Saturday, February 28, 2009

February 28 2009: Heads you lose, tails you die

Alfred Palmer Nipple Tuck February 1942
Firestone factory, Akron, Ohio. War conversion of beverage containers. Oxygen cylinder for high altitude flying, manufactured by the metal division of a large Eastern rubber factory, placed on a huge stack ready for shipment to the Army

Ilargi: Two short looks at increasing perversity in the economy:

  1. The FDIC’s insatiable funding needs lead it to enhance the fees it demands form its member banks, eevn though many of them are already in deep trouble. It's not just a fine way to drive some banks into bankruptcy if you'd want to, there's another aspect that looks out of place. For some big banks, the one-time "funding call" the FDIC announced this week means they have to hand over $1 billion or more. These banks would have been long gone if not for the hundreds of billions thrown into their tar pits by the Treasury. In the end, where does the added FDIC money come from? From the taxpayer. Why not simply fund it through the Treasury?

  2. Citigroup wants to exchange $52.5 billion of its existing preferred shares for common stock worth $3.25 each. The same common shares that traded at $1.50 on Friday. The main holders of Citi's privately-placed preferred shares, the U.S. government, the Singapore sovereign wealth fund and Saudi Prince Alwaleed, will have their holdings converted based on the price of their original investment (!!) even if they bought them at 20-30 times their present value.

    Holders of Citi's publicly traded preferred shares are less lucky: they'll get an unknown premium on the market price. Most of Citi's different classes of publicly traded preferred shares closed at less than 40% of their original values Friday. That's still a lot better than holders of common stock, which will be diluted by 74%. Friday's closing price puts their value at 39 cents.

    To make the smart part of the investor crown happy, Citi had another give-away to offer. Preferred shares could be exchanged for 7.7 shares of common stock. Preferred traded for $7.50, while 7.7 common shares were at about $10.50. Buy preferred, exchange for common, pocket $3. Rinse and repeat. Like a million times on your Friday lunch break. Make $3 million without breaking a sweat. You can do it on your Blackberry.

    Where does the money come from, that difference between preferred and common shares? Hey, who owns Citi? You do, the taxpayer. Well, not on paper, of course, you paid 5 times teh value of the institution for one third of its shares. Why am I thinking that if Citi were nationalized, it would get a lot harder to play these perverted games? Alwaleed should bleed like all other shareholders. Them's the rules of the game. Instead, he was handed untold billions of your money on a rainy Friday afternoon.

I wonder where we're going to take this thing, how much further down this road we'll get before the alarm goes off. If you can get your holdings converted at the price you bought them for, you can't lose, right? But if we adopt this model, it means that there must be a party that can do nothing BUT lose. It’s like what i was thinking the other day when people claimed the Dow had lost 50%, meaning all winnings of the past decade had been wiped out. Right away, it was obvious to me that that is not true. The guys at the top get to keep their gains. So there too, there must be a party that can do nothing BUT lose. One more thing: the US GDP shrank by 6.2% in the last quarter. Obama's budget needs a minimum 3.2% economic growth next year to be viable, or even to make any sense at all.

As I said the other day: Heads you lose, tails you die.

Fresh evidence points to paralysis of global economy
The sharpest contraction in US growth for more than a quarter of a century, a collapse in Japanese factory output and an emergency package of help for the struggling countries in Eastern Europe provided fresh grim evidence today of the paralysis in the global economy. Amid fears that the downturn triggered by the credit crunch has turned into the worst slump in output since the 1930s, data from Washington showed that the havoc wreaked by the problems on Wall Street last Autumn was far worse than originally believed.

American gross domestic product in the final three months of 2008 declined at an annual rate of 6.2%, much weaker than the earlier estimate of a 3.8% fall and the worst performance by the world's biggest economy since early 1982. A breakdown of the data revealed that consumer spending, exports and investment in commercial property were all even lower than originally believed, although the main reason for the downward revision to growth was that the build up of inventories by companies was far less pronounced than originally believed.

Analysts said there had been no let-up in the bad news since the turn of the year and the markets are now braced for payroll figures next Friday to show that around 750,000 jobs were lost in the US during February, with worse to come in future months. Rob Carnell, economist at ING Financial Markets, said: "Data released so far in the first quarter of 2009 suggest that we are in for another horror story, with new record lows being set in consumer confidence, accelerating declines in the labour market [we may be nearing a million payrolls losses per month before long] and further severe contractions for business investment." Paul Ashworth of Capital Economics said he did not expect the US economy to begin expanding again until 2010 and even then the recovery was likely to be "muted".

Meanwhile, there was also grim news from the world's second biggest economy, with industrial production dropping 10% between December and January and real household spending 5.9% lower last month than it was in January 2008. Exports from Japan have been severely impaired by the retrenchment in the US and much slower levels of growth in China. Three development institutions - the World Bank, the European Investment Bank and the European Bank for Reconstruction and Development today announced a €24.5bn (£22bn) loan programme to help central and eastern Europe, where plunging industrial production and falling currencies have raised concerns that the region will become the scene for the next stage of the global crisis.

The three banks said the two-year plan would provide quick, large-scale financing to banks and ensure smaller companies would not be shut off from capital, but the markets - which believe a much bigger package will be necessary to prevent economic collapse - greeted the plan coolly. The Hungarian government will tell an EU summit on Sunday that the money from the World Bank, the EIB and the EBRD needs to be multiplied 10 times for central Europe alone.

Under the development bank plan, the EBRD will provide up to €6bn euros this year and next to the region's financial sector, which will include trade finance through banks. The EIB said it will lend €11bn to businesses in central, eastern and southern Europe, of which €5.7bn is ready to be disbursed, and a further €2.8bn should be approved by the end of April. The Washington-based World Bank said it intends to propose lending and political risk guarantees of up to €7.5bn for banks, infrastructure projects and trade financing.

Its president Robert Zoellick said earlier this week that $120bn (£84bn) could be needed to recapitalise Eastern Europe's banking system, which has seen the large sums invested by Western banks during the boom years disappear during the credit crunch. "It (the €24.5bn package) sounds like a lot of money, but when (commercial) banks have lent Eastern Europe about 1.7 trillion dollars, 25 billion is peanuts," said Nigel Rendell, emerging markets strategist at Royal Bank of Canada in London. "Ultimately we will have to get a much bigger package and a coordinated response from the IMF, the European Union and maybe the G7."

Economy moving in reverse faster than predicted
The economy is moving in reverse faster than the government can measure. The contraction for the fourth quarter of 2008 had been estimated at 3.8 percent just a month ago. Then the Commerce Department raised it to an astonishing 6.2 percent Friday — the largest revision since the government started keeping records in 1976. That was the economy's worst showing in a quarter-century and raised the prospect that the nation could suffer its worst year since 1946. "Consumers are just hunkering down and saying 'game over,' and businesses in response are cutting back on investment and employment," said Brian Bethune, economist at IHS Global Insight. "It's a negative feedback loop."

Now in its second year, the recession is expected to stretch at least through the first six months of 2009, as shoppers slash spending in the shadow of hard times at home and aboard. Companies, in turn, are being forced to cut jobs and production while resorting to other cost-saving measures to survive. The Commerce Department's new report was also weaker than the 5.4 percent drop economists had expected. The biggest culprit behind the record-breaking revision: Businesses actually cut inventories instead of building them as the government originally thought. That reduced — rather than added to — economic activity. In addition, consumers pulled back even more on their spending — which accounts for about 70 percent of national economic activity. U.S. exports suffered a bigger drop and businesses retrenched further.

Many economists lowered their forecast for this year's gross domestic product to show a deeper contraction of at least 2 percent. GDP, the value of all goods and services produced in the United States, is the best barometer of the country's economic health. White House press secretary Robert Gibbs said the latest GDP figure "underscores the urgency with which the president feels we have to move to improve our economy." The economy has not suffered a decline for a full year since 1991, and that was just by 0.2 percent. If the new projections prove accurate, it would mark the worst annual showing since an 11 percent plunge in 1946. "The slide in our economy is very severe and very broad across all industries and regions of the country," said Mark Zandi, chief economist at Moody's "It is about as dark an economic time that we've experienced since the 1930s."

Before Friday's report was released, many economists were projecting an annualized drop of 5 percent in the current January-March quarter. Given the fourth quarter's showing and the dismal state of the jobs market, some economists believe a decline of closer to 6 percent in the current quarter is possible. The nation's jobless rate is now at 7.6 percent, the highest in more than 16 years. The Federal Reserve expects the rate to climb to close to 9 percent this year, and probably will stay elevated into 2011. California's unemployment rate jumped to 10.1 percent in January, the state's first double-digit jobless reading in a quarter-century. The jobless rate announced Friday by the state Employment Development Department is well above the national jobless rate, and represents an increase from the revised figure of 8.7 percent in December.

On Wall Street, stocks fell Friday as investors reacted to a decision by Citigroup Inc. to turn over a big piece of itself to the government and a move by General Electric Co. to slash its quarterly dividend by 68 percent. Investors also paid close attention to the lower GDP figures. The Dow Jones industrials fell more than 119 points to 7,062.93, its lowest close since May 1, 1997. The faster downhill slide in the final quarter of 2008 came as the financial crisis — the worst since the 1930s — intensified. Both the new and the old fourth-quarter figures marked the weakest quarterly showing since an annualized drop of 6.4 percent in the first quarter of 1982, when the country was suffering through an intense recession.

For all of 2008, the economy grew just 1.1 percent, weaker than the government initially estimated. That was down from a 2 percent gain in 2007 and marked the slowest growth since the last recession in 2001. In the fourth quarter, consumers cut spending at a 4.3 percent pace. That was deeper than the initial 3.5 percent annualized drop and marked the biggest decline since the second quarter of 1980. Businesses slashed spending on equipment and software at an annualized pace of 28.8 percent in the final quarter of last year. That was deeper than first reported and the worst showing since the first quarter of 1958.

Fallout from the housing collapse spread to other areas. Builders cut spending on commercial construction projects 21.1 percent, the most since the first quarter of 1975. Home builders slashed spending at a 22.2 percent pace, the most since the start of 2008. In the long run, the reduction in new projects should aid the housing market's recovery as fewer properties for sale help increase competition and stabilize prices. But at the moment, a stable housing market appears months away. A sharper drop in U.S. exports also factored into the weaker fourth-quarter performance. Economic troubles overseas are sapping demand for domestic goods and services.

