddock in the least amount of time. And yet, in January 2005, at 30, he up and quit fishing to join the currency-trading department of Landsbanki. He speculated in the financial markets for nearly two years, until the great bloodbath of October 2008, when he was sacked, along with every other Icelander who called himself a "trader." His job, he says, was to sell people, mainly his fellow fishermen, on what he took to be a can’t-miss speculation: borrow yen at 3 percent, use them to buy Icelandic kronur, and then invest those kronur at 16 percent. "I think it is easier to take someone in the fishing industry and teach him about currency trading," he says, "than to take someone from the banking industry and teach them how to fish."
He then explained why fishing wasn’t as simple as I thought. It’s risky, for a start, especially as practiced by the Icelandic male. "You don’t want to have some sissy boys on your crew," he says, especially as Icelandic captains are famously manic in their fishing styles. "I had a crew of Russians once," he says, "and it wasn’t that they were lazy, but the Russians are always at the same pace." When a storm struck, the Russians would stop fishing, because it was too dangerous. "The Icelanders would fish in all conditions," says Stefan, "fish until it is impossible to fish. They like to take the risks. If you go overboard, the probabilities are not in your favor. I’m 33, and I already have two friends who have died at sea."
It took years of training for him to become a captain, and even then it happened only by a stroke of luck. When he was 23 and a first mate, the captain of his fishing boat up and quit. The boat owner went looking for a replacement and found an older fellow, retired, who was something of an Icelandic fishing legend, the wonderfully named Snorri Snorrasson. "I took two trips with this guy," Stefan says. "I have never in my life slept so little, because I was so eager to learn. I slept two or three hours a night because I was sitting beside him, talking to him. I gave him all the respect in the world—it’s difficult to describe all he taught me. The reach of the trawler. The most efficient angle of the net. How do you act on the sea. If you have a bad day, what do you do? If you’re fishing at this depth, what do you do? If it’s not working, do you move in depth or space? In the end it’s just so much feel. In this time I learned infinitely more than I learned in school. Because how do you learn to fish in school?"
This marvelous training was as fresh in his mind as if he’d received it yesterday, and the thought of it makes his eyes mist. "You spent seven years learning every little nuance of the fishing trade before you were granted the gift of learning from this great captain?" I ask. "Yes." "And even then you had to sit at the feet of this great master for many months before you felt as if you knew what you were doing?" "Yes." "Then why did you think you could become a banker and speculate in financial markets, without a day of training?" "That’s a very good question," he says. He thinks for a minute. "For the first time this evening I lack a word." As I often think I know exactly what I am doing even when I don’t, I find myself oddly sympathetic. "What, exactly, was your job?" I ask, to let him off the hook, catch and release being the current humane policy in Iceland. "I started as a … "—now he begins to laugh—"an adviser to companies on currency risk hedging. But given my aggressive nature I went more and more into plain speculative trading." Many of his clients were other fishermen, and fishing companies, and they, like him, had learned that if you don’t take risks you don’t catch the fish. "The clients were only interested in ‘hedging’ if it meant making money," he says.
In retrospect, there are some obvious questions an Icelander living through the past five years might have asked himself. For example: Why should Iceland suddenly be so seemingly essential to global finance? Or: Why do giant countries that invented modern banking suddenly need Icelandic banks to stand between their depositors and their borrowers—to decide who gets capital and who does not? And: If Icelanders have this incredible natural gift for finance, how did they keep it so well hidden for 1,100 years? At the very least, in a place where everyone knows everyone else, or his sister, you might have thought that the moment Stefan Alfsson walked into Landsbanki 10 people would have said, "Stefan, you’re a fisherman!" But they didn’t. To a shocking degree, they still don’t. "If I went back to banking," he says, with an entirely straight face, "I would be a private-banking guy."
Back in 2001, as the Internet boom turned into a bust, M.I.T.’s Quarterly Journal of Economics published an intriguing paper called "Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment." The authors, Brad Barber and Terrance Odean, gained access to the trading activity in over 35,000 households, and used it to compare the habits of men and women. What they found, in a nutshell, is that men not only trade more often than women but do so from a false faith in their own financial judgment. Single men traded less sensibly than married men, and married men traded less sensibly than single women: the less the female presence, the less rational the approach to trading in the markets.
One of the distinctive traits about Iceland’s disaster, and Wall Street’s, is how little women had to do with it. Women worked in the banks, but not in the risktaking jobs. As far as I can tell, during Iceland’s boom, there was just one woman in a senior position inside an Icelandic bank. Her name is Kristin Petursdottir, and by 2005 she had risen to become deputy C.E.O. for Kaupthing in London. "The financial culture is very male-dominated," she says. "The culture is quite extreme. It is a pool of sharks. Women just despise the culture." Petursdottir still enjoyed finance. She just didn’t like the way Icelandic men did it, and so, in 2006, she quit her job. "People said I was crazy," she says, but she wanted to create a financial-services business run entirely by women. To bring, as she puts it, "more feminine values to the world of finance." Today her firm is, among other things, one of the very few profitable financial businesses left in Iceland. After the stock exchange collapsed, the money flooded in. A few days before we met, for instance, she heard banging on the front door early one morning and opened it to discover a little old man. "I’m so fed up with this whole system," he said. "I just want some women to take care of my money."
It was with that in mind that I walked, on my last afternoon in Iceland, into the Saga Museum. Its goal is to glorify the Sagas, the great 12th- and 13th-century Icelandic prose epics, but the effect of its life-size dioramas is more like modern reality TV. Not statues carved from silicon but actual ancient Icelanders, or actors posing as ancient Icelanders, as shrieks and bloodcurdling screams issue from the P.A. system: a Catholic bishop named Jon Arason having his head chopped off; a heretic named Sister Katrin being burned at the stake; a battle scene in which a blood-drenched Viking plunges his sword toward the heart of a prone enemy. The goal was verisimilitude, and to achieve it no expense was spared. Passing one tableau of blood and guts and moving on to the next, I caught myself glancing over my shoulder to make sure some Viking wasn’t following me with a battle-ax. The effect was so disorienting that when I reached the end and found a Japanese woman immobile and reading on a bench, I had to poke her on the shoulder to make sure she was real. This is the past Icelanders supposedly cherish: a history of conflict and heroism. Of seeing who is willing to bump into whom with the most force. There are plenty of women, but this is a men’s history.
When you borrow a lot of money to create a false prosperity, you import the future into the present. It isn’t the actual future so much as some grotesque silicon version of it. Leverage buys you a glimpse of a prosperity you haven’t really earned. The striking thing about the future the Icelandic male briefly imported was how much it resembled the past that he celebrates. I’m betting now they’ve seen their false future the Icelandic female will have a great deal more to say about the actual one.