Thursday, February 21, 2008

Debt Rattle, February 21 2008

Updated 2.45 pm

Ilargi: Look at the tone of this article. Bloomberg is mostly boringly neutral, but this is downright nasty.

Auction Debt Succumbs to Bid-Rig Taint as Citi Flees
The collapse of the auction-rate bond market, where state and local governments go to raise cash, demonstrates that regulators are no match for Wall Street.

Hundreds of auctions have failed this month, sending borrowing costs as high as 20 percent because dealers from Goldman Sachs Group Inc. to Citigroup Inc., UBS AG and Merrill Lynch & Co. stopped using their own capital to support the sales. Regulators, who allowed the manipulation of bids and lack of information to persist even after two probes in the past 15 years, are now watching a $342 billion market evaporate at the expense of taxpayers.

Inadequate disclosure 'may have masked the impact of broker-dealer bidding on rates and liquidity,' Martha Haines, head of the Securities and Exchange Commission's municipal office, said in an interview. 'The large numbers of recent auction failures, which are reported to have occurred due to a reduction in bidding by broker-dealers, appears to indicate those concerns were well founded.'

Citizens Property Insurance of Tallahassee, Florida, a state-run insurer that protects homeowners against hurricane losses, is a casualty. The rate Citizens pays on a portion of the $4.75 billion in securities it has sold jumped to 15 percent from 5 percent at an auction run by UBS that failed on Feb. 13.

'The banks were the backstop,' said Sharon Binnun, the chief financial officer of Citizens. 'If you had more sell orders than buy orders, they'd pick up the difference and you wouldn't have a failed auction.' UBS told its brokers this month that it won't buy bonds that fail to attract enough bidders, and Merrill said it was reducing its purchases.[..]

From 1984 through 2006, only 13 auctions failed, typically because of changes in the credit of the borrower, according to Moody's Investors Service. There were 31 failures in the second half of 2007, and 32 during a two-week period beginning in January. That compares with more than 480 failures yesterday alone, according to figures compiled by Deutsche Bank AG, Wilmington Trust Corp. and Bank of New York Mellon Corp.

'It's ugly,' said Luis I. Alfaro-Martinez, finance director for the Government Development Bank of Puerto Rico, which saw the rate it pays on $62 million of debt rise to the maximum of 12 percent set out in documents governing the bonds, from 4 percent at a Feb. 12 auction handled by Goldman. 'It's getting uglier.'

Non-Agency Mortgage Bond Holdings Jump $48 Billion at Big Banks
Bank of America Corp., Citigroup Inc., and the eight other U.S. commercial banks with the largest portfolios of mortgage-backed securities boosted holdings of 'non-agency' home-loan bonds by $48 billion last quarter as prices were tumbling, according to Barclays Plc analysts.

The increase offset an $11 billion decline in holdings of 'agency' mortgage securities backed by entities such as Fannie Mae and Freddie Mac to boost the banks' portfolios to $582 billion, according to a report yesterday by New York-based Barclays analysts Ajay Rajadhyaksha and Derek Chen.

The banks, which also include Wells Fargo & Co., Wachovia Corp. JPMorgan Chase & Co., probably boosted non-agency holdings, the analysts wrote, because of the dearth of investor demand for new securities backed by loans they were making, a need to consolidate off-balance-sheet vehicles that lost other funding, and margin calls on 'leveraged' investment funds. 'It seems unlikely that banks were active non-agency buyers,' the analysts wrote.

Non-agency mortgage bonds have suffered unprecedented downgrades and price drops amid the highest U.S. foreclosure rate on record. Bonds rated AA and backed by prime 'jumbo' mortgages typically traded at 72 cents on the dollar in early February, down from 80 cents in mid-December, according to Bear Stearns Cos. The bonds were issued at or near their face amount.

Ilargi: Some things you have to see to believe. Never mind that the extended village that Vancouver is now has higher real estate prices than New York City. If we all move to British Columbia, we'll all be rich and getting richer. Or so they say.

Credit Union of Central British Columbia study reveals bright economic future for British Columbia
The provincial economy will experience the strongest five-year period of growth since 1985, between 2008 and 2012, says a B.C. economist. A study produced by the Credit Union of Central B.C. stated that B.C.’s real (adjusted for inflation) gross domestic product (GDP) is forecast to grow by an average of 3.6 per cent annually through 2012, which is up from 3.4 per cent over the past five years. The study entitled B.C. Economic Forecast 2008-2012 said this would be the strongest rolling five-year performance since 1985 through 1989.

“Weakness in U.S. housing, credit derivative and secondary equity markets will continue to dampen the economic outlook into 2009,” said Dave Hobden, economist with Credit Union of Central of B.C. “(However) we don’t see the B.C. economy getting hammered, by the sub prime mortgage crisis, the high Canadian dollar and weak US export, as much as the B.C. government does in the next five years.”