US Economy in Worst Fall Since '82
The U.S. economy deteriorated far more than previously thought in the fourth quarter, according to new revisions of government data, casting fresh doubt about the chances of a recovery this year. With falloffs in consumer spending and exports, gross domestic product declined at a 6.2% annual rate in the fourth quarter of 2008, according to a Commerce Department report Friday. The agency's first estimate for GDP, reported in January, was for a 3.8% decline. The more recent figure -- which represents the steepest dropoff since the depths of the 1982 recession -- raises pessimism among economists. Until recently, many had been hoping for a rebound in 2009 and now sound downbeat about the remainder of this year.

Besides the revised GDP, economic indicators for the first two months of the year point to a deepening recession -- and the prospect of a dismal first quarter, too. Every week in February, more than 600,000 people filed new claims for unemployment insurance, and the unemployment rate rose to 7.6% in January, from 7.2% in December. "The first quarter is going to be bad," said Christina Romer, chairwoman of the Council of Economic Advisers, at an economics gathering Friday sponsored by the University of Chicago and Brandeis University. She told the audience that Obama administration officials have been watching with deepening concern what's been going on around the world.

The U.S. has been hurt by the synchronized nature of the current global downturn. Exports declined at a 24% annual rate, compared with the 20% rate previously reported. Meanwhile, it appears the world's other economies truly fell apart in the fourth quarter. India reported on Friday its fourth-quarter GDP growth was lower than expected, while Japan said last week its GDP had contracted more than 12%. Growth in both Europe and the U.K. fell at an identical 5.9% annual rate. These numbers mean the U.S. can't lean on its trading partners to buy goods and help buoy business activity. Private investment, which encompasses everything from business spending to homebuilding, fell at a 21% annual rate in the fourth quarter. That portends poorly for the first quarter of this year since one company's cutbacks in spending can lead another to do the same.

In Essex Junction, Vt., Bradley Aldrich, the president of an engineering firm, says he is putting off big purchases until he gets a clearer idea of where the economy is headed. His company, Forcier Aldrich & Associates Inc., spends up to $40,000 a year on various equipment. Mr. Aldrich has particular interest in a $30,000 software system that would allow the firm to hold a vast database of blueprints and other documents. He guesses it would save up to $5,000 a year in paper costs. "It makes sense to do it, but with the economy the way it is right now we're reluctant to make the investment," says Mr. Aldrich. Still, Ms. Romer strikes an optimistic tone about the prospects for a turnaround in the economy later this year. The Obama administration Thursday offered economic projections in its budget that were rosier than most private-sector forecasts. Defending the projections, Ms. Romer said a turnaround is likely this year as the federal fiscal stimulus package works its way through the economy.

Some economists have a much dimmer view, arguing the best the stimulus can do is prevent a recession from turning into depression. "There's no way we are going to be able to avert a deep and long recession," says Joshua Shapiro, chief U.S. economist at research firm MFR, Inc. Conrad DeQuadros, senior economist at RDQ Economics in New York, forecasts "a fairly lackluster recovery in 2010," and projects that unemployment will graze double digits from its current 7.6%. Federal Reserve officials in recent days have tempered their call for an economic rebound this year, saying they still expect one, but it depends critically on the success of officials in repairing the damaged financial system. "Below-potential growth is likely to persist until financial markets and financial institutions can resume more normal functioning," Eric Rosengren, president of the Federal Reserve Bank of Boston said at the Friday economics conference.

Nearly half of the revision was due to inventory levels that turned out to be lower than originally thought -- meaning companies ordered fewer goods in anticipation of weak customer demand. Inventory levels were first reported to add about 1.3 percentage points to growth in the fourth quarter, but that was revised down to just a 0.16 percentage-point boost. The silver lining, however, is that companies may rebuild stocks sometime in the first part of this year, possibly giving a bigger boost than anticipated to growth. Retailers in particular weathered a brutal fourth quarter, as the loss of consumer spending hit right during their crucial holiday season. The Commerce Department's GDP report showed that consumer spending on non-durable goods, such as food and clothing, declined at a 9.2% annual rate. That compares to the previously-reported figure of 7.1%. With an abysmal finish to 2008, retailers responded with layoffs, store closings and cost-cuts that stand to further weaken the U.S. economy.

Saks Inc., for example, expects sales in stores open at least a year to drop by double-digits this year, as chief executive Stephen I. Sadove this week called the current landscape "perhaps the most challenging the company has faced in its 84-year history." Leather-goods retailer Coach Inc. laid off 150 employees, or about 10% of its U.S. corporate staff. It is also reducing prices and paring back new-store openings this year. Even lower-priced chains are reeling, and are moving quickly to adjust inventories to match customer demand. Kohl's Corp. said Thursday its fourth-quarter net income dropped 18%, and chief executive Kevin Mansell said the company is "planning conservatively in our sales expectations, inventory levels, and expenses" for 2009. Federal spending helped blunt the GDP decline, but was offset by a fall in state and local spending. Falling sales, income and property taxes have saddled cities and states with the worst budget gaps in a generation, forcing them to lay off employees and make cuts in normally untouchable programs like schools and police forces.

Obama Budget Calls For 3.2% Growth Next Year
The coming federal deficits are already huge, and they're based on rosy expectations. Yesterday we wondered whether there would be enough rich to support the $1 trillion in new taxes that Obama hopes to raise by taxing them. The budget also leans heavily on PE and hedge fund types, which obviously aren't making anywhere near the money they used to be. And as WSJ notes, the budget calls for 3.2% GDP growth next year. Seriously? What in the world is going to push us towards that kind of growth? Government spending will help a bit, but unless the country was one more gigantic bubble in it (we doubt it, we think we're bubbled out for now) we just have a hard time seeing it. For what it's worth, "professional forecasters" see 2.1% growth next year, which also doesn't seem all that likely.
The Obama budget puts the deficit at less than $600 billion starting in 2012 from $1.75 trillion this year. Getting to that point requires GDP to rise more than 4% a year by then -- meaning the U.S. would quickly return to growth rates similar to the boom years of the 1990s -- after the worst financial shock since the Great Depression.

Breaking point for the eurozone?
Ireland's 'miracle' economy has turned terrifyingly sour - and as it strains against the inflexibility of the euro, its next crisis may shake the entire EU. They can barely let the words pass their lips, but some of the EU's most important policymakers were forced this week to discuss what was once unthinkable: that at least one of the 16 eurozone countries might be on the brink of ditching the single currency. Jean-Claude Trichet, president of the European Central Bank, admitted that the 10-year-old eurozone was under "extreme strain", with weaker countries struggling to keep their economies afloat in the face of the devaluation of other currencies, such as sterling and the dollar.

Joschka Fischer, Germany's former foreign minister, darkly suggested that we would soon find out whether the eurozone would turn out to be "a disaster", while the German finance ministry is vacillating on whether it would be prepared to bail out insolvent states. The current thinking is that Germany and France, as the strongest economies in the zone and "lenders of last resort", would have to bail out failing states: the prospect of the eurozone breaking up would bring the future of the EU into question. But the most startling fact to emerge this week is that the country which is seen as the most vulnerable, and therefore the most likely to ditch the euro, is not Slovenia, or Cyprus, or Greece, but Ireland.

Until a year ago, the Republic's Celtic Tiger economy, which attracted such blue-chip companies as Dell, Microsoft and Intel, seemed unstoppable. In a decade, the Irish economy grew by almost 90 per cent, catapulting it from one of the poorest countries in Europe to the fourth-richest per capita. Government advisers from as far afield as Chile and Israel made pilgrimages to marvel at a model that they were desperate to emulate. Not any more. All of a sudden, Ireland's debt-fuelled economy, built largely on a construction boom, has collapsed in a more spectacular manner than almost any other in Europe. Irish government bonds are rated as the riskiest in the EU, and there has been panicky talk of Ireland as "the next Iceland".

On the streets, there is a whiff of revolution, with 120,000 people staging Dublin's biggest mass rally in 30 years last weekend to protest at the government's handling of the economy and its decision to impose what amounted to a pay cut on public sector workers. The unions have now threatened a "Doomsday" strike next month if the prime minister, Brian Cowen, does not think again. As the celebrated Irish economist David McWilliams put it: "The entire Irish episode will be studied internationally in years to come as an example of how not to do things. So how did it all go so wrong?

Visiting Dublin this week, I took a stroll down the south bank of the River Liffey, to the site where Ireland's tallest building, the U2 Tower, should by now have been rising out of the ground as the ultimate symbol of the Celtic Tiger's "economic miracle". Designed by Lord Foster, the 60-storey glass skyscraper was to have housed dozens of one-million euro apartments (£1 million), topped by a penthouse recording studio for Ireland's most successful band. Instead, there was nothing to see but dead grass, crushed beer cans and a rusting skip inhabited by 3ft weeds. Two months ago, the developers postponed the project indefinitely. This scruffy patch of former dockland represents the end of the dream for Ireland, whose "economic miracle" was largely based on a crazy construction bubble, fuelled by tax incentives, which, when it finally (and inevitably) burst, created a black hole that threatens to suck in the rest of the failing economy.

In 2006, Ireland (population 4.2 million) built 88,000 houses, compared with 150,000 in the UK (population 60 million). At one point, a fifth of the workforce, swelled by tens of thousands of immigrants, worked in construction. Irish families on middle and even low incomes cashed in their pensions or borrowed heavily to buy second, third or even fourth properties, believing they could rent them out to the migrant workers who had caused net immigration for the first time in Ireland's history. They could borrow from banks that enjoyed one of the loosest regulatory regimes in Europe, and which shipped in money from abroad to further stoke up the boom.

Ireland now has up to 350,000 empty homes – more than its entire private rental market – many of them simply abandoned as builders went bust. House prices are expected to fall by 80 per cent. Ireland might have been able to withstand Europe's most savage property collapse had not its export trade been shredded at the same by currency devaluation in its two key markets – Britain and America. The relative rise in the value of the euro against sterling and the dollar has made Irish goods – and wages – prohibitively expensive. Businesses in the north of the Republic are on their knees because competitors in Northern Ireland are undercutting them by as much as half. In an ominous sign of things to come, the computer firm Dell has announced 250 redundancies at its plant in Limerick, simultaneously confirming that it intends to create thousands of new jobs in Poland.

The slump in the Irish job market means that the country's youth, who for years now have been able to find jobs at home, are once again having to look abroad for employment, so that the Republic may soon return to its traditional pattern of net outward migration. Already, large numbers of Irish workers are moving to Britain seeking work. Crucially, the Irish government is powerless to act because, as a member of the eurozone, it has no control over interest rates or currency devaluation. While the Bank of England could cut interest rates to one per cent and plans to devalue sterling with "quantitative easing", the Irish have had to resort to desperate measures to reduce their budget deficit, such as the public sector wage cuts which led to the mass demonstrations.

