Wednesday, February 6, 2008

Debt Rattle, February 6 2008

Updated 5.00 PM

The Coming Collapse of International Credit Ratings Agencies

So you thought the Ambac/MBIA bond insurers crisis was bad? You ain't seen nothin' yet. The problem, the challenge, the scandal, is not that the bond insurers are about to be downgraded. The real scandal lies in the fact that they haven't been downgraded a long time ago - and much deeper than from "AAA" to "AA". In fact, what needs to be downgraded are the major international credit ratings agencies, Moody's, Standard & Poor, and Fitch.

Ironically, they are already in the process of downgrading themselves. Moody's, for example, recently issued a statement cautioning investors not to rely on its ratings so exclusively. Ha! That's like a corporate CFO saying investors shouldn't rely on the company's financial statements so much when making their decisions. Why do they need to be downgraded? Because the top three or four ratings agencies are ridiculously behind the curve when it comes to letting investors know about problems with the entities whose credit standing and investment outlook they (pretend to) rate. The reason for that appears to be an unresolvable conflict of interest which emanates from how these agencies get paid. They get paid for their services by the companies (and governments) whose performance they rate.

Somewhere in the distant past, in the early 1970s, they were paid by the investors who needed to tap them for their information so investors could make educated judgments on investment risks. That is no longer so. Now, they serve two masters at the same time - but only one master really gets the benefit: the one who pays them.
Unfortunately, the ones left in the dust in this scenario are the world's institutional and professional investors, and they are largely the ones who most influence the prices of investment products.

What's the Big Deal?
The ratings agencies are the paper investing world's equivalent of an air traffic control system. Particularly institutional investors rely on them almost exclusively when deciding whose debt paper to buy and whose to ditch. Picture yourself as the pilot of a big airliner. It is nighttime, it's foggy, and you need to land. The question is: are the runway and the landing approach clear? You communicate with the tower of the airport of your destination, and you hear: "Oh sure,go ahead" through your earphones, so you commence your landing approach. What you don't realize, though, is that the way the air controllers get compensated has just been changed.

No longer do they get bonuses for sterling records of no accidents over a period of time. Now, they get paid extra if they can manage to land as many airliners as possible - simultaneously! You can probably see where that might cause a little problem. In other words, you can't rely on the air controllers' directives anymore - but you don't know that. So you crash-land your plane, only narrowly escaping an in-air collision with another plane, and then you start asking questions.

The world's institutional investors are as dependent on the accuracy of the agencies' ratings as airline pilots are on air traffic controllers, but just like in our analogy, the change in payment structure has compromised the interests of the recipient of the information. One result of this conflict of interest is that, according to an interview with Sean Egan of Egan-Jones Ratings aired on CNBC Friday, February 1, 2008, the ratings agencies' bank and Wall Street investment house customers have actually exerted pressure on the agencies to issue ratings on CDOs - the very subprime mortgage-backed instruments that caused the current credit crunch!

As if that wasn't bad enough, the ratings agencies then reportedly began to demand that bond insurers develop "mutiple streams of income" in order to get their coveted "AAA" ratings - and that entailed insuring CDOs as well, which ultimately benefited their customers, the bankers, who wanted to push that toxic stuff into the markets. Naturally, the agencies bowed to their masters requests, which in part caused them to sustain the very subprime-related losses they are now being downgraded for. Funny how that works, isn't it?

The upshot of all this is that the entire global professional investing world has traditionally heavily relied on these ratings outfits in making investment decisions. "AAA" ratings that used to be regarded as immovable, solid landmarks in the investment landscape now turn out to be nothing more than shape-shifting phantoms. In fact Egan-Jones, which is a relatively new ratings agency that decided to follow the old model of getting investors to pay for their services, rates MBIA not "AA" (to where Moody's wants to downgrade it) but only a mere BB+, which is essentially junk status.

There is no telling how many other companies and bond-issuing governmental entities might be affected in a similar way. Quite tellingly, and in anticipation of potential future criticism, Moody's has recently warned that it may have to downgrade the United States of America's credit rating. There are international efforts underway to "fix" the coming ratings disaster by making the companies adhere to "higher ethical standards. Yeah, right. That has always helped, hasn't it? Just think "Sarbanes-Oxley". The only thing that will fix the problem is to prohibit the ratings companies from accepting money from the institutions they rate. Period.