In preparation for the 2008 budget, Finance Minister Carole Taylor lowered the five-year economic growth forecasts for the province, due to several key factors including the weakening U.S. economy, the high Canadian dollar and labour shortages in the construction industry.

Taylor predicted B.C.’s real gross domestic product will increase by 2.9 per cent in 2008 and 2009. For the years 2010-2012, economic growth is forecast at 2.8 per cent. The five-year economic forecast produced by the Credit Union of Central B.C is more optimistic in its outlook. “Growth in B.C.’s real GDP will be moderate through 2009, followed by a spike around the 2010 Winter Olympic Games, another moderate year in 2011 and robust growth in 2012,” Hobden said.

Mortgage Application Volume Falls As Rates Rise
Mortgage application volume fell a whopping 22.6 percent on a seasonally adjusted basis for the week ending February 15, according to the latest survey from the Mortgage Bankers Association. On an unadjusted basis, application volume was off 21.2 percent compared to the prior week and up 33.9 percent compared to the same week a year ago.

The decline was led by a pullback in both refinance and purchase activity, with refis off a startling 27.9 percent from the previous week and purchases down 11.5 percent, on a seasonally adjusted basis. That caused the refinance share of total applications to fall to 61.7 percent from 67.4 percent the prior week, the third straight weekly decline.

Interest rates were no help as applications cooled, with fixed-rate mortgages rising substantially week-over-week. The average 30-year fixed climbed to 6.09 percent last week from 5.72 percent, while the 15-year jumped to 5.55 percent from 5.18 percent.

Ilargi: Funny, I just counted the number of times the word ‘inflation’ pops up in this Rattle. Inflation at The Automatic Earth?! Where did that come from? Well, we DO aim to please, for entertainment purposes only. But I’ll still go with this quote:

“Like Stephanie, I don't know how you get hyperinflation out of this one."

Mortgage Application Volume Falls As Rates Rise
Mortgage application volume fell a whopping 22.6 percent on a seasonally adjusted basis for the week ending February 15, according to the latest survey from the Mortgage Bankers Association. On an unadjusted basis, application volume was off 21.2 percent compared to the prior week and up 33.9 percent compared to the same week a year ago.

The decline was led by a pullback in both refinance and purchase activity, with refis off a startling 27.9 percent from the previous week and purchases down 11.5 percent, on a seasonally adjusted basis. That caused the refinance share of total applications to fall to 61.7 percent from 67.4 percent the prior week, the third straight weekly decline.

Interest rates were no help as applications cooled, with fixed-rate mortgages rising substantially week-over-week. The average 30-year fixed climbed to 6.09 percent last week from 5.72 percent, while the 15-year jumped to 5.55 percent from 5.18 percent.

Ilargi: Take heed, Britain. You're about to lose your shirt, and your homes.

UK housing market close to collapse, analyst says
Britain's housing market is a "house of cards" that is set to implode after years of reckless mortgage lending, chronic oversupply of new flats and widespread fraud, a leading analyst said yesterday.

"We believe it is payback time for years of speculation and sharp practice," Alastair Stewart, of Dresdner Kleinwort Wasserstein, said in a note to clients issued at the start of British housebuilders' results season.

The warning came amid rising fears of endemic fraud in the housing market. The Financial Services Authority (FSA) said yesterday that it had banned a further two mortgage brokers for submitting false applications to lenders, in what appears to be a growing trend.

Rising Inflation Limits the Fed as Growth Lags
Nowhere have the Fed's limitations been more apparent than in the home mortgage market. Even though the central bank cut short-term interest rates twice in January, in part to stabilize the housing market, investors remained so worried about the longer-term outlook that mortgage rates have edged up steadily in the last three weeks.

"What's disturbing and scary is that the Fed is doing all the right things — cutting rates, and saying they'll do more — but it's not doing anything," said Michael Menatian, president of Sanborn Mortgage, based in West Hartford, Conn. "We have hundreds of customers who want to refinance, but they're locked out." Fed officials do not see themselves as powerless. The central bank stunned investors by reducing rates twice in January, once at an unscheduled emergency meeting on Jan. 22 and again at a scheduled policy meeting on Jan. 30. Those moves brought the Fed's benchmark overnight lending rate down to 3 percent.

According to minutes of both meetings, released on Wednesday along with policy makers' latest economic projections, Fed officials were increasingly worried that plunging confidence in financial markets would lead to a self-fulfilling prophecy of tighter credit conditions, stalled activity in the broader economy and even more fear in financial markets. Fed policy makers, according to the minutes, noted that credit was becoming harder to get for both consumers and businesses and that financial institutions were vulnerable to more economic weakness after booking huge losses on mortgage-backed securities.

"Some noted the especially worrisome possibility of an adverse feedback loop, that is, a situation in which a tightening of credit conditions could depress investment and consumer spending, which in turn could feed back to a further tightening of credit conditions," the central bank said in its summary of the discussion.