Evidence of the effect on Ireland's real economy, as unemployment heads towards 10 per cent, is everywhere. In Dublin's docklands, once expected to become a sort of European Dubai, row upon row of kitchen suppliers, interior design and furniture shops have closed since my last visit nine months ago, their windows covered in a thick layer of grime. Catherine Claffey, whose family have sold flowers at the same pitch in Grafton Street, a few yards from Chanel and Louis Vuitton, for 85 years, told me business was down 60 per cent on last year. "I've only been able to keep going because I've never taken out any big loans," she said. "But I have friends earning very modest salaries in the public sector who have been told their wages are going to be cut by 500 euros a month. How are they going to survive?"

A hundred yards down the road, a group of taxi drivers was staging a noisy protest over the government's failure to manage taxi numbers. Thousands of workers who have lost their jobs in other sectors have been allowed to set up as cabbies, meaning that Dublin now has 16,000 licensed taxis. New York, with a population 17 times as large, has 13,000. Andy Doyle, a cabbie for 20 years, said: "There are so many taxis now that you can be waiting two-and-a-half hours on a rank before you pick up a fare. Yesterday I waited an hour and three quarters for a 6.20 euro fare. You just can't live on that. But the government is happy to let it go on because it keeps the unemployment figures down. It's madness." The resounding "No" vote in last year's referendum on the European Constitution suggested that Ireland has finally fallen out of love with Europe. But will it now take the ultimate step and ditch the euro?

Sean Murphy, director of policy at the business organisation Chambers Ireland, believes not. "Everything positive in the Irish economy for the past 30 years has been driven by our membership of the EU," he said. "In the long term it will continue to benefit us. We have a small, flexible economy, which means we will be able to turn it round much quicker than a bigger economy like the UK's. "It's become clear that we need a more balanced, diverse economy, with more jobs in things like alternative energy and information technology. I believe our EU membership can only help with that." But if the Irish economy, and that of other struggling EU states, continues to nosedive, the cohesion of the eurozone is likely to be tested to breaking point.

Dire growth data fuel Asian fears
Weak growth data from India and Malaysia on Friday provided fresh evidence of the deepening impact of the global recession on developing Asia. The figures are likely to put pressure on authorities to take much more forceful fiscal and monetary interventionism to counter the downward spiral. The 5.3 per cent growth from a year earlier in India and 0.1 per cent annual expansion in Malaysia’s economy in the fourth quarter of last year came as Japan’s manufacturing output suffered a record 10 per cent month-on-month drop in January. New job offers in Japan also plummeted 18 per cent to complete an abysmal set of recent figures from the world’s second-largest economy, including a record 45.7 per cent fall in exports in January.

The figures are further proof that Asia’s economy fell off a cliff in the closing months of 2008 and raise the likelihood that the bad news will continue to flow as the region’s export-dependent nations are forced to cut jobs and manufacturing capacity because of weak western consumer demand. The collapse in Asian exports over the fourth quarter was “nothing short of breath-taking”, said Frederic Neumann, Asia chief economist at HSBC. “Economic models and experience suggest that financial turmoil tends to transmit far more gradually into the real economy than has occurred this time around. In fact, the severity and rapidity of the fall in output exceeds anything we have ever seen before.”

Economists predicted that the Reserve Bank of India might cut interest rates as early as this weekend after the economy recorded its slowest expansion in the past six years. The gross domestic product data indicated that India is suffering a much greater impact from the global crisis than New Delhi has so far acknowledged, including in politically sensitive areas such as farm output. Friday’s announcements from south-east Asia were equally grim. Malaysia’s economy grew at its weakest pace in eight years in the fourth quarter from a year earlier, while Thailand’s exports and industrial production fell at a record pace in January. “It’s now a given that every government is going to spend until it drops, whether or not they have the money, like India,” said Sharmila Whelan, senior economist at CLSA, an Asia-focused brokerage. “We are looking for aggressive rate cuts everywhere.”

India’s economy expanded by 7.6 per cent in the July to September quarter. Just a few weeks ago, the country’s Central Statistical Organisation forecast growth of 7.1 per cent for the full financial year, which ends in March 2009. Ashok Chawla, the economic affairs secretary, on Friday continued to talk up the country’s prospects, suggesting that a surge in government spending and resilient agricultural production would allow India to finish this year with growth of about 7 per cent. But the sharp deceleration at the end of 2008 raises serious doubts about whether India’s economy, which had averaged growth of 9 per cent annually for the past three years, can meet such high expectations. Ahead of a general election that is due to be held by May, Jehangir Aziz, chief economist in India for JP Morgan, said the worse-than-expected data “bring perception much closer to reality”.

With inflation rapidly disappearing as a threat across Asia, economists said that central banks had room to cut rates much more rapidly. In India, for instance, although the RBI has lowered its key policy rate by 350 basis points in the past few months, declining inflation has left real interest rates higher than they were. “My sense is this will jar the policymaking team and get them started on some real aggressive loosening that needs to be done – at least on the monetary side,” Mr Aziz said. John Richards, head of research at Royal Bank of Scotland in Tokyo, said that Japan was “laying the groundwork for a deflationary environment”, after it reported that the core consumer price index, which excludes fresh food but includes oil products, was flat from a year earlier. “We have a very severe downturn and that is feeding into the banking system to create Japan’s own version of some of the stresses we’ve got in the rest of the world,” Mr Richards said.

Citigroup Prefers Some Preferred Shareholders Over Others
Some of Citigroup Inc.'s preferred shareholders are more preferred than others. On Friday, Citigroup said it would offer to exchange up to $52.5 billion of its existing preferred shares for common stock worth $3.25 each. Owners of Citigroup's privately-placed preferred shares, which include the U.S. government, will have their holdings converted based on the price of their original investment even though the bank's share price has collapsed since they were made. But owners of Citigroup's publicly traded preferred shares won't get as sweet a deal. They will be converted at an as-yet-undetermined premium to the market price. On Friday, the bulk of Citigroup's different classes of publicly traded preferred shares closed at less than 40% of their original values, with most settling between $8 and $10.

Citigroup didn't explain in its press release the uneven treatment of its preferred shareholders, which essentially treats some investors based on the book value of their holdings and others based on the market value. But one reason for the complicated deal structure could be that the bank wants to keep its funding options open. At the current depressed common stock price - Citigroup shares closed at $1.50 after touching a fresh 52-week-low on Friday - issuing new common stock is almost certainly out of the question. By protecting buyers of privately placed shares - like the U.S. and Singaporean governments, as well as Saudi Arabian Prince Alwaleed Bin Talal - Citigroup may be keeping its funding options open if it needs to tap markets for capital again, since it will be showing its willingness to take care of investors who agree to take a large-sized risk on the shaky bank.

"It shows they are not trying to slam the door, which is what [happened] with Fannie and Freddie," said Donald F. Crumrine, the chairman of Pasadena, Calif.- based Flaherty & Crumrine Inc., an investment adviser specializing in preferred securities. Crumrine was referring to the government seizure of mortgage giants Federal National Mortgage Association , also known as Fannie Mae, and Federal Home Loan Mortgage Corp., known as Freddie Mac., which hurt both preferred and common shareholders alike. While the deal may be good news for the bank's prospects, it has some holders of its publicly traded preferred shares hopping mad. They feel like Citigroup has given them short shrift, even though they have already suffered as the bank's shares wilted from near all-time highs just 18 months ago.

"It's incredibly frustrating," said Christopher M. Brown, the president of Lexington, Ky.-based Aristides Capital LLC, "both as a money manager and as a citizen." Brown holds Citigroup preferred shares. What's more, a number of investors said in interviews Citigroup's statement sewed confusion in the market, since investors were unsure how to gauge the value of the bank's preferred shares. Citigroup has said it will announce the redemption values of its public preferred shares in a filing with the U.S. Securities and Exchange Commission, but the bank didn't say when that data will be available. As a result, prices on some of the bank's preferred shares swung wildly on Friday. One series of preferred shares fell below $5 in morning trading before soaring to well above $9 - all before noon. The shares finally ended the day above $8 per share.

"It was total confusion this morning," said Brown. Of course, even the holders of the publicly traded preferred shares are doing better than the holders of Citigroup's common stock. After Citigroup converts its preferred shares - both privately placed and publicly traded - common stock shareholders will be diluted by 74%, according to David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller LLC. Calculated from Friday's closing price, that would push Citigroup's common shares to a value of 39 cents.

Here’s Why Citi’s Preferred Soared
A lot of people were a bit mystified when the preferred shares of Citi soared after news broke on the government's latest rescue. After all, these things stand to get converted to Citi’s common, which sunk to a new all time low.  Shouldn’t the preferred shares getting converted have sunk right down with the common? It’s a perfectly reasonable question. The reason Citi’s preferred rallied is that the shares were so cheap already that conversion to common at dirt cheap levels actually makes sense. On Wall Street they call this an “arbitrage play,” which is a fancy term for trying to make money when two prices that should move together have moved apart. Here’s how the Citi arbitrage play worked today.
  • Citi said it would offer to exchange all preferred shares to common stock at $3.25 per share, giving the preferred around 7.7 share of common stock. The common, however, was trading far below $3.25--all the way down to $1.50. Basically, Citi was asking preferred holders to pay $3.25 for shares that you could buy in the open market for just $1.50. Who would do that?
  • Smart guys at hedge funds, that's who.
  • Let’s take the Citi preferred shares called “Class M.” There are something like 81 million shares of these things and they originally sold for $25. But Citi’s troubles led investors to sell those off so steeply that they were recently trading between $5 and $7. 50.
  • Now the math is simple. If you get 7.7 shares of common worth $1.50 a share, each share of preferred is worth $11.55.
  • To put it differently, if you bought a share of preferred for $7.50, you could flip them for common worth $11.55. When investors—especially hedge funds—got their mind around this, they started buying up the preferred shares like crazy, sending the price higher.
  • Want to make this even better? Short the common while you buy the preferred. That way even if the common keeps dropping, you won’t have to worry about losing your money. This is exactly what hedge funds were doing today.

Citigroup’s Third U.S. Rescue May Not Be Its Last, Analysts Say
The U.S. government’s third attempt to help rescue Citigroup Inc. won’t stanch the company’s losses, which will continue to swell and may lead the bank to require more money in coming months, analysts said. Yesterday’s action didn’t furnish the New York-based bank with new money, although it cuts expenses by eliminating dividends on preferred stock. Instead, it converted preferred shares into common equity, which absorbs the first hit in the event of further losses, at an above-market-value price of $3.25. The stock, which has fallen 78 percent since the beginning of the year, closed in New York trading yesterday at $1.50, its lowest since November 1990.