But, regardless of how, whether, and when the ratings companies themselves will get fixed, the neglect they have shown in the past has caused systemic problems. That malfeasance is opening up a veritable maelstrom, a black hole for international credit ratings. The collective reputation of these agencies has pumped up the value of many bank and government-issued debt instruments for the past three decades - and now that "value" is threatening to collapse. The question now is: on how many - and on which ones - of these credit ratings did they goof up? Six years ago they failed to timely warn of Enron, Worldcom, and others. Now, it's Ambac and MBIA. Who's next?

The very fact that these agencies have been whitewashing their clients' credit ratings over the past several decades throws every single rating they have issued into doubt.
That means there are likely to be huge numbers of bone-deep ratings cuts coming down the pike - and nobody knows which ones, or how deep those cuts will be. One thing, however, is almost for certain: The very fact that Moody's has warned of a credit downgrade for the United States indicates that such a downgrade is probably long overdue - and that will spook a whole lot of international US treasury investors - like China, India, Japan, and Saudi Arabia.

Let that sink in for a moment.

Updated 3.00 PM

Ilargi: I cannot recommend today's first article, from Dr. Housing Bubble Blog, enough, nor the sources from the Great Depression that it’s based on. The similarities send ice cold shivers. Maybe this is how we can make people understand what lies in front of us: 80 years on, the script is the same, as is the dialogue; only the actors have changed.

Our foreland is our hinterland. This is where we’re headed, and fast. We’ll be lucky if it doesn’t get worse than the Great Depression; we come from far greater heights this time. This is what a credit crunch means: it leaves no money for a society to provide for even the most basic needs. Job losses will be staggering, and bank accounts and pension funds will be wiped out. Please do prepare for that.

And if anyone would like to explain how this could possibly be inflationary, please do so. But come prepared if you try.

The Menace of Mortgage Debts:
Lessons from the Great Depression Series
Part IV: Where do we go After the Housing Crash?

“As the great depression advances into the fourth year it becomes increasingly apparent that the mortgage crisis involves something more than the “little fellow” struggling to keep his home. It is not only the function of “shelter” that is involved. The mortgage structure is a part of the whole economic scheme, into which is woven the intricate system of social inter-dependability which allows us to live and carry on.

When the customary flow of credit is seriously interrupted at any one point many diverse processes are also interrupted upon which we depend for both the comforts and the necessities of life. Since the War the civilized world has experienced the greatest economic upheaval of which we possess a recorded history. The mortgage crisis is perhaps the final phase of this world-wide dislocation of our credit system.”

You could take the above paragraph out of any business section of today’s business journals. We are suffering much like the credit problems of the 1930s. Housing even 76 years ago had a major impact on the overall health of the US economy. This housing mess is much beyond “subprime” since housing is a staple of the American economy and we are seeing even prime loans coming under strain.
“To understand what has happened it is necessary to look at the problem in perspective. In the first place all facts are relative. We cannot understand the menace of the mortgage situation unless we consider the cost of carrying our present mortgage burden in relation to our changed national income. In 1929 the national income for the United States was 85 billions of dollars. By the year 1932 this figure had fallen to 36 billions.
The most conservative figure for mortgages that I can find shows that in the year 1929 the combined total of urban and rural mortgages in the United States amounted to at least 46 billions of dollars. It is difficult to determine how much this figure has changed between 1929 and 1932. The first effect of the calling of outstanding loans was to increased the amount of money borrowed against real estate. It is safe to say, however, that any general increase in the total of mortgage loans has since been erased by the calling in of outstanding mortgages and the constant demand for the reduction of principal. I, therefore, assume that the total present mortgage indebtedness is about 43 billions of dollars.”
We already know that wage growth has been stagnant throughout the past decade. However, during the Great Depression national income fell by an astounding figure while mortgage debt remained rather stable. What this did is increased the overall burden of debt servicing with less income. Sounds familiar? We are already given an idea of why it is important to quickly adjust mortgages to current market prices to alleviate some of the burden or we will quickly fall into a similar fate.
“The reduction of the national income has had a drastic effect upon the rents which it has been possible to pay. In other words, the yield of real property has suffered a sharp decline. The best estimates that I am able to gather indicate that this decline amounts to as much as 35 per cent. Yet the fixed mortgage charges have declined hardly at all.”
We are already having predictions of this kind. Merrill Lynch went so far as predicting a 30 percent decline in national real estate. Of course to mention the Great Depression or any historical knowledge is blasphemy in today’s world of 24 hour pseudo-business cable stations. Yet we are already mentioning similar price declines in the magnitude of the 1930s. In fact, this bubble is much larger than any in history including the Great Depression.
“But the prosperity of the nation depends upon its ability to make economic use of what is capable of producing; that is, it must either consume what it produces or sell it abroad. If because of fixed contracts, real estate levies too large a tool on the national income, the amount of income available for the consumption of commodities contracts also. As a result we have industrial stagnation, followed eventually by hunger and suffering.