Wall Street Abandons "Neediest" Clients
Wall Street Abandons "Neediest" Clients
In case you are wondering, "Wall Street Abandons Neediest Clients" is a Bloomberg headline we saw this morning. The hilarious part is what passes for "neediest" on Wall Street. Rest assured it is a far cry from what passes for "neediest" on Main Street.
Just who are these "neediest cases"? For one, investors and hedge funds that use borrowed money to purchase securities. Also, companies such as auto parts maker Delphi and Solutia Inc., a nylon and plastics maker looking to emerge from bankruptcy.

Last week JP Morgan and Citigroup reported having trouble syndicating the $6.1 billion in loans Delphi needs to emerge from bankruptcy protection. Solutia has gone so far as to take Citigroup to court to try and force CEO Virkam Pandit to answer questions as to why the bank decided to walk away from the company's $2 billion financing plan to emerge from bankruptcy.

And then there's Luminent Mortgage (LUM), a company that as recently as a year ago could access $640 million for a price tag of just $20 million, but today finds that $20 million only buys $80 million worth of credit. The bottom line is that banks have little choice in the matter. They have been forced to take so many assets back onto their balance sheets that they simply no longer have the flexibility to offer credit to borrowers that only a year ago would have had little trouble raising capital.

German Wages, Prices Limit ECB's Room for Rate Cut
IG Metall, Germany's largest labor union, won the biggest pay increase for steelworkers in 15 years and producer prices rose more than economists forecast, limiting the European Central Bank's room to cut interest rates.

IG Metall said today it secured a 5.2 percent pay raise for some 85,000 steelworkers at companies such as ThyssenKrupp AG. Producer prices rose 3.3 percent in January from a year earlier, the Federal Statistics Office in Wiesbaden said. That's the biggest gain since December 2006 and above economists' forecast for a 2.8 percent increase. "It will be difficult for the ECB to move toward cutting rates,'' said Rainer Guntermann, an economist at Dresdner Kleinwort in Frankfurt. "Today's inflation and wage data out of Germany suggest there won't be an easing in inflation anytime soon.''

Inflation in the 15-nation euro region accelerated to 3.2 percent in January, the fastest pace in 14 years. The Frankfurt- based ECB, which aims to keep inflation just below 2 percent, on Feb. 7 left its benchmark interest rate at a six-year high of 4 percent, even as economic growth slows. ECB President Jean-Claude Trichet in January threatened to raise rates if unions push through wage increases that take the jump in inflation into account. While he retracted the threat this month as the growth outlook weakens, investor bets on imminent rate cuts may be misplaced, some economists said.

Dresdner Rescues $19 Billion SIV, Follows Citigroup
Dresdner Bank AG, Germany's third- largest bank, agreed to rescue its $18.8 billion K2 structured investment vehicle, joining Citigroup Inc. and HSBC Holdings Plc in putting capital at risk to bail out investment funds crippled by the collapse of the subprime mortgage market.

Dresdner, a unit of Munich-based Allianz SE, will provide a credit line to enable K2 repay all of its senior debt, the bank said in an e-mailed statement today. Dresdner will cut the size of the fund, which has been reduced from $31.2 billion since July, according to the statement. The bank is the last of the world's biggest financial institutions to salvage debt funds from the seven-month freeze in credit markets. Banks including Citigroup, HSBC, Bank of Montreal and WestLB AG have disclosed plans to support their SIVs with $140 billion of assets.

"This is a potential threat to Dresdner Bank,'' said Thilo Mueller, managing director of MB Fund Advisory in Frankfurt. "There is little liquidity for some of these assets and with comparative assets continuing to fall, you need to book further writedowns.''
SIVs, which use short-term borrowing to buy higher-yielding assets, have shrunk by $100 billion from $400 billion since August, according to Moody's Investors Service.

Pressure builds over CDS settlement
International regulators are stepping up pressure on the financial industry to introduce a clearer system for settling contracts after a corporate default in the $45,000bn credit derivatives market. In particular the New York Federal Reserve and UK's Financial Services Authority are urging industry associations such as the International Swaps and Derivatives Association – the trade body whose documents underpin the market – to introduce binding rules about how credit default swaps (CDS) contracts are settled in default.

The moves come amid growing expectations that corporate bond default rates will rise sharply in the next couple of years. It also comes amid signs that some mainstream investors are becoming uneasy about the ability of the CDS infrastructure to withstand a wave of defaults – particularly as settlement procedures are still relatively untested. Settlement has become a particular concern because the CDS market has expanded so dramatically this decade that the volume of derivatives contracts can sometimes be 10 times bigger than the underlying cash bonds on which the CDS are based.