Vikram Pandit, 52, Citigroup’s chief executive officer, told investors yesterday that increasing tangible common equity to as much as $81 billion from $29.7 billion should "take the confidence issues off the table," regarding the company’s ability to absorb losses. Still, Citigroup, which lost $27.7 billion in 2008, is expected to lose $1.24 billion in the first six months of 2009, according to the average of analysts’ estimates compiled by Bloomberg. "There’s no difference here," said Christopher Whalen, co- founder of Institutional Risk Analytics, a Torrance, California- based risk-advisory firm. "It won’t fix revenue, and you’re still going to see loss rates."

One immediate change from yesterday’s announcement was that the value of the government’s investment fell by more than half. The government said it would convert as much as $25 billion of its preferred stock to common shares for a 36 percent stake in the bank. At yesterday’s closing price of $1.50, that investment is worth about $11.5 billion. Citigroup has a stock market value of $8.2 billion today. "Taxpayers are being ripped off," Congressman Brad Sherman, a Democrat from California who sits on the House Financial Services Committee, said in a statement. "The only thing worse than nationalizing a bank is to pay for the entire bank and only get one-third of it."

Goldman Sachs Group Inc.’s analysts, led by Richard Ramsden, recommended that investors avoid Citigroup shares because "it is unclear whether this is the last round of capital restructuring, which means that existing equity may be further diluted in the future." The analysts also noted that the bank’s new 4.3 percent ratio of tangible common equity to total assets falls to just 2 percent if deferred tax assets are excluded. Those will only become valuable if and when the bank returns to profitability. Rather than boosting confidence, the move led Moody’s Investors Service to cut its senior debt rating for Citigroup to A3 from A2 and prompted Standard & Poor’s to change its outlook on the bank’s debt to "negative" from "stable."

"Citi will face a tough credit cycle in the next two years, which will likely result in weak and volatile earnings," S&P analyst Scott Sprinzen wrote in a statement. "We cannot rule out the possibility that further government support may prove necessary." Some analysts and investors were more heartened by yesterday’s news. David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller in New York, said the transaction fortifies the bank’s balance sheet, and he expects the stock to rise back to $3 "once the emotion of the moment passes." William Isaac, chairman of Secura Group LLC and a former chairman of the Federal Deposit Insurance Corp., said that while he hopes yesterday’s action is enough, the government may need to put in more money if the economy continues to deteriorate. "If they need more money we should put it in," Isaac said. "The best approach is to do what you think will work as you go along."

In its first two efforts to rescue Citigroup, the U.S. Treasury provided $45 billion by buying preferred stock and joined the Federal Reserve and FDIC in agreeing to guarantee the bank against all but $29 billion of losses on a $301 billion portfolio of assets. Yesterday, the Treasury, as well as other preferred stockholders including the Government of Singapore Investment Corp. and Saudi Prince Alwaleed bin Talal, gave up their dividends and agreed to take common stock at $3.25 a share. "The administration and the past administration have tried so many different ways that we can only hope and pray that this time they get it right," said Charles Rangel, a Democratic congressman from New York who serves as chairman of the House Ways and Means Committee. "It seems like with the banks it is a never-ending thing."

The government was in a near-impossible position trying to set a price to convert the stock, said Tony Plath, a finance professor at the University of North Carolina at Charlotte. "You can’t massively overpay because the taxpayer will scream, but you can’t pay market price because that doesn’t give them enough tangible common equity," Plath said. "The value of the equity is close to zero, but you can’t let it fall to zero because so much of it is owned by private money outside the U.S." Institutional Risk Analytics’ Whalen said the government’s efforts are mainly protecting those who hold Citigroup bonds, which he said are widely held by other financial institutions and foreign governments. "The taxpayer is funding the operating loss and protecting the bondholders," Whalen said. "The subsidy for the banks will become one of the biggest lines in Washington’s budget."

Citigroup’s $3 billion of senior unsecured bonds that mature in May 2018 rose to 87 cents on the dollar yesterday from 85 cents a day earlier, according to data reported on Trace, the real-time bond-price reporting service of the Financial Industry Regulatory Authority. Whalen said it would be better if the government organized bondholders in Citigroup and insurer American International Group Inc., which got a $150 billion U.S. bailout, and reach a deal to convert some debt to equity. Standard & Poor’s, in cutting its outlook on Citigroup’s debt to negative, said even bondholders may be affected. "Debt holders could eventually be required to participate in further government-led restructuring actions," S&P said.

The Incredible Sinking Citi
Citigroup has its new deal with the government, but the result may end up looking more like shuffled deck chairs than a final solution to the bank's problems. First the good news: Citi is significantly boosting a key capital measurement, known as tangible common equity, by converting $25 billion worth of preferred shares into common shares at a discount. This gives the government, which has bought $45 billion worth of preferred shares in Citi since last October, a 36% stake in the bank. Tangible common equity would jump from about $30 billion, or 1.9% of total assets, to $81 billion, or 4.6% of assets, a level more in line with other major banks. By another measure, it would increase from 3.6% of risk-weighted assets to 8.8%.

The ratio, which tells common shareholders how much they would get in the event their company was liquidated, used to take a back seat to another ratio, Tier 1 capital, which for Citi is at 11.9%. But analysts are increasingly focusing on tangible common equity as another way to judge a bank's financial strength. Citi has struggled more than other major banks to fill a capital hole left by the deteriorating value of assets on its balance sheet and mounting loan losses. It recorded $18 billion in losses for 2008 and on Friday said it would revise fourth-quarter results to include a $9 billion impairment charge for writing off goodwill for its consumer banking division. The government's larger stake stops short of the full nationalization some had feared, though it will mean existing common-share holders will see the value of their holdings erode even more. On Friday, Citi shares fell 38%.

Vikram Pandit, Citi's chief executive, who gets to keep his job, said Friday that "this capital should take confidence issues off the table, even in a stressed environment." As for nationalization, "this announcement should put those concerns to rest," he added. Citi is enticing (some might say forcing) other private investors to go along with the conversion to common stock by eliminating the dividend on preferred shares. (It also suspended the dividend on common shares.) So far, some of its biggest supporters have said yes, including Saudi Arabian billionaire Prince Alwaleed bin Talal, Singapore Investment Corp. and Capital Research. There was yet no word on what Sanford I. Weill has decided. The former chief executive of Citi was part of a group, along with Prince Alwaleed, that raised $12.5 billion in capital for the bank in January 2008 in a preferred share purchase.

This is Citi's third trip to the government trough, though technically Friday's transaction involves no additional investment by the government. Outsiders remained skeptical of what the future holds for the bank. A government-mandated stress test on the biggest U.S. banks, including Citi, began this week but won't be completed until the end of April. At that point, Citi would be eligible to apply for more capital, the U.S. Treasury Department said in a press release. Fitch Ratings, which affirmed Citi's ratings at A-plus, cautioned that Citi still faced significant challenges. "Global economic difficulties will cause the inflow of new problems ranging from U.S. and international consumer exposures to large corporate exposures," it said. "Consequently, loan loss provisions and charge-offs will escalate from already high levels in 2008."

Analysts also sounded cautious about the ultimate effect the transaction would have on Citi's prospects. David Trone of Fox Pitt Kelton said, "While Citi's balance sheet is now much more fortified, its asset-risk profile is very high, and the effect of even minority government ownership is unclear." Other bank stocks, as well as a basket of bank preferred stocks that trades as an exchange-traded fund, fell Friday on fears other banks would follow Citi's lead. Preferred bank share holders were hit as they scrambled to exit positions they feared would no longer pay dividends. The PowerShares Financial Preferred ETF fell 11%. Those fears may be overblown, Trone says. "Citi is an isolated case, and investors should not assume other banks will meet the same fate. We believe other banks will either require no additional actions [or] will get convertible preferreds that will become common only in the event of emergency down the road."

Another consequence for Citi will be increased government involvement in the bank's operations. The board faces a shake-up, says Richard Parsons, the newly appointed chairman. Three of the current 15 directors are not standing for election in April. "We are actively conducting a search and expect to announce several new directors shortly," Parsons said Friday. On a conference call, Pandit said Citi's senior executives "completely remain in charge" of day-to-day operations. Lucky them.

This 'multinationalisation' may not be the worst alternative for Citi
Citigroup has become the United Nations of the global banking system. Sure, Uncle Sam is almost certain to emerge from the New York conglomerate's massive recapitalisation with the biggest single shareholding. But this isn't a nationalisation along the lines of, say, Britain's takeover of Royal Bank of Scotland. Fold in the stakes that will probably be held by funds linked to the governments of Singapore and Kuwait and a Saudi prince, and a quasi-sovereign group - a sort of coalition of the begrudgingly willing - will have a majority, effectively controlling stake in what was formerly the biggest US bank. Maintaining Citi in private hands would have been ideal - but this "multinationalisation" may not be the worst alternative for Citi's business.

Of course, the US government's stake of up to 36pc does present complications. It may force the company to reconsider its footprint around the world. That's because many countries place restrictions on entities that are even partly owned by foreign governments. Mexico, for example, has a law that bars a company that is more than 10pc owned by a foreign government from operating a bank. That raises vexing questions about Citi's ownership of Grupo Financiero Banamex, the second largest bank in the country. Citi might be forced to sell the business if it cannot reach an understanding with the Mexican government. Of course, given Citi's continuing need for fresh capital, a sale might be necessary anyway.

Limitations on Citi's size now or in the future don't, however, have to be a disaster. The bank is still too sprawling to be managed effectively. While Citi might not get great prices if forced to sell pieces of itself in Mexico, Poland or Korea right now, there may be benefits for shareholders and regulators in having a better managed Citi over the long haul. In the meantime, having the governments of Singapore and Kuwait - not to mention Prince Alwaleed - more deeply enmeshed in its capital base may bring Citi's bankers greater sympathy from clients in the still-rich Middle East and Asia. It surely beats the alternative: a fully-controlled subsidiary of the US government.

Citigroup shares plunge again after latest bail-out plan is revealed
Panicked Citigroup shareholders fled the ailing banking group in droves last night as the US government stepped in with plans to take a 36% stake in the company and remove a number of directors. After the government released plans to take what is in effect a controlling shareholding in the world's biggest banking group Citi shares plunged 39% to close at just $1.50. The rout contributed to a fall of 119 points in the Dow Jones Industrial Average, taking it to 7,062 points - a twelve-year low. The US government's move, made after days of speculation that Citi was to be nationalised, is the third attempt by the US Treasury to stabilise the troubled banking group and arrest the rapid decline in its share price.