Production cannot be generally resumed until credits are liberated to restore the purchasing power of the people. Credits cannot be liberated for the purchase of commodities, in appreciable quantity, so long as current funds are being drained off for the liquidation of capital obligations. Increased lending for refinancing purposes will only make matters worse, because on the one hand it draws off additional funds which might otherwise have gone into compensating producers, while at the same time it reestablishes debt burdens which we acknowledge we are unable to carry.“

This is a major rub for our current economy. At least during the Great Depression, we had a larger agricultural and industrial base. The amazing thing of today’s modern economy is that we essentially had an economy that was built on trading, building, financing, and flipping real estate. Our manufacturing base is nearly obsolete due to off-shoring. The center of our economic machine was trading houses to one another in the pyramid climb to larger and bigger homes. How we went on this long is simply amazing.

Ilargi: Read the article for much more on Roubini’s Twelve Steps to Financial Disaster

Panzner on Roubini: Still at the Forefront
The bad news is that Nouriel Roubini is an economist and an academic. The good news is that this background has not prevented him from being one of the leading authorities on the economic and financial disaster that has been unfolding for many months now. While other "experts" claim to have seen things coming, he has been out there, at the forefront, sharing his thoughts for all to see (and, earlier on, getting ridiculed for daring to espouse such controversial views.)

In his latest blog post, "The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster," Professor Roubini addresses the question that TV pundits, stock traders, and most of the mainstream press should have asked, but didn’t.

  1. This is the worst housing recession in US history and there is no sign it will bottom out any time soon
  2. Losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs
  3. The recession will lead – as it is already doing – to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are dozens of millions of subprime credit cards and subprime auto loans in the US
  4. While there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided
  5. The commercial real estate loan market will soon enter into a meltdown similar to the subprime one
  6. It is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt.
  7. The banks’ losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans – a good chunk of which were issued to finance very risky and reckless LBOs – is now at serious risk
  8. Once a severe recession is underway a massive wave of corporate defaults will take place
  9. The “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions
  10. Stock markets in the US and abroad will start pricing a severe US recession – rather than a mild recession – and a sharp global economic slowdown
  11. The worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk
  12. A vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction

Fitch Takes Rating Actions on 172,326 Bonds
From Fitch: Fitch Takes Rating Actions on 172,326 MBIA-Insured Issues
Concurrent with its rating action earlier today on MBIA Insurance Corp. and its affiliates (MBIA), Fitch Ratings has taken various rating actions on 172,326 bond issues (172,168 municipal, 158 non-municipal) insured by MBIA. ...

Fitch placed MBIA's 'AAA' Insurer Financial Strength (IFS) on Rating Watch Negative following Fitch's announcement that it will be updating certain modeling assumptions in its ongoing analysis of the financial guaranty industry.

Quite a few ripples in the pond.

Papers Show Wachovia Knew of Thefts
Last spring, Wachovia bank was accused in a lawsuit of allowing fraudulent telemarketers to use the bank’s accounts to steal millions of dollars from unsuspecting victims. When asked about the suit, bank executives said they had been unaware of the thefts. But newly released documents from that lawsuit now show that Wachovia had long known about allegations of fraud and that the bank, in fact, solicited business from companies it knew had been accused of telemarketing crimes.