This creates a growing logistical headache for bankers because a CDS contract in effect pledges to protect an investor against loss if a default occurs – which has traditionally meant that counterparties need to get hold of bonds when a default occurs, to pay back investors. In recent years the industry has scrambled to avoid a stampede for cash bonds in these cases by auctions to decide the implicit value of bonds – and then settling the contracts in cash instead. However, the scheme has hitherto only been used on an ad hoc basis, since it is not formally written into any CDS contracts.

Fresh credit market turmoil
Credit markets were thrown into fresh turmoil on Wednesday as the cost of protecting the debt of US and European companies against default surged to all-time highs. The sharp jump, which rivalled the sell-off at the height of last summer's credit market turmoil, came as traders rushed to unwind highly leveraged positions in complex structured products.

The sell-off was triggered partly by fears of more unwinding to come as investors rushed to exit before conditions worsen. As losses have snowballed, further unwinding has been triggered. "There's a domino effect taking place," said Mehernosh Engineer, credit strategist at BNP Paribas.

The cost of insuring the debt of the 125 investment-grade companies in the benchmark iTraxx Europe rose more than 20 per cent to as high as 136.9 basis points, before closing at 126.5bp. That compares with a level of about 51bp at the start of the year, according to data from Markit Group.

Markets assess the costs of a monoline meltdown
In recent years the residents of Wilkes-Barre, a small city in Pennsylvania, have been nurturing dazzling dreams. For years their local ice rink lay vacant, while the park in which it stood suffered from neglect. Yet Thomas Leighton, the town mayor, had plans to turn the area into "the region's premier recreational facility"...

....Although the underlying finances of his authority are in good shape, last week Mr Leighton told a congressional subcommittee in Washington that "under the current [bond] market conditions, this necessary development will be extremely difficult for the city of Wilkes-Barre to complete".

The tale is one being echoed in many other unlikely corners of America – as well as other parts of the global financial system. When losses on securities linked to risky subprime mortgages started to appear a year ago, many bankers hoped that the problem would be easily "contained" – meaning that it would not spread beyond the most esoteric niches of finance on Wall Street or in the City of London.

Now, however, the rhetoric of containment is being replaced by a new buzzword: contagion. It has become increasingly clear that the losses in the credit world are being felt far beyond the subprime mortgages market. More pernicious still, it is also becoming clear that these defaults are creating some complex financial chain reactions – which, in turn, are hurting institutions such as the Wilkes-Barre authority.

The fundamental problem is that this decade's wave of banking innovation has created a financial system that is not just highly complex but also tightly interlinked in ways that policymakers and investors sometimes struggle to understand. This is epitomised by the issue currently causing headaches for entities such as the Wilkes-Barre government – the increasingly precarious position of a group of companies known as the monoline insurers.

These companies essentially offer insurance to investors against the possibility that their bonds might default. They initially sprang up three decades ago to guarantee the municipal bond market – a line of business that has hitherto produced a steady, albeit unexciting income stream. Over the past decade, however, the monolines shifted their business into the realm of structured finance too, offering guarantees against the chance that complex bundles of mortgage-linked assets would default by writing derivatives contracts known as credit default swaps (CDS).

Ackman bid to spin off bond insurers' municipal units
William Ackman, hedge fund manager and ardent critic of bond insurers, has submitted to banks and regulators a proposal that would split the companies' businesses and overhaul their capital management. Bond insurers such as MBIA have been under scrutiny because of their exposure to risky structured products.

Mr Ackman's proposal would hive off the relatively low-risk municipal insurance units from the structured finance operations. These spun-off municipal units would be capitalised to achieve a triple-A rating and would continue to write insurance and generate income, according to the 13-page presentation.

Income from the municipal units would be used to pay claims arising from the structured finance operations, which would be put into "run-off" mode and cease to write new business. Municipal policyholders would be insulated from losses in the structured portfolio, which would in turn be supported by revenue from the municipal unit. The plan would also divert dividends from the bond insurers' parent companies to the structured finance unit until all claims arising from the division had been paid.

Ambac, MBIA Short Seller Proposes Way Of Splitting Bond Insurers
MBIA said Ackman's proposal would deprive MBIA's holding company of access to the cash necessary to service its obligations, including its publicly outstanding debt. If that happened, Ackman's bearish bets would benefit, MBIA said.
"This proposal is simply a continuation of Mr. Ackman's campaign to profit from his short positions and credit default swaps in the bond insurance industry," the company said.

Ackman's plan would also be bad for banks that have bought guarantees from bond insurers to hedge their holdings of complex structured finance securities including collateralized debt obligations, MBIA argued. "Mr. Ackman's proposal is not good for one group of policyholders," the company said in a statement. "Our preference, like the regulators, continues to be finding a solution that would be in the best interest of all policyholders."

Indeed, S&P issued a similar warning after learning of FGIC's plan to create a new unit and separate its muni bond business from structured finance exposures. "This process may result in the allocation of capital or other corporate resources in such a manner that other classes of policyholders may be disadvantaged," Robert Green, an analyst at S&P, wrote on Friday.