Previous government efforts to restore the bank's fortunes - including a $45bn (£32bn) capital injection in exchange for preferred shares and a guarantee on more than $316bn worth of dodgy loans - did not restore the market's confidence. In the face of this continued failure, the US Treasury made its boldest move yet to save Citigroup an hour before Wall Street opened for trading yesterday. The government proposed converting to common equity some $25bn worth of the preferred shares it received in exchange for the earlier capital injections. The exchange will be made at $3.25-a-share - a 32% premium to Thursday's closing share price - and only if and when a group of private preferred stock holders agree to do the same.

Those private investors, who hold some $27.5bn of preferred Citi stock between them, include long-time Citi backer Saudi Prince al-Waleed bin Talal and the Government of Singapore Investment Corp. If the plan is fully executed the US government's stake in Citi would exceed 36% while existing shareholders would see their holding slump to just 26%. "This securities exchange has one goal - to increase our tangible common equity," Citi chief executive Vikram Pandit said. Critics of the government intervention say the new plan is in effect a nationalisation of Citigroup, but Treasury and White House officials maintain that they want to avoid direct government ownership of private banking companies.

Government intervention in Citi's day-to-day affairs is already apparent, however. As the government deal was announced, Dick Parsons, the Citi chairman, also announced plans to get rid of five of the board's 15 directors. It is understood that hiring a majority of so-called "independent" directors was a condition of the renewed government bail-out. Parsons said the new directors will be brought on board as "soon as is feasible" but it is understood that several prospective directors have turned down offered directorships in recent weeks. "It is not exactly a job many people would want to take on in the current environment," said one Citi insider.

Citi also suspended its 1-cent-a-share dividend last night as it boosted its already record losses for 2008 by a further $10bn to $27.7bn. In the coming weeks Citi, along with all other major US banks participating in the US government bail-out schemes, will be forced to endure a so-called "stress test" to see if it can survive further pressure.Anticipation of the results is only serving to further spook investors, however. The market's reaction to the latest Citi plan was a clear indicator that investors feel betrayed by Citi and the US government. "Investors pretty much lose everything they had in Citi through this deal," said David Wyss, the chief economist at Standard & Poor's in New York who owns a small number of Citi shares in a personal account.

"This deal is clearly good for the long-term survival of the bank and for its bondholders," Wyss added. "The equity holders can complain but you have to say to a certain extent that this is what they are there for. They take a risk and invest, if it doesn't go well they lose." The cost of insuring Citigroup bonds over five years - a key measure of how creditworthy the company is - dropped dramatically as soon as the government deal was announced, showing bondholders are much more pleased with the deal that equity holders. "Bondholders now have, almost, the full faith and credit of the US treasury behind them," Wyss said.

Obama May Put Fannie, Freddie on Federal Budget, Orszag Says
Fannie Mae and Freddie Mac’s $6.6 trillion of liabilities may be added to the federal budget once the Obama administration has time to review the potential consequences, White House budget director Peter Orszag said. President Barack Obama’s budget blueprint released yesterday didn’t incorporate the mortgage-finance companies, which the government seized in September, because economists haven’t had enough time to analyze the implications, Orszag said yesterday in a Bloomberg Television interview. He advocated adding the debt last year when he was running the Congressional Budget Office.

"I haven’t really changed my mind," said Orszag, who is now director of Obama’s Office of Management and Budget. "We had five weeks to put together this budget overview. In that context, we tried to deal with the most urgent issues." "Consolidating the books of the government-sponsored enterprises, Fannie Mae and Freddie Mac, directly into the federal budget will be something that we’ll be looking at as we have a little more time to process everything," he said.
Obama’s budget outline said Fannie and Freddie will need $173 billion in federal aid through 2011. Washington-based Fannie said yesterday it will draw $15.2 billion from a $200 billion emergency fund set up by the U.S. Treasury Department. McLean, Virginia-based Freddie, which has already received $13.8 billion in aid, said last month that it will need as much as $35 billion.

Fannie and Freddie are the largest U.S. mortgage-finance companies, owning or guaranteeing about $5.3 trillion of the $12 trillion in residential mortgage debt. They now account for about 75 percent of the financing for new residential mortgages.The Federal Housing Finance Agency on Sept. 6 put the government-chartered companies back under federal control for the first time in about 40 years after their losses threatened to further disrupt the housing market. The Treasury committed to invest as much as $200 billion in their preferred stock as needed when the value of the companies’ assets drops below what they owe. Last week the Treasury doubled the amount pledged as Obama called on the companies to assist in an "ambitious" effort to help as many as 9 million Americans keep their homes.

The federal takeover failed to address whether Fannie and Freddie’s liabilities should be included in the budget, or whether their debt carries an explicit government guarantee. At a Sept. 9 press briefing, Orszag, who was then head of the Congressional Budget Office, said that much of the companies’ unsecured debt would likely be counted as part of the federal budget and that their mortgage securities wouldn’t necessarily translate into the same amount of federal debt because loans and other assets back those liabilities. "To actually implement that consolidation of their operations directly onto the federal budget is a complicated undertaking," Orszag said in the interview yesterday. "We’re going to study it carefully. I’ve obviously put forward the rationale for doing it in the past. And as this process unfolds, I just want to make sure that there are no unintended consequences or complications in actually doing that."

Fannie Mae portfolio shrank in January, delinquencies jump
Fannie Mae, the largest U.S. home funding company, on Friday said its mortgage portfolio declined in January, while delinquencies on loans it guarantees accelerated. The delinquency rate on conventional single-family mortgages jumped 0.29 percentage point in December to 2.42 percent, the Washington-based company said in its January monthly summary. That is up sharply from where it stood in January 2008, when the delinquency rate was at 1.06 percent. Fannie Mae also said its mortgage portfolio declined at a 2.6 percent annualized rate in January to $785.5 billion.

President Barack Obama last week announced a housing rescue plan that heavily relies on government-controlled Freddie Mac and its sibling, Fannie Mae, to stabilize the housing market that is in its worst downturn since the Great Depression. Under the plan, the companies can expand their portfolios to $900 billion, from a previous cap of $850 billion, in 2009. The government also doubled its capital pledge for each of the companies to $200 billion.

Berkshire Profit Plunges 96% as Buffett Writes Down Derivatives Positions
Warren Buffett’s Berkshire Hathaway Inc. posted a fifth-straight profit drop, the longest streak of quarterly declines in at least 17 years, on losses from derivative bets tied to stock markets. Fourth-quarter net income fell 96 percent to $117 million, or $76 a share, from $2.95 billion, or $1,904 a share, in the same period a year earlier, the Omaha, Nebraska-based firm said in its annual report. Berkshire, where Buffett serves as chairman, chief executive officer and head of investing, suffered as the benchmark Standard & Poor’s 500 Index turned in its worst year since 1937. Liabilities widened on derivatives linked to world equity markets, though the contracts don’t require Berkshire to pay out until at least 2019, if at all.

"This is an abnormal time," said Tom Russo, a partner at Gardner Russo & Gardner, in an interview before the earnings were released. The derivatives, Russo said, "are pegged to a market that’s declining, so you’re going to see some losses on those." Berkshire shares have fallen 44 percent in the past year as the value of the firm’s top stock holdings dropped and losses increased on the derivatives. Nineteen of the top 20 stocks in Berkshire’s U.S. portfolio, valued at $51.9 billion as of Dec. 31, declined last year. Coca-Cola Co., Berkshire’s top holding, dropped 26 percent. American Express Co. plunged 64 percent. Oil producer ConocoPhillips fell 41 percent.

Book value, a measure of assets minus liabilities, fell 9.1 percent in the three months ended Dec. 31 to $109.3 billion on the declines in the equity and fixed-income portfolios and the derivatives writedown. Berkshire’s liability on equity derivatives grew about 49 percent in the quarter to $10 billion. "Derivatives are dangerous," Buffett said in his annual letter to shareholders that accompanies the yearend results. "Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake." Book value per share slipped 9.6 percent for all of 2008, the worst performance since Buffett took control in 1965. The only other annual decline was a 6.2 percent drop in 2001.

In his "owner’s manual" for Berkshire shareholders, Buffett says he considers book value to be an objective substitute for the best, albeit subjective, measure of a firm’s success: a metric he calls intrinsic value. Buffett doesn’t provide a number for intrinsic value. Net income fell 62 percent to $4.99 billion for all of 2008, with storm claims from Hurricanes Ike and Gustav contributing to the decline. Industrywide, insurers faced $25.2 billion in claims on natural disasters in 2008, the most since the record storm season of 2005, a trade group said last month. Berkshire’s derivative contracts were sold to undisclosed buyers for $4.85 billion as of Sept. 30. Under the agreements, Berkshire must pay out if, on specific dates starting in 2019, four market indexes are below the point where they were when he made the agreements. Buffett, recognized as one of the world’s pre-eminent investors, gets to use the money in the interim.

The worldwide recession and global contraction of the credit markets is giving Buffett, 78, opportunities to invest some of the firm’s cash hoard, which was worth more than $30 billion on Sept. 30. Berkshire agreed in the past six months to purchase preferred shares of General Electric Co. and Goldman Sachs Group Inc., and made deals to buy debt in firms including motorcycle- maker Harley-Davidson Inc., luxury jeweler Tiffany & Co. and Sealed Air Corp., the maker of Bubble Wrap shipping products. Berkshire is commanding yields as high as 15 percent at a time when potential rivals are no longer able to make such investments. "He’s been able to put a lot to work," said Russo, whose largest holding is Berkshire stock. The derivatives are tied to four stock indexes -- the S&P and three others -- that would all have to fall to zero for Berkshire to be liable for the entire amount at risk, which was $37.1 billion as of November and can fluctuate with currency valuations. The liabilities on the derivatives are accounting losses that reflect the falling value of the stock indexes, not cash Berkshire has paid out.

Buffett built Berkshire over the past four decades with dozens of acquisitions, buying companies that make candy, sell ice cream and lease corporate jets. The firm typically gets about half its profit from insurance operations, which Buffett has said are attractive because they offer a similar business model to the derivative agreements, allowing him to invest policyholder premiums until the money is needed to pay claims. Declining investments and falling property and casualty rates caused fourth-quarter profit declines or losses at 21 of the 22 companies in the KBW Insurance Index that reported results so far.