Internal Wachovia e-mail, for example, show that high-ranking employees at the nation’s fourth-largest bank frequently warned colleagues about telemarketing frauds routed through its accounts. Documents also show that Wachovia was alerted by other banks and federal agencies about ongoing deceptions, but that it continued to provide banking services to multiple companies that helped steal as much as $400 million from unsuspecting victims.

“YIKES!!!!” wrote one Wachovia executive in 2005, warning colleagues that an account used by telemarketers had drawn 4,500 complaints in just two months. “DOUBLE YIKES!!!!” she added. “There is more, but nothing more that I want to put into a note.”

However, Wachovia continued processing fraudulent transactions for that account and others, partly because the bank charged fraud artists a large fee every time a victim spotted a bogus transaction and demanded their money back. One company alone paid Wachovia about $1.5 million over 11 months, according to investigators.
“We are making a ton of money from them,” wrote Linda Pera, a Wachovia executive, in 2005 about a company that was later accused by federal prosecutors of helping steal up to $142 million. Ms. Pera left Wachovia in 2006, and could not be located.

Lawyers pursuing the lawsuit against Wachovia, which was filed in a Pennsylvania federal court on behalf of a woman named Mary Faloney and other apparent victims, have asked a judge to declare the case a class action, which could expand it to as many as 500,000 plaintiffs. The lawsuit alleges that Wachovia accepted fraudulent, unsigned checks that withdrew funds from the accounts of victims, often elderly. Wachovia forwarded those checks to other banks that were unaware of the frauds, which in turn sent money to the swindlers.

Ilargi: Satyajit Das spreads it out before us, once more, cold and clear.

In 2008 The Worst May Keep Getting Worse

Satyajit Das is one of the world’s premier experts on derivatives

2007 may come to associated with the start of the "big" credit crunch. 2008 has begun with a number of "unresolved" items. Hope of an early resolution seems to be fading. In the words of Lily Tomlin, the American comedian: "Things are going to get a lot worse before they are going to get worse."

The total level of sub-prime losses is still far from clear. Based on current trading levels of ABS indices, estimates of losses range between US$ 150 and 400 billion, not all of which has been written off to date.
Interest rates on large volumes of sub-prime mortgages – estimated at around US$ 900 billion are due to reset by end 2008. Interest rates and repayments will rise significantly. The impact on delinquencies and losses are unknown. The rate reset freeze plan (which has not been in the news since being announced) and its impact are also still unclear.

As America’s mortgage markets began unravelling, economists initially pointed to sub-prime mortgages issued to low-income, minority and urban borrowers. Closer analysis reveals risky mortgages in nearly every corner of the USA. Analysis by The Wall Street Journal indicates that from 2004 to 2006, when home prices peaked in many parts of the country, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined US$1.5 trillion in high-interest-rate, high risk loans. The potential losses on these loans are unknown.

There are also emerging concerns in the US$915 billion credit card debt markets. Credit card providers are all boosting loan loss provisions. There is anecdotal evidence that cash strapped mortgagors are using credit cards to make mortgage payments. Analysts expect credit card delinquencies to increase if consumers unable to use home-equity lines of credit to pay off their credit card debt start running up higher card debt. A number of banks have begun to boost reserves against anticipated losses.

Financial institutions have already incurred losses of over US$100 billion. A substantial volume of assets is likely to return onto bank balance sheets as off-balance sheet structures and hedge funds are forced to sell. The total amount to be re-intermediated by banks may be in the range of US$1 to 2 trillion. This will make substantial depends on bank liquidity and capital.

How risky are uninsured bank deposits?
The Federal Deposit Insurance Corp. is gearing up for the prospect of a large bank failure. So double-check that all your deposits, including interest, are well within FDIC insurance limits. The agency seeks comment by April 14 on a proposed rule designed to help it make a quick insurance determination amid an increasingly complex quagmire of FDIC rules and tough-to-figure-out bank accounts. One section would place a provisional hold on a fraction - say, 10% or so -- of certain account balances at some 159 of the nation's largest banks. The hold could affect some accounts with balances under $100,000.