Fed Sees Rate Low 'for a Time,' Then Chance of 'Rapid' Reversal
Federal Reserve officials signaled they are prepared to quickly reverse last month's interest-rate cuts after concluding that borrowing costs need to be kept low for now. Policy makers cut their 2008 growth forecasts and said that rates should be held down "for a time,'' minutes of their Jan. 29-30 meeting showed yesterday. They also called inflation "disappointing,'' and some foresaw raising rates, possibly at a "rapid'' pace once the economy recovers.

The threat goes beyond remarks by Chairman Ben S. Bernanke, who last week warned that policy will have to be "calibrated'' over the next year to meet both inflation and growth objectives. Central bankers are wary of past criticism for keeping rates too low, too long and inflating asset bubbles, said analysts including David Greenlaw at Morgan Stanley.

"I don't think there's any question that they've learned from those experiences,'' said Greenlaw, chief fixed-income economist at the firm's New York office. "That lesson becomes more powerful as you get lower and lower on the funds rate target.'' The minutes did nothing to dispel investor expectations for another half-point cut in the federal funds rate to 2.5 percent at the Federal Open Market Committee's next meeting on March 18.

SocGen Reports Record Loss on Trading, Writedowns
Societe Generale SA, France's second- largest bank by market value, said unauthorized trading and subprime-related writedowns led to a record 3.35 billion-euro ($4.9 billion) fourth-quarter loss. The net loss compares with profit of 1.18 billion euros in the final quarter of 2006. For the full year, Societe Generale's net income fell to 947 million euros from 5.22 billion euros, the Paris-based bank said in a statement today, matching preliminary results announced on Feb. 11.

Societe Generale blames the reversal mostly on unauthorized bets by 31-year-old Jerome Kerviel, whose positions led to 4.9 billion euros of trading losses. A report from three independent board members yesterday said management failed to follow up on 75 warnings over more than two years about Kerviel's trading, adding to questions about oversight at the 144-year-old bank run by Chairman Daniel Bouton.

The top 10 Northern Rock losers

There are no winners from the British government's decision this week to nationalise Northern Rock, the mortgage lender. There is, however, an embarrassment of losers. Northern Rock is only one of many troubled banks. Even Credit Suisse, which seemed to have side-stepped the worst of the credit crisis, turns out to have had a hole in its balance sheet. But Northern Rock is the first British bank to suffer a run on its deposits since 1866. It is still hurting reputations across the financial and political world, right up to Gordon Brown, the prime minister....

....3. Alistair Darling. You could view the chancellor of the exchequer's decision to reject the Lloyds TSB offer, then guarantee the Rock's deposits, then negotiate with private bidders and finally nationalise it as a statesmanlike mulling of less-than-perfect options culminating in decisive action. Or you could see it as pathetic dithering followed by the abandonment of all hope. Unfortunately, some Downing Street officials, while espousing the former view in public, seem privately to favour the latter.

2. Gordon Brown. Talking of Downing Street, there sits the prime minister formerly known as prudent. He has taken the advice of the Treasury and Goldman Sachs and punted on owning the Rock rather than off-loading it to Sir Richard. The good news is that, if anything goes wrong, he can ditch his chancellor for getting him into a mess. The bad news is that Mr Darling is the only equity he has left to burn.

1. Britannia. No, not the building society but the nation. Time was when the UK, with its 9.4 per cent of gross domestic product devoted to financial services, looked like the epitome of post-industrial, creative capital, economies. Less so now. Britannia ruled the waves of the global financial services industry but her Rock has had to be propped up and the waves lap around her.

Monoline Capital Finesse?
I received a surprising e-mail from an investor on a rumor he heard from a well-placed source. He was a bit incredulous as to what he was told, and I am skeptical too. Nevertheless, I thought it would be worth posting in case anyone else had heard something along these lines.

His message:
"I had a conversation today with someone who is friendly with someone with access to the monolines, and he suggested that the path out of the current situation for the monolines was, assuming they did a split into a muni book and structured book, that the capital requirements for the muni only book would be lowered dramatically by the rating agencies and that this would free up a $10B+ amount of capital to support the structured book. This was, I believe, informed speculation on his part.

My reaction to it was that I had trouble believing that the rating agencies would cut the capital requirements for the muni business that much, despite the good loss record, given that they were revamping their models to indicate that substantially more capital was needed in the business as a whole. But I'm beginning to wonder whether this might actually be "the plan."..."

....This frankly makes no sense. If the capital (technically, reserves, that's the name for the cushion at the insurance subsidiary level) is insufficient for the combined entities, merely splitting them cannot suddenly make things better. In fact, the boundary condition is that the reserves needed to properly capitalize the combined book of risks is less than or equal to the reserves needed to insure them separately.