Regulators shutter 2 more banks
State bank regulators closed two more banks on Friday, the 15th and 16th banks to fail this year, as the worsening recession pulled more regional banks underwater. The announcement marks the seventh consecutive week of bank failures being announced on a Friday evening.
The Federal Deposit Insurance Corp. said that Security Savings Bank of Henderson, Nevada, had $238.3 million in assets and $175.2 million in deposits as of December 31, 2008. Heritage Community Bank of Glenwood, Illinois, had assets totaling $232.9 and deposits totaling $218.6 million as of December 5, 2008. Combined, the two bank failures will cost the Deposit Insurance Fund approximately $100.7 million.

Bank of Nevada agreed to assume all of Security Savings Bank's deposits, and purchase approximately $111.3 million of the failed bank's assets. The FDIC will retain the remaining assets, and estimates that the cost to its fund will be $59.1 million. Heritage was purchased by MB Financial Bank, N.A., of Chicago, Illinois, which agreed to acquire all of the failed bank's deposits and $230.5 million of the failed bank's assets, said the FDIC, which estimated the cost to its fund at $41.6 million. Customers will be able to access their deposits with debit cards and checks over the weekend. Those who owe loan payments should continue making those payments.

The FDIC fully insures individual accounts up to $250,000 through the end of 2009. In all of 2008, 25 banks failed and the FDIC's list of troubled banks grew to 252 during the fourth quarter, marking the highest level since 1994. Bank failures could cost the FDIC fund $65 billion by 2013, the agency said Friday at its board meeting. In order to prevent larger banks from failing, the government has injected billions of dollars into those institutions. On Friday, the government said it had taken control of 36% of Citigroup, which had already received $45 billion from the government. 

FDIC Sets Fee Increases to Refill Its Coffers
In an effort to deal with greater-than-expected losses from bank failures, U.S. regulators are sharply raising the fees they collect from banks for deposit insurance. The Federal Deposit Insurance Corp.'s board on Friday approved a proposal to charge banks a one-time fee of 20 cents on every $100 of domestic deposits, as well as give the agency the power to collect other emergency fees in the future. Those charges would be combined with a general increase in the amount banks pay each quarter for the government to back deposits in U.S. bank accounts. The FDIC, led by Chairman Sheila Bair, said the new fees could raise $27 billion for the deposit insurance fund in 2009, nine times what the agency collected last year.

Opposition to the proposal came from John Reich, the departed director of the Office of Thrift Supervision. Mr. Reich, who stepped down from his post on Friday, said he didn't think it appropriate to levy a new tax on banks that are already in a weakened condition. He said he would support higher fees in more profitable times. Describing the need for the changes, the FDIC staff said "a deepening recession and continued severe problems in the housing and construction sectors, financial markets and commercial real estate, contribute to staff's expectations [of] significantly higher losses for the insurance fund." The fee change comes a day after the FDIC disclosed that U.S. banks finished the last three months of 2008 by reporting the worst results since the middle of the savings-and-loan crisis.

This included a sharp increase in the number of banks on the FDIC's "problem list." It also said the deposit-insurance fund -- which protects consumers' bank accounts -- was nearly cut in half by losses from bank failures. The FDIC staff said Friday that it had raised the FDIC's expectation for the likely costs from future bank failures over the next five years. Officials now expect losses to reach $65 billion over the next five years after recording $18 billion in losses during 2008. FDIC Vice Chairman Martin Gruenberg said the expected losses mean the deposit insurance fund could fall to zero this year if regulators don't act. The plan will give the FDIC seven years to boost the health of the deposit-insurance fund, rather than the five it had originally settled on last year. The longer horizon will give the agency more time to collect additional fees from banks for protecting consumer bank accounts.

Fed Officials Weighing 'Exit Strategy' for End of Recession
The Federal Reserve’s efforts to bolster credit markets and revive growth pose a long-term risk of provoking inflation and worsening other problems that must be solved quickly when the crisis wanes, Fed policy makers said. Central bank officials, after cutting interest rates almost to zero and more than doubling Fed assets to $1.9 trillion, should design an "exit strategy" that will enable them to steadily reduce credit, Philadelphia Fed President Charles Plosser said yesterday. He spoke at a New York conference that included economists and five other Fed district bank presidents. The Fed, already facing congressional criticism for invoking emergency power to expand its balance sheet, may face political pressure to keep interest rates low and credit abundant when economic growth resumes, Plosser said. Inflation may surge unless the Fed can withdraw monetary stimulus in a timely manner and fulfill its mandate to keep prices stable, he said.

"It is difficult to make credible commitments to price stability when the implementation of policy is disconnected from such an important policy objective," Plosser said. "The absence of an exit strategy, or an entrance strategy, creates uncertainty." The need to start curtailing credit isn’t pressing, central bank officials said. The economy contracted at a 6.2 percent annual rate in the fourth quarter of 2008, the worst performance in 26 years, the Commerce Department said yesterday. The consensus of economists surveyed by Bloomberg is for contraction of 5 percent in the first quarter of this year, with some estimates ranging as high as 8 percent.

The economy will probably "shrink significantly in the first half of this year," Boston Fed Bank President Eric Rosengren said at the U.S. Monetary Policy Forum, a conference sponsored by the University of Chicago Booth School of Business and the Brandeis International Business School. He doesn’t vote on the Federal Open Market Committee this year. Some time in the second half of the year, growth will probably resume, the Fed officials said. The central bank will need to begin raising interest rates and shrinking its balance sheet to ensure liquidity provided during the crisis doesn’t stoke inflation, they said. "When things go back to normal, it is extremely important to get out of this business" of providing emergency credit, former Fed Governor Frederic Mishkin said. "It does leave you wide open to a lot of political problems."

Government officials, reluctant to increase spending and compound the federal budget deficit, may push the Fed to expand the money supply to boost growth, he said. High levels of unemployment may also discourage the Fed from quickly withdrawing credit. The jobless rate is forecast to remain above 8 percent through 2010, according to the Bloomberg survey. Attending the conference along with Plosser and Rosengren were San Francisco Fed Bank President Janet Yellen, St. Louis Fed Bank President James Bullard, Minneapolis Fed Bank President Gary Stern and Chicago Fed Bank President Charles Evans. The Fed’s lending programs are designed to wind down as markets strengthen, automatically shrinking the balance sheet.

The central bank provides credit at higher interest rates than private lenders, so borrowers will probably return to private markets when the crisis abates. Interest rates in the commercial paper market have fallen below the 2.24 percent the Fed charges to buy unsecured debt under its Commercial Paper Funding Facility. Other Fed programs will probably continue as the economy recovers, and many of the assets the Fed is buying, such as mortgage-backed securities, are long-term. The central bank may need to swap less-liquid assets on its balance sheet for Treasuries so it can more easily raise interest rates once the economy recovers, Plosser said.

He proposed the Fed seek an agreement with the Treasury Department to swap non-Treasury assets and non-discount-window loans for Treasuries, transferring credit risk to the U.S. fiscal authority. The move would provide the Fed with easier-to-sell securities, facilitating its efforts to tighten credit.
"Plosser’s sentiments can only go so far -- the Fed’s board is in control," said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. "Nevertheless, as a top Fed official his remarks will be used as ammunition by those worried about the way in which the Fed is enlarging its balance sheet." Plosser, 60, a former economics professor who does not vote on policy this year, said policy makers must "clarify the criteria under which we choose to step in as a lender of last resort," to prevent market-roiling speculation about the Fed’s intent. He also reiterated his support for the Fed to adopt an explicit numerical inflation "target" and commit to achieving the objective over a period of time.

Last week, the Fed released the first long-term forecasts by policy makers for inflation, economic growth and unemployment, moving closer to an inflation goal without making it explicit. That should help "reinforce inflation expectations of around 2 percent," Yellen, 62, said. The Fed’s inflation-fighting credibility sustained public confidence in price stability as the price of oil rose to a record last year, she said. Continued attention to inflation should help moor price expectations amid signs of disinflation now, the Fed officials said. Longer-term, as the economy rebounds, the central bank must reinforce that commitment to price stability, said Yellen, who votes on monetary policy this year. "The Fed must always be vigilant in guarding its inflation credibility."

The light dims at General Electric
Thomas Edison will be turning in his grave. On his invention of the electric lightbulb and other innovations sits one of the world's biggest, most historic and best respected companies. For the humble lightbulb, through cookers and fridges, to jet engines, medical scanners and nuclear reactors, it is famous throughout the globe for the tradition of inventiveness infused by its legendary founder. If an American owns just one share, chances are it will be General Electric. It is the only member of the Dow Jones Industrial Average to have been a member of that index for all its 113 years. Millions rely on its stock for its dividend income; the company's bonds are the bedrock of any conservative pension plan; its chief executive – Jeff Immelt now, like Jack Welch before him – is a kind of business guru for the nation.

And yet there is a cancer at the company's heart. From beginnings in the Great Depression, when GE started offering loans to customers so they could afford its appliances, its finance arm has grown to the point that it accounted for more than half its bottom-line profit in 2007. Thanks to the solidity of the rest of the business, GE was able to raise cheap debt that it lent out to businesses, property speculators, homeowners and credit card borrowers the world over. There was nothing inventive about that particular money-go-round. Sadly, there is nothing surprising about the pain that GE is currently suffering, now the credit bubble has burst. As GE Capital undergoes an intensive dose of chemotherapy to bring it back under control, GE is sicker than ever.

Mr Immelt is struggling to hold together the competing interests of bondholders, shareholders and GE's own businesses, which had hoped to make big investments in profitable new areas such as wind turbines and other renewable energy projects. It looks like something is going to have to give. For the past week, analysts on Wall Street have been combing through GE's annual report and coming to the conclusion that the collapse in GE Capital's earnings will force the parent company to cut its dividend – a seismic event for a company with an army of small shareholders – or face losing the gold-plated AAA credit rating on its bonds. One analyst, Deutsche Bank's Nigel Coe, even suggested the parent company may have to pump more money into GE Capital to keep it solvent, something head office denied. The cost of insuring GE's bonds against default soared to more than even Citigroup's, and the shares plunged into the single digits, down to about $9 apiece, for the first time in 13 years.

"GE is such a popular share because the company is so diverse, it reflects the economy globally and investing in GE is like investing in the market as a whole," Daniel Holland, an analyst at Morningstar in Chicago, says. "Of course, a lot of the profits for GE, like a lot of the profits in the world, were generated by its financial companies, and it looks like GE had a little too much to drink at the party." In April last year, GE shocked the stock market with a profit warning, less than a month after Mr Immelt had given an up-beat presentation to invest-ors. The culprit then, as now, was the spiralling losses on commercial property held by the finance division, and the incident led analysts to question whether head office had a proper grip on the problems at GE Capital.