If you have uninsured deposits at a bank, should you worry? Possibly. Depositors without FDIC coverage lost money in at least two recent failures -- NetBank, Alpharetta, Ga., and Miami Valley Bank, Lakeview, Ohio. Of $109 million in uninsured deposits at NetBank, nearly 30% has not yet been reimbursed. Of $14 million in uninsured funds at Miami Valley, only 5.9% of uninsured funds, so far, has been reimbursed. All deposits in the most recent failure -- Douglass National Bank, Kansas City, Mo. -- have been reimbursed.

Fortunately, FDIC insurance limits have increased on certain accounts in recent years. Certain retirement accounts, for example, now are insured to $250,000, up from $100,000 per person. But the tide on FDIC reimbursement of uninsured depositors may have changed in 1991 for the worse. Congress sharply curtailed the FDIC's discretion to extend protection beyond insured deposits. Now the FDIC must enter into the "least costly" transaction when dealing with a troubled bank. So the FDIC won't reimburse uninsured depositors if it means increasing the loss to the deposit insurance fun.

FDIC data indicate that as of Sept. 30, there were 65 institutions with assets of $18.5 billion on its list of "problem" institutions. Barr would not elaborate on their sizes. Nor will the FDIC name the institutions. Institutional Risk Analytics, Torrance, Calif., based on FDIC data from that same date, puts Bank of America Corp., Citigroup Inc., J.P. Morgan Chase & Co , Wachovia Corp. and HSBC Holdings PL , as the riskiest big banks. More recently, Managing Director Chris Whalen cited J.P. Morgan, Citigroup and Bank of America as his chief concerns due to their heavier trading activity. He stresses that there is a 45-day lag time from the close of a quarterly period and the publication of FDIC data. Bank conditions can deteriorate very quickly. Fourth quarter 2007 FDIC data won't be released until late February.

MBIA, Ambac Downgrades May Lead to Bank Rating Cuts
Downgrades of bond insurers, including MBIA Inc. and Ambac Financial Group Inc., may lead to cuts in credit ratings at banks, Standard & Poor's said. If more bond insurers lose their top credit ratings, the markets in which they back debt, including municipal bonds and structured finance, could slow, affecting bank profits, S&P said in a report today. Bond insurer downgrades also could affect banks directly by causing them to recognize more losses and reverse gains in securities they hold guaranteed by the bond insurers, S&P said.

"We believe that the specific, identifiable effect on banks may be significant and, in a few cases, could lead to downgrades," Tanya Azarchs, a New York-based S&P analyst wrote in the report. The collapse of the U.S. subprime mortgage market has led to about $146 billion of losses and markdowns at securities firms and banks since the beginning of 2007. They may report more losses if the bond insurers falter because the insurers have backed $125 billion of collateralized debt obligations tied to loans to borrowers with poor credit, S&P said.

Those contracts are concentrated at a small number of banks, S&P said. "Few banks have disclosed how much that exposure is," the report said. CDOs repackage assets such as mortgage bonds and buyout loans into new securities with varying risk.

Banks that have disclosed how much of their CDO holdings are offset by guarantee contracts include Citigroup Inc., which said it has $10 billion of insurance on top-rated CDOs, and Merrill Lynch & Co., which has nearly $20 billion of such contracts, and Canadian Imperial Bank of Commerce, with $9.9 billion, S&P said. Citigroup and Merrill are both based in New York and Canadian Imperial is based in Toronto. In addition to shielding them from losses, these contracts with bond insurers allowed the banks to book profits in their CDOs, S&P said. Downgrades of bond insurers could result in a need to reverse those gains, the New York-based unit of McGraw- Hill Cos. said

Moody's Expects to Downgrade Builders
Moody's Investors Service expects to downgrade some major homebuilders in 2008 on expectations that the housing industry will continue to languish. "Recent data provide fresh evidence supporting our view that a meaningful sector recovery is unlikely before 2009, at the earliest," Joseph Snider, senior vice president, said in a statement.

Homebuilders have curbed building and slashed prices in hopes of selling excess inventory. That strategy also generates excess cash that can be used to invest in new land when the market recovers. But Moody's said this strategy is not paying off as in previous downturns. Most inventory reductions this time are coming through write-offs, not sales.