But recall what we said early on in this mess:
"The mistake is believing, as we perhaps have too much, that the rating agency saber rattling means they have the will to downgrade. They don't. The very last thing they want to do is be accused of causing The End of the Financial World as We Know It."

Son of Spitzer
You buy an insurance policy. A tree falls on your roof. Then your state's insurance regulator calls you in for a meeting. He tells you that some people will say that you should have cut down that tree. He suggests that you and all the other homeowners likely to submit claims should join together and send a big check to your insurance company to help pay for repairs.

If that sounds bizarre, well, something like it is playing out in the state of New York. State Insurance Superintendent Eric Dinallo, a protege of Governor Eliot Spitzer, has caught his boss's zest for meddling in private markets without much wisdom and is venturing beyond his explicit legal authority. In the process, he's helping to abrogate private contracts and may make the credit crisis worse....

....A financial system runs on trust, and the credit crisis is continuing in part because there is so much mistrust about the magnitude of potential losses and where those losses reside. By encouraging bond insurers to unilaterally rewrite their contracts, Messrs. Spitzer and Dinallo are only creating more mistrust and uncertainty. We assume the banks that bought the bond insurance and signed the contracts will take their insurers to court.

Junk Borrowers at Risk of Violating Covenants Rises
A record 41 companies with high- yield, high-risk credit ratings are in danger of breaching terms of their loan agreements within 12 months as the slowing economy cuts into corporate profits, Moody's Investors Service said....
....``With the economy slowing down, their cushion's just getting smaller,'' said John Fenn, a high-yield strategist at Citigroup Inc. in New York. ``You're going to see an increase in the default rate.''....

....The percentage of speculative-grade bonds that are distressed, meaning their yields are at least 1,000 basis points higher than benchmark rates, rose to 20.9 percent as of Feb. 15, about the same ratio as in the months preceding the recession that began seven years ago, according to Merrill Lynch & Co.

Debt is 20 times more likely to default within a year once it's crossed the distressed threshold, according to data by Martin Fridson, chief executive officer of high-yield research firm FridsonVision LLC in New York. sees home prices down 20 percent
A rapidly deteriorating U.S. economy will cause home prices to drop by 20 percent peak-to-trough, a leading economist said on Wednesday. Mark Zandi, chief economist and co-founder of Moody's, said he also expects a recession in the first half of this year.

Zandi, speaking at the Reuters Housing Summit in New York, said this is a "significant" change from the Moody's outlook published in December, which called for a 13 percent drop.

Our Economic Dilemma
Although it is too soon to tell whether the United States has entered a recession, there is mounting evidence that a recession has in fact begun. Key measures of economic activity stopped growing in December and January or actually began to decline. The collapse of house prices and the crisis in the credit markets continue to depress the real economy.

The sharp reduction in the federal funds interest rate and the new fiscal stimulus package may, of course, be enough to avert a downturn. Many forecasters still predict that the economy will just slow in the first part of this year and then rebound after the summer. But the hope that monetary and fiscal policies would prevent continued weakness by boosting consumer confidence was derailed by the recent report that consumer confidence in January collapsed to the lowest level since 1992.

If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.

But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.

In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.

A Sharper Focus On Consumer Spending
The decline in spending growth is occurring across all income levels – even among respondents who earn more than $150,000 per year.

Most importantly, while this is our fourth consecutive survey since June showing a consumer pullback, this is first time consumer spending growth has actually gone into the red.

Where is Spending Slowing? Nearly every consumer category we looked at in the survey scored lower than a year ago in terms of spending going forward – led by restaurant spending which has deteriorated a whopping 12-pts compared to year ago levels....

....Those are deflationary trends, no ifs ands or buts about it. Past reflation efforts by the fed were successful because consumers and businesses were willing to play along. Indeed, in the recession of 2001, consumers did not stop spending at all. It was even considered patriotic to spend in the wake of 911. Those days are gone.

A point of inflection has been reached. Consumers and businesses are unable or unwilling to spend and banks are unable or unwilling to lend. That's a brick wall known as sentiment. And in the real world, sentiment trumps academia.

Mortgage crisis: Don't forgive debt, just postpone repayment
A plan that would help troubled mortgage borrowers today - and might make lenders whole later on - was unveiled Wednesday in Washington.

The Office of Thrift Supervision (OTS) is urging the federal savings and loans lenders under its authority to refinance loans by reducing mortgage balances to the current market values of the homes. Thanks to falling home prices, many homeowners are now stuck with mortgages that are actually worth more than the houses themselves.

But instead of having lenders forgive the difference between the old mortgage and a house's current resale value, called a short sale, the OTS advises that lenders issue a warrant or "negative amortization certificate" for the difference. If a home regains its market value and is then sold, lenders have first claims to the profits.

Postpone But Don't Forget
The central idea behind the plan is "Don't forgive debt, just postpone repayment". With that idea in mind, let's call this the Postpone But Don't Forget Plan....