Inevitably, those problems have only got worse, and analysts are increasingly fearful about a full-on meltdown of the commercial property market this year, as mortgages come up for refinancing and some of the world's biggest buildings might end up having to be sold. Meanwhile, GE Capital is still sitting on personal loans and residential mortgages from the UK, France, Australia and elsewhere, whose future profitability is uncertain. What you can say in GE's defence is that it did not plant the sort of timebomb under its finance division that sat under many of the world's biggest banks and insurers, which chased after complicated mortgage derivatives and credit default swaps and now find themselves with billions of dollars in losses that they are still struggling to understand. Nonetheless, it is scrambling to bring the business back down to size and labouring under the intense problems in the credit markets, where a lot of its short-term funding came from.

It has had to avail itself of the insurance provided by the federal government so it can refinance GE Capital's borrowings; GE used a $15bn fund raising from Warren Buffett and new shareholders last year to plump up a cash cushion; and the dividend that GE Capital used to remit to the parent company has been slashed. The company's problems don't stop there: there's a hole opening up at the head office pension fund, whose collapsing portfolio of stock market in-vestments has turned a $14bn surplus into a $7bn deficit, and the low-margin consumer and industrial division is still within the company (after failing to find a buyer last year), threatening to drag earnings lower. "Deterioration in GE Capital's business or a further capital injection could strain cash flow and make it difficult to sustain the dividend," says Stephen O'Neil, an analyst at Hilliard Lyons. "GE's board had previously signed off on management's plan to maintain the dividend through 2009. However, after approving the April dividend, it then indicated it will review payments in the second half of the year."

With the Obama administration's economic stimulus plan promising investment in the infrastructure for renewable energy, a business that GE is shooting to dominate, there could be big opportunities for growth, if only the conglomerate had the cash to invest in manufacturing. The black hole at GE Capital means it may have to forego some of the opportunities, with knock-on consequences for earn-ings growth. Or alternatively, there is the bond rating that could be jettisoned, al-though a bout of speculation about a GE downgrade in 2005 sparked turmoil in the credit markets, making such a move potentially even more explosive than a dividend cut. Morningstar's Mr Holland, though, questioned the value of maintaining the AAA rating at all costs, if the financial markets are ignoring it anyway. "GE issued a number of bonds in January at about a 7 per cent interest rate. That compares to about 5 per cent on a 30-year mortgage so, goofily, the company is being asked to pay more than an individual buying a house. Let's put it this way: there's not a lot of respect."

Global giant: GE's many parts

Energy Infrastructure

2008 revenues: $38.6bn (2007: $30.7bn)
2008 profit: $6.1bn (2007: $4.8bn)
From oil wells to wind turbines, GE's energy infrastructure business spans the globe and spans the ways that we produce energy. Also included in the division is equipment for water treatment.
Technology Infrastructure
2008 revenues: $46.3bn (2007: $42.8bn)
2008 profit: $8.2bn (2007: $7.8bn)
Includes many of GE's fastest growing businesses, from manufacturing of medical scanners and testing equipment, to cutting-edge aircraft engines.
GE Capital
2008 revenues: $67.0bn (2007: $66.3bn)
2008 profit: $8.6bn (2007: $12.2bn)
During the credit market boom, GE Capital grew to be the group's most profitable division, offering comm- ercial loans, mortgages, insurance, credit cards and other personal loans, all around the globe.
NBC Universal
2008 revenues: $17.0bn (2007: $15.4bn)
2008 profit: $3.1bn (2007: $3.1bn)
GE is also one of the world's leading media and entertainment companies, spanning film, television, news, sports and special events.
Consumer & Industrial
2008 revenues: $11.7bn (2007: $12.7bn)
2008 profit: $365m (2007: $1.0bn)
From its familiar light bulbs, washing machines and toasters to the latest advancements in consumer technology, the historic core of the business has shrivelled in importance as the rest of the conglomerate has grown.

California cities face 20% cuts in water use during crisis
Gov. Arnold Schwarzenegger declared a statewide drought emergency Friday, urging cities to cut their use of water 20 percent and paving the way for projects such as desalination plants and water recycling projects to bypass standard environmental reviews. Despite heavy rainstorms this month, state officials say California's water supply remains critically low because of three dry winters in a row, restrictions on water pumped from the Sacramento-San Joaquin River Delta and a population that has grown by 9 million since the last drought, in 1991. In making the declaration, Schwarzenegger said the state must prepare for several more years with little rain. Experts predict this year's runoff - the critical spring melt from Sierra Nevada snow - will be 57 percent of normal.

"This drought is having a devastating impact on our people, our communities, our economy and our environment - making today's action absolutely necessary," Schwarzenegger said. The governor's proclamation stopped short of invoking mandatory statewide rationing, but officials said that option - which would be a first in California history - is available if other tactics fail. "No Californian can use water as though we have an unlimited amount, period," said Tim Quinn, executive director of the Association of California Water Agencies. About two dozen water agencies in the state, including the East Bay Municipal Utility District, have ordered water rationing to protect dwindling reservoirs. The governor declared a drought emergency last year, but Friday's announcement outlined more sweeping efforts to stem the crisis.

In addition to conservation, the governor called on state agencies to expedite water transfers, to study emergency connections between water systems and to streamline the process for approving projects for drought relief and increased water supply. Those could include facilities that turn seawater into drinking water - controversial technology that environmentalists say requires tremendous amounts of energy and could harm marine ecosystems. "It's very disturbing because the state has a record of building large projects that provide water for the short term but don't look to the long term," said Linda Sheehan, executive director of the watchdog group California Coastkeeper Alliance.

California's aging water system has come under increased scrutiny in the past several years after the collapse of several important fish species, including the delta smelt, a tiny fish exclusive to the Sacramento-San Joaquin Delta. The hub of the state's water system, the delta has become an increasingly inhospitable place for the fish, prompting a series of environmental orders that slashed the amount of water funneled out by giant state and federal systems that send water to two-thirds of California. Farmers, who use the lion's share of the state's available water supply, are among the hardest hit by the pumping reductions and dry weather. In a separate announcement, a state board that issues permits for drawing water directly from creeks and streams said that even "senior" water rights holders - those whose water rights date back as far the Gold Rush era - might not exercise their rights this year. Many senior water rights holders are farmers whose businesses have passed from generation to generation. The last time the state banned water diversion from streams was during a drought in the late 1970s.

After plowing under withered plants last year, many farmers this year elected to fallow their land. State agricultural leaders fear the repercussions of the projected losses of 80,000 farm jobs and billions in income from produce not planted. Schwarzenegger's action Friday provides financial aid to laid off farm workers. Like the governor, who introduced a $9 billion water bond last year, many in the farming industry favor building new dams and a peripheral canal that would carry water around the delta to growers and ranchers in the Central Valley. State voters rejected a peripheral canal in 1982.

The Legislature should follow the governor's lead "with a comprehensive, long-term plan that includes new surface water storage facilities and improved water delivery systems as essential strategies, along with water recycling and others," said Doug Mosebar, president of the California Farm Bureau Federation. But environmentalists, who point out that urban, not rural, communities are being asked to conserve, worry that proponents of large-scale storage and canal projects are using the drought to further their agenda. "There are opportunities in crisis," said Laura Harnish, regional director of the Environmental Defense Fund. "We have a chance to scale back within our means and use water more wisely. On the heels of the budget woes in California, it seems an inopportune time to introduce multibillion-dollar bond measures that haven't proven they'll solve the problem."

Gov. Arnold Schwarzenegger's declaration of a statewide drought emergency Friday called for the following:
  • Urban water users cut water use by 20 percent.
  • Department of Water Resources expedites water transfers between agencies, offers water management assistance to agriculture industry.
  • Labor and Workforce Development Agency to offer job training and financial aid to unemployed workers primarily in agricultural areas.
  • State agencies immediately enact water conservation measures in facilities, landscaping, etc.
  • Streamline regulatory approval process for projects related to drought relief or increasing water supply, such as desalination and water recycling plants.

Newspapers' Woes Worsening
The venerable Rocky Mountain News published its final edition Friday, just two months shy of its 150th anniversary. Colorado's oldest paper is just the latest to succumb to severe, industry-wide financial pressure stemming from declining ad revenue and circulation. Other high profile publications, including the Seattle Post-Intelligencer, the Tucson Citizen, and, perhaps most importantly — because its home is already a one-newspaper town — the San Francisco Chronicle. Thirty-three U.S. papers have filed for bankruptcy protection. What does it all mean for the nation, and where is the trend headed?

The demise of the Rocky Mountain News is, says Columbia Journalism Review Executive Editor Mike Hoyt, "quite sad." He told Early Show Saturday Edition co-anchor Erica Hill it not only cost many people their jobs, it's "a voice lost. Newspapers are very tied in with the community, and "The Rocky" had a personality. It's a big loss. "I'm sure the Denver Post will pick up a few staffers and will profit economically, and it will help them in the short-run," he said. "But in the long run, it's bad for the city." When a city only has one paper, Hoyt said, "you lose competition, and you lose the edge, and you lose energy. Competition is good. It sharpens the news gathering, and the investigative reporting." Should the Chronicle fail as well, it would be "a big blow," Hoyt observed to CBS News.

"Now, in cities like San Francisco and Chicago, there are alternative newspapers, and there are online papers — small ones, but many of them, and they have their niches, whether it's political junkies or sports fans, whatever. Would all those outlets add up to something approximating a newspaper? It's a good question, but I'd doubt it. "The daily newspaper in a major metropolitan market is the voice of a city. It provides a civic forum that everyone can relate to and come together to talk about. And it can take on complicated problems, and be a watchdog for the community." He adds, “You need big institutions to cover big problems and big situations.” Even surviving papers are suffering staff cuts. Hoyt says the CJR puts the number at more than 12,500 editorial jobs cut since January 2007.

That is, he says, "a tremendous amount. And it hurts the caliber of reporting. You just can't keep cutting without hurting the effectiveness of a newspaper. And if newspapers go under, you lose the transparency of government. Journalists are the watchdogs, and being able to shine a spotlight on corruption or scandal is vital to our democracy." Newspapers are, he says, feeling the impact of the recession on their ad-based bottom lines. “Meanwhile, there’s a longer-term shift toward the Web, and newspapers were slow to wake up to it. They’re wide awake now. The problem is, there’s not much money there. Web advertising is climbing, but it’s not climbing fast enough. The amount of money they get is not enough.”