"The possible saving grace for the industry -- sharp inventory reduction and mighty cash flow generation -- is not living up to expectations," Snider said.

Toll Brothers Posts Drop In Home-Building Revenue
Toll Brothers Inc. Wednesday said that its fiscal first-quarter home-building revenue fell 22% from year-earlier levels to $842.7 million and it doesn't see any end in sight to housing-market woes. The company said it is still finalizing its first-quarter impairment analysis, but expects pretax write-downs of between $150 million and $300 million.

"The housing market remains very weak in most areas. Based on current traffic and deposits, we are not yet seeing much light at the end of the tunnel," said Robert Toll, the firm's chairman and CEO. Toll Brothers said its backlog fell to $2.4 billion, down 42% from the fiscal first quarter of 2007. The company said the gross number of signed contracts on homes fell 46% from last year. Toll said the average price of a house it sold fell, while the average price of cancelled houses rose.

"With conditions still weak in most markets, we expect to continue to face challenging times ahead," Toll said.

Moody's Considers Substituting Numbers for Ratings
Moody's Investors Service is considering a new ratings system based on numbers for structured- finance securities that would abandon the letter grades created by founder John Moody about a century ago. Moody's in a letter today asked investors for comments on five options it is reviewing to improve ratings including a numerical scale and a designation of ".sf" to differentiate a structured finance ranking from a corporate credit grade.

The ratings company is also requesting investor comment on designations indicating higher risk that a security may be downgraded by more than one level. New York-based Moody's said it may decide to leave the ratings scale alone and plans to disclose more information through research. "Some public authorities and some market participants have called for additional steps," Moody's analysts led by Richard Cantor wrote in the letter. "They have asked whether the credit rating agencies should differentiate ratings assigned to structured products from those assigned to corporate and government issuers."

Moody's may make the changes after boosting its prediction for losses on subprime mortgages packaged into securities, a key factor in ratings models. The company today raised its loss assumptions to as much as 17.8 percent on 2006 subprime bonds packaged into collateralized debt obligations, heralding further ratings downgrades as defaults increase. Standard & Poor's last week also raised its loan-loss estimate, and Fitch Ratings is expanding the use of housing- market and economic data that will boost its loss assessments as well.

Services contract in US, fading fast in euro zone
The world economy shuddered at the start of the year, with markets rocked by reports on Tuesday suggesting the vast U.S. services sector unexpectedly contracted to recessionary levels and the euro zone's was barely growing. News that an index measuring services business in the world's largest economy fell off a precipice last month, swinging from modest growth to contraction, shook bank trading desks and triggered a sell-off on an already battered Wall Street.

The Federal Reserve, which has already slashed interest rates by 1.25 percentage point over the past few weeks, looks set to deliver more and the pressure on the European Central Bank to cut borrowing costs is whistling at full blast. The Institute for Supply Management said its key non-manufacturing services index plunged to 41.9 in January from 54.4 in December, more than 10 points below the Reuters consensus for 53.0 and taking analysts totally by surprise.

This was the lowest since October 2001, after the Sept. 11 attacks that destroyed the World Trade Center in New York and when the U.S. slipped into a mild recession. "An absolutely stunning ISM non-manufacturing number leaves the chart of the index looking like it has fallen off the edge of a cliff, and is heartwarming only for those who think the economy is already in a recession," said Alan Ruskin, strategist at RBS Greenwich.

CDO Market Is Almost Frozen, JPMorgan, Merrill Say
Buying and selling of collateralized debt obligations based on mortgage bonds, high-yield loans or preferred shares has ground to a near-halt, traders said at the securitization industry's largest conference. "We're definitely in a period of very low liquidity at the moment, which has actually been dropping precipitously in the last few weeks," Ross Heller, an executive director at JPMorgan Securities Inc., said yesterday during a panel discussion at the American Securitization Forum's annual conference in Las Vegas. "It's a challenging time."