....This is clearly another attempt to prevent people from walking away. Details are scant and many questions need to be answered. For example, what happens if home prices keep falling? What happens if they rise? Who does the appraisal? From an accounting standpoint I am wondering if this is a blatant attempt to prevent writedowns based on potentially worthless certificates that permit recovery down the road. But most importantly why would someone hugely underwater on their home want to take part in this scheme?

Unless there are sale restrictions, time restrictions, or unless the appraisals are ridiculously high, banks might get killed on this idea as presented. This scenario is a perfect solution for some set of homeowners but not the bank. Those with potential buyers at lower prices can take advantage of the offer and escape the debt trap scot-free, perhaps by swapping similar houses. Those without potential buyers or who simply want out now, can still walk. This sounds like a free option to me. I am all in favor of free options for the homeowners.

Is US Next Japan?
Professor Stephanie Pomboy:

I think a critical point to make - aside from the magnitude of leverage - is that what's 'different' in this cycle is the degree to which that leverage has been created outside the banking system over which the Fed (and other central banks) exert control.

This makes pulling the traditional levers less useful in preventing deflation 'this time.' Even the nontraditional measures (TAF, expanded collateral accepted at the Discount Window, etc.) are less useful in that they focus on the banks, which accounted for a meager 19% of credit creation over the last year.

Of course, all of that strengthens the case for deflation...

Minyan Peter: Two other differences I see in this cycle which point me to deflation are:

a) the breadth of debt categories involved and
b) the degree to which the lenders are global.

Japan was almost entirely commercial real estate and margin debt, where, as we all know, this one is pretty much every loan category under the sun. Its debt bubble was largely contained within the Japanese banking/financial system (with a little New Zealand thrown in).

You need only look at the police line up for the monoline insurer bail out to see that the impacts of this one are flowing all through Europe and into Asia. By my count the top banks in countries representing 80% of global GDP have been adversely impacted.

Like Stephanie, I don't know how you get hyperinflation out of this one.

More People Tap 401(k) Accounts for Cash
Trent Charlton knew the risks when he borrowed $10,000 from his 401(k) and cut his retirement savings in half.
But Charlton, a 40-year-old account executive at an Irvine, Calif., trucking company, said he had little choice because he and his wife could not keep up with monthly expenses after American Express reduced the limits on three credit cards.

As home prices fall and banks tighten lending standards, more people are doing the same thing: raiding their retirement savings just to get by and spending their nest eggs to gas up SUVs, pay mortgages or put food on the table. But dipping into 401(k) accounts can carry risks because defaulted loans and hardship withdrawals are taxed as income and are subject to a 10 percent penalty if the worker is under 59 1/2 years old. That means if the trend grows, many Americans will risk coming up short on retirement savings or may have to rely on an overburdened Social Security system.

"People who take out a loan or withdrawal are adding to a looming retirement crisis over the next 30 to 40 years," said Eric Levy, a partner at global consulting firm Mercer. "And what implications will that have (for) our economy?" Some of the nation's largest retirement plan administrators, such as Great-West Retirement Services and Fidelity Investments, are seeing double-digit spikes in hardship withdrawals and increases in loan requests, a sharp departure from levels that traditionally varied little.


Anonymous said...

re: 401K Withdrawal.

I'm almost there with them. Not even for hardship, more like "a bird in the hand is worth more than 2 in the bush."

I started investing in a 401K account in 1999 for 3 years (laid off and didn't touch the account since). The money in that account benefited greatly from the inflated stock market of the past 8 years.

So what if I take a 10% penalty plus full taxes on that withdrawal, I'm still way ahead of what I put into the account.

And while it is prudent to think about life 30 years from now, it's the next 3 I'm a bit nervous about.

-Forrest D

goritsas said...

One thing I’d say about the current situation, for those of us who’d just rather get on with the fucking maelstrom rather than sit and watch the economic equivalent of the Keystone Cops enacted writ large, we could be in for a much longer ride than we might have expected.

It seems every crack gets an instant dose of Pollyfilla from some sector of TPTB. While the inevitable seems inevitable, one thing that seems certain is this has a few twists and turns that will catch nearly all of us off centre. A bit like watching England. You know they’re going to lose, they just put so much effort in to preventing it from being so obvious that many get drawn in and think this time it might be different.

Anonymous said...

Interesting viewpoint on inflation vs. deflation:
Investors Wait At A Critical Crossroad

Good question:
"While near-term nuances are difficult to digest, the big picture has come down to a simple question. Will foreigners allow the dollar to devalue further, paving the way toward hyperinflation, or will capital drain from the system and introduce a prolonged period of deflation? "

The author agrees with TAE that the Fed et al will fight for inflation but eventually lose. Nothing new there I guess, but I think there is growing awareness now of what is occuring and what will occur.