A complicating factor is papers offering their content on their Web sites — content they might want to charge for, but that people are used to getting for free. "About ten years ago," Hoyt says, "newspapers around the country made what amounts to an historic mistake. They believed it would be wrong to charge extra for online customers, and thought they could rely on advertisers for all their revenue.” Now, he adds, the consensus is shifting. “You can sort of feel it moving toward, ‘Maybe we should sell our content.’ It’s an unknown (whether that could work). Content’s gotta be good enough to buy.” The New York Times had been charging for online access to its columnists, but has stopped that, for now at least. Newsday is reportedly readying to charge readers for online content. If it catches on, it would create a model. But the jury's still out on whether people will pay for something they're used to getting for free. In the meantime, they have to hope the money will come from more traditional sources.

Still, Hoyt says he's "actually optimistic" about the future of papers. "And the biggest reason is — we're based at the Columbia School of Journalism, and there are a lot of young people there who are committed to solid journalism. And they're eager to learn and even re-invent the craft. ... There are students who still believe in newspapers and want to work there. And the recession won't last forever. People will buy cars and refrigerators again, and when they do, advertising will pick up, and advertisers will spend again and newspapers will be healthier. There will always be a need for newspapers."

Lloyds finds £80bn of high-risk loans at HBOS
Lloyds banking Group revealed yesterday that it had found £80bn of high-risk loans at HBOS, the bank it bought last month to save it from collapse. The high-risk assets are part of £165bn of loans that Lloyds said were outside its own appetite for risk. Surging bad debts on HBOS's books drove it to a £10.8bn loss for 2008. Impairment losses at HBOS surged to £9.9bn from £2.01bn a year earlier, with two-thirds coming from the corporate bank, with its heavy weighting towards the stricken commercial property and housebuilding sectors.

Alex Potter, a banking analyst at Collins Stewart, said: "The scale of the deterioration in the HBOS book has shocked us." Lloyds said that HBOS's estimate of the losses for 2008 was only a third of Lloyds', which itself turned out to be too low by £1.6bn. Eric Daniels, Lloyds' chief executive, said the bank's forecast had not predicted that the economy would shrink by 1.5 per cent in the last quarter of 2008, increasing pressure on borrowers. "While we were pretty gloomy, what actually happened is we were not gloomy enough," he added. But he insisted that the losses were not far off Lloyds' expectations and were manageable.

Half of the raciest loans are in HBOS's corporate bank, which was run by Peter Cummings, the banker to high-profile entrepreneurs such as Sir Tom Hunter and Sir Philip Green. In retail banking Lloyds identified £31bn of high-risk buy-to-let, sub-prime and other "specialist" mortgages. The other £9bn are in international markets, particularly Ireland's rapidly shrinking economy. Lloyds, whose cautious business model allowed it to weather the credit crunch well, has faced criticism for taking on HBOS's risky balance sheet. Mr Daniels said: "I appreciate there has been a huge concern about short-term issues [in the] lending portfolio. HBOS is a high-risk bank. It will feel the impact of the economic downturn more."

The surge in bad debts at HBOS highlighted the need for Lloyds to take part in the Government's asset protection scheme, which insures banks against future losses. The bank was aiming to announce the terms of its participation yesterday but was unable to strike a deal in time. Sir Victor Blank, Lloyds' chairman, said talks were going well and that Lloyds hoped to make an announcement soon, adding that the scheme was sensible. Royal Bank of Scotland said on Thursday that it would put £325bn of assets into the scheme. Sir Victor said: "The whole of the Treasury team spent three nights solidly sorting out RBS. They are absolutely and completely knackered."

Lloyds shares plunged by 22 per cent to 58.3p yesterday, wiping out almost all Thursday's surge after RBS announced its participation in the Government's plan. Sir Victor and Mr Daniels declined to discuss details of their talks with the Treasury. The Government already owns 43 per cent of the bank but Lloyds has protested that it would not have needed state support without the takeover of HBOS, which it was encouraged to make by the Government. Lloyds does not want the Government to increase its stake and is looking to swap £4bn of high-interest preference shares for a different form of non-voting stock. Mr Daniels said that Lloyds expected corporate credit impairments to remain high this year and for retail banking bad debts to rise along with unemployment.

Lloyds forecast that the group would suffer another loss this year. The former Lloyds TSB business made a statutory profit of £807m, down from £4bn, as its impairments jumped to £3bn. But the bank's bosses said that they would still have made the acquisition if they had been forearmed with the information they have now. Sir Victor said: "Is this deal going to be a success? It is the unanimous and firm view of every member of our board that it will be." He insisted that once short-term conditions had eased, Lloyds would have dominant market shares in all aspects of UK retail banking that it would never have been allowed if it had not rescued HBOS.

Mr Daniels added that Lloyds had 240 people in a business support unit working on HBOS's credit problems. The bank will triple the size of the unit this year, he said. Mr Daniels said Lloyds did not now expect the economy to pick up until "well into 2010" with the eventual recovery happening slowly. The scale of HBOS's risky loans was revealed as Paul Moore, the bank's former head of risk, renewed his assault on alleged complacency about risk at the bank. In evidence to the House of Commons Treasury Committee, Mr Moore alleged that the Financial Services Authority had warned HBOS in 2003 that its commercial property portfolio was unusually large and that its approach to managing credit risk on the loans was "very different".

Lloyds counts cost of HBOS takeover and property slump as 500,000 customers slip into negative equity
The number of mortgage-holders borrowing from Lloyds Banking Group that are trapped in negative equity surged last year to half a million, the group, which is 43 per cent owned by the taxpayer, revealed yesterday. The bank, which controls 28 per cent of the mortgage market, said that most of these homeowners were customers of HBOS, the bank that owns Halifax and was rescued by Lloyds TSB last month. HBOS, Britain’s biggest mortgage lender, revealed that 381,669 customers, about 16.8 per cent of its mortgage book, owed more than the value of their homes. At Lloyds TSB, 162,000 homeowners, 15 per cent of its mortgage book, were in the same position.

These figures compare with only 0.1 per cent of customers of each bank – a total of less than 4,000 households – being in negative equity at the end of 2007. The number of customers at least three months behind with their mortgage payments rose by 40 per cent. David Black, at Defaqto, the financial data provider, said: "Lloyds TSB has one of the best-quality mortgage books in the industry, but clearly the situation is not as good at Halifax. If the situation is this bad at Lloyds, Lord knows how other lenders are faring." Michael Saunders, chief economist at Citigroup, said last month that the bank estimated homeowners with negative equity was up to about 1.2 million, from 100,000 a year ago, out of a total of between 11 million and 12 million mortgages. "There is no sign that the decline in house prices – and hence the surge in negative equity – is yet close to ending," he said.

He said in December that about one owner in four could be in negative equity if prices fell by a total of 30 per cent by 2010, as many analysts expect.
The Council of Mortgage Lenders, which represents 90 per cent of mortgage lenders, said that the number of those who were in arrears had risen to 220,000 and it expected the figure to hit 500,000 by the end of this year. HBOS plans to write off £1.12 billion in losses related to bad mortgage debts in 2008, a huge rise on the £28 million loss that it made on residential mortgages in 2007. Lloyds TSB will write off £167 million in bad debts related to home loans for 2008, compared with only £18 million in 2007.

A year ago HBOS was still offering 125 per cent loan-to-value deals via its Birmingham Midshires brand. There were more than 220 deals available two years ago that loaned up to 100 per cent of a property’s value on the market. There are only ten such deals available now, according to, the financial website. Banks and building societies fear that if borrowers in negative equity default on their home loans, that potentially would force lenders to repossess homes worth less than the debts secured against them and sell the homes at a loss. Ray Boulger, of John Charcol, the broker, said: "Every lender has been caught off guard by the speed and the extent of the fall in house prices. The worry now for lenders is that profits will be hit as an increasing number of borrowers in negative equity also get in trouble with their mortgages."

The gloomy figures coincide with the latest data from the Land Registry showing a 15 per cent fall in house prices over the past year, raising the spectre of widespread negative equity blighting up to half of households in the UK. A further 10 per cent fall in house prices this year, predicted by a number of commentators, would push the total number of homeowners in negative equity to five million, according to GfK Nop, the financial researcher. Last week Barclays reported that the number of customers with mortgages worth more than 95 per cent of the value of their property had jumped from 0.3 per cent to 3.1 per cent in 12 months. With most lenders unwilling to offer mortgages of more than 90 per cent of a home’s value, homeowners caught in negative equity could find it impossible to switch to a new lender when their present deals come to an end.

HSBC to launch record $20 billion share issue
HSBC is preparing to raise around $20bn (£13bn) from shareholders in a fundraising to be announced alongside its full-year results on Monday. The share issue will strengthen the bank’s finances as it contends with the twin crises of a deterioration in its core Asian markets and escalating losses in the US. Bad debts in its stricken US sub-prime Household operation are expected to have hit $16.1bn last year, according to analysts at Keefe, Bruyette & Woods.
The fundraising, which is almost certain to be offered in full to the bank’s existing investors, is believed to have been underwritten by Goldman Sachs and JP Morgan Cazenove.

The deal will eclipse last year’s £12bn rights issue by Royal Bank of Scotland as the UK’s largest ever private-sector fundraising and will provide a rare vote of confidence in the equity markets. HSBC, which has not required state assistance, is also expected to announce a cut in the dividend. Final details, such as the price, have yet to be set and the deal could be delayed beyond Monday. Despite its problems in the US, HSBC is expected to report profits of about $20bn for 2008 – driven again by a strong performance in Asia. However, the bank is expected to say that trading in Asia is weakening faster than had originally been predicted.

HSBC will argue that it is recapitalising from a position of strength to prepare it for the recession but analysts have raised concerns about as yet uncrystalised losses in its so-called "assets for sale" book, capital shortfalls in its main Asian subsidiary, the Hong Kong Shanghai Banking Corporation, and losses in the US mortgage business. Until recently, the bank had been one of the world’s most prudently capitalised lenders but a series of state interventions have left it relatively undercapitalised.

At the end of Septemb er, its tier one ratio – the key measure of financial strength – was 8.9pc and its core tier one ratio about 7.9pc. By comparison, Royal Bank of Scotland after this week’s bail-out has a core tier one ratio of 12.4pc. A 50pc cut in the dividend and $20bn in fresh capital would, Morgan Stanley analyst Michael Helsby has argued, give HSBC a tier one ratio comparable to its best-capitalised European and Asian rivals. Escalating concerns about HSBC’s trading have pushed its shares down 30pc this year, closing 35,5 lower at 491,5p yesterday.