The slowdown of the more than $2 trillion CDO market follows record downgrades in mortgage-linked securities last year. Some AAA rated debt lost all its value. CDOs, which have fueled unprecedented bank writedowns since mid-2007, repackage assets into new securities with varying risks. Lighter trading volumes for asset-backed bonds and larger- than-typical differences between the prices at which they can be bought and sold have made valuing holdings difficult and dissuaded investors from purchasing the debt, said Sanjeev Handa, head of global public markets at TIAA-CREF.

Demand for new CDOs has stalled, with just one created in the U.S. so far this year, according to JPMorgan. The creation of CDOs dipped about 10 percent last year to $494.7 billion, according to the company. The figures include only issuance for which investor money was collected upfront.

Fitch Ratings today said it may downgrade the $220 billion of CDOs it assesses that are based on corporate securities. The New York-based company said it may lower the notes by as much as five levels after failing to accurately assess the risk of debt that packages other assets. More than 60 "opportunity" funds have been created to take advantage of a plunge in prices for mortgage assets, said Carlos Mendez, a senior managing director at Institutional Credit Partners LLC.

Along with insurers, they're among the limited number of buyers of existing mortgage-linked CDOs, Mendez and Heller said.
Merrill Lynch & Co., the New York-based securities firm with a record loss last year amid writedowns on the most-senior AAA pieces of mortgage CDOs it underwrote, "has been actively talking to people" about purchasing its super-seniors, said Brian Carosielli, a managing director. Investors with experience with residential-mortgage assets have been buyers, paying in the "mid-teens to low 30" cents on the dollar for the senior-most, or super-senior, classes of CDOs comprised of low-rated asset-backed bonds, he said.

Fannie Mae, A Ticking Time Bomb
Congress created Fannie Mae in 1938 as a government sponsored entity (GSE) with private ownership. Their goal was to provide financing to make home ownership available for the common man. With the present housing collapse, this giant is facing a fiscal catastrophe. Meltdown is probably a better choice of words. This implies a Congressional bailout (the price of gas will go up another dollar).

The housing market swings like a pendulum, right now it's going the wrong way. The financial institutions are not set up for a swing of this magnitude. Fannie Mae can weather a 20 % drop in home values and break even. Most of their note packages are at 80% of actual value. The typical Fannie Mae loan has a 20% down payment or a 20% second mortgage held by a third party. In banking circles, a 20% drop in housing values is almost unheard of. Just about every house sold in the last ten years could come under the axe. That’s how far values have swung.

Fannie Mae has about 2.7 trillion dollars worth of loans guaranteed. They have 34 billion cash on hand. Just for the sake of simplicity, let’s figure the average guaranteed home loan at $340,000. Divide $340,000 into the 34 billion cash on hand and the result is 100,000. That figure is the actual number of houses Fanny Mae can redeem at any one point in time. So if the pundits are predicting 2 million foreclosures this year and Fanny Mae underwrites 40% of the market, that’s about 800,000 houses.

Figure a best case scenario. Calculate houses guaranteed at $170,000 apiece, half of the price above. That would give them room to cover 200,000 returned contracts. Also figure of the 2 million homes that only 20% of them are covered by Fannie Mae (another 50% reduction). The total houses would still be 400,000. Fannie Mae's goal is to convert each home to cash and apply the proceeds to the next problem loan. It could prove difficult. There are side issues here that are not real apparent. Another 1.2 million houses are in the same foreclosure mill in competition with them. Is the house boarded up? Have the pipes frozen and broke? Has the house been stripped or trashed? Who pays the property taxes? Converting the asset to cash will take time.

What can be deduced from this experiment in unscientific speculation is that Fannie Mae will run out of operating capital (cash in the till) somewhere between 100,000 and 200,000 housing contracts.

The Minsky Moment
Twenty-five years ago, when most economists were extolling the virtues of financial deregulation and innovation, a maverick named Hyman P. Minsky maintained a more negative view of Wall Street; in fact, he noted that bankers, traders, and other financiers periodically played the role of arsonists, setting the entire economy ablaze. Wall Street encouraged businesses and individuals to take on too much risk, he believed, generating ruinous boom-and-bust cycles. The only way to break this pattern was for the government to step in and regulate the moneymen.