I was at a doctor's office yesterday with my mother who is 90. The dr started asking her what it was like during the depression because he wanted to know what things might be like in the future. He's a young guy in his early thirties.


goritsas said...

“Will foreigners allow the dollar to devalue further, paving the way toward hyperinflation, or will capital drain from the system and introduce a prolonged period of deflation?”

First off, unless the U.S. government starts printing money, I’m not exactly sure how this makes any sense. How can foreigners “allow” the dollar to fall further? Even if these folk did “allow” the dollar to fall further, in what way would that be hyperinflationary? There’s no positive net change in the supply of money and credit so exactly where is the inflation going to come from?

That’s not to say if the relationship of the dollar to other currencies weakens the relative price of imports wouldn’t rise. But which foreigners could possible be in the position to allow dollar appreciation? This is the logical opposite of these fine folk that have the power to allow devaluation. If they can allow the dollar to devalue then they hold the power to allow the dollar to appreciate. So then, who are these Tom Wolfe “Masters of the Universe?” China? Russia? Japan? The Euro? Canada? Britain? Who exactly can rule over the dollar other than the U.S.?

The second clause of the sentence explains what is happening and what will happen for years into the future, deflation and depression. We have front row seats in the greatest economic collapse in the history of history. So make sure diaries are written and pictures sketched and artefacts are squirreled away, because the folk of the future are going to want to know why we fucked it all up. For a few bob, as it were.

Stoneleigh said...

Forrest D,

I'm inclined to agree about the 401K. Thirty years is a long time, especially considering the degree of uncertainty we're facing. Quite frankly I'd be surprised if any pots of money survived in the system for anything like that long, given the multiple claims to every scrap of real wealth that a credit expansion engenders. If you have your liquidity under your own control, then you'll stand a much better chance of being able to retire one day IMO, although I think retirement as a concept will probably have ceased to exist by then.

In countries where the state provides no social support, that role is played very effectively by extended families, and communities. It might therefore be a good idea to make sure that all your family relationships are in good shape, and if you don't have an extended family then you may be able to make one. That's what I've been doing. United we stand, divided we fall.

Stoneleigh said...

Goritsas said:

"A bit like watching England. You know they’re going to lose, they just put so much effort in to preventing it from being so obvious that many get drawn in and think this time it might be different."

LOL - I remember what it was like from when I lived in England :)

I'm afraid I failed Norman Tebbit's 'cricket test' (the supposed duty of everyone in England to cheer for English sports teams, wherever they come from themselves), by cheering for Cameroon in the World Cup some years back.

Anonymous said...


I think foreigners have the ability to control the value of the dollar by either participating or not participating in the games the US plays with it. So if China, Japan, Saudi Arabia and others stop buying dollars and investing them in this country, the US will have to raise interest rates to get them to come back. That would be dollar strengthening. If they continue to play our game forever, we will keep on borrowing from them until the dollar has no value, which would be hyperinflation. I'm no expert, but I think that is the core of the argument.


Greyzone said...

I saw ilargi's comment about inflation being mentioned in so many articles but I think it is important to distinguish between what most of us here call inflation (an expansion of the money supply) versus what others call inflation (rising prices).

It is entirely possible to have deflation (contracting money supply) and rising prices for some things at the same time. The basic notion of supply and demand is not going to go away just because total money supply shrinks and some things (food) are almost completely inelastic to price.

So while we see the word "inflation" in many of these articles, keep that distinct in your head from monetary inflation or monetary deflation.

peakto said...


There are many variations to the inflation/deflation game. I don't know if it is even a good idea to try to guess yet.

IMO, we will see both hyperinflation and deflation.

Along the way there will be stagflation, re-inflation, hyperinflation, and ULTIMATELY - deflation - induced by deep depression systemic failure/collapse.

Why do I think this will happen - I believe the TPTB, foreign governments will do EVERYTHING they can to keep the system going - oh yes, I also believe that NO country is isolated from this mess, therefore, they have to. IMO.

Greyzone said...

Your article "Auction Debt Succumbs to Bid-Rig Taint as Citi Flees" points back to TAE.

The correct URL is:

Greyzone said...


All data to date is that we are experiencing monetary deflation. There are some price increases occurring but so far money is leaving the system faster than it is entering by every available measure we can see. Regardless of what prices are doing, that is, by definition, monetary deflation.

That's why I recommended that we keep an eye on who is saying what. If someone is pointing out rising prices, that rise may not have anything to do with monetary inflation and instead may symptomatic of supply/demand issues. Oil is in this category.

Anonymous said...

USD is sinking at an accelerated pace. Does that indicate inflation or deflation?

Bigelow said...

“USD is sinking at an accelerated pace. Does that indicate inflation or deflation?”

Increasing demand for other possibly higher yielding currencies is another answer to why the USD is falling. The supply of dollars is inflating or deflating, but exchange rates are influenced by interest rates differences too, not just the supply side.