Many of Minsky’s colleagues regarded his “financial-instability hypothesis,” which he first developed in the nineteen-sixties, as radical, if not crackpot. Today, with the subprime crisis seemingly on the verge of metamorphosing into a recession, references to it have become commonplace on financial Web sites and in the reports of Wall Street analysts. Minsky’s hypothesis is well worth revisiting. In trying to revive the economy, President Bush and the House have already agreed on the outlines of a “stimulus package,” but the first stage in curing any malady is making a correct diagnosis.

Minsky, who died in 1996, at the age of seventy-seven, earned a Ph.D. from Harvard and taught at Brown, Berkeley, and Washington University. He didn’t have anything against financial institutions—for many years, he served as a director of the Mark Twain Bank, in St. Louis—but he knew more about how they worked than most deskbound economists. There are basically five stages in Minsky’s model of the credit cycle: displacement, boom, euphoria, profit taking, and panic. A displacement occurs when investors get excited about something—an invention, such as the Internet, or a war, or an abrupt change of economic policy.

The current cycle began in 2003, with the Fed chief Alan Greenspan’s decision to reduce short-term interest rates to one per cent, and an unexpected influx of foreign money, particularly Chinese money, into U.S. Treasury bonds. With the cost of borrowing—mortgage rates, in particular—at historic lows, a speculative real-estate boom quickly developed that was much bigger, in terms of over-all valuation, than the previous bubble in technology stocks.

As a boom leads to euphoria, Minsky said, banks and other commercial lenders extend credit to ever more dubious borrowers, often creating new financial instruments to do the job. During the nineteen-eighties, junk bonds played that role. More recently, it was the securitization of mortgages, which enabled banks to provide home loans without worrying if they would ever be repaid. (Investors who bought the newfangled securities would be left to deal with any defaults.) Then, at the top of the market (in this case, mid-2006), some smart traders start to cash in their profits. The onset of panic is usually heralded by a dramatic effect: in July, two Bear Stearns hedge funds that had invested heavily in mortgage securities collapsed. Six months and four interest-rate cuts later, Ben Bernanke and his colleagues at the Fed are struggling to contain the bust. Despite last week’s rebound, the outlook remains grim.

Media Meltdown: Unreporting the Housing Bubble
Need some comic relief? Check out the alarmist cover of BusinessWeek which shouts, Meltdown: for housing the worst is yet to come. Uh, can you say "Duh!"? Where were these clowns in 2005 or even 2006, when the bubble was expanding and they could have warned readers to stay out of the market? Indeed--where was the entire mainstream media? Missing in action, at every step of the way.

Now that the horses have long left the barn, BusinessWeek is on top of the story: "Barn door left wide open, horses have vanished into the night! Woe is us! Who could've predicted an open barn door would lead to this catastrophe?"
The Standard & Poor's/Case-Shiller 20-city home price index fell 7.7% in November from the year before, the biggest decline since the index was created in 2000.
And that could be just the start. Brace yourself: Home prices could sink an additional 25% over the next two or three years, returning values to their 2000 levels in inflation-adjusted terms.

You mean just like all of us housing bloggers have been saying--and providing charts to support the case--for years? Were housing blogs some sort of secret which was unavailable to BusinessWeek editors?
A Harris Interactive survey for in December found that 36% of homeowners thought their homes had increased in value over the past year, vs. 23% who thought they had decreased. That willful optimism translates directly into the record overhang of unsold existing homes: more than 4 million.

Golly, I wonder where the average American got the idea that his/her house is still climbing in value. Could it possibly be the relentless cheerleading about housing's never-ending rise they saw on TV, heard on radio, read in newspapers and magazines, and saw on MSM Websites?
A 20% decline in home prices would wipe out the equity of 67% of people who bought last year, estimates.

And where were you, "watchdog press"? Protecting the citizenry with hard, skeptical reporting on the housing boom's inevitable bust? Warning readers in front-page stories that a reversion to trend was inevitable? Hardly. To quote Mogambo: hahahahahahahahaha.

We all know the government regulators were asleep at the wheel; so what's the media's excuse? Why wasn't the financial media reporting the dangers so visibly inherent in no-document, no-down loans, and all the other chicanery which enabled the lending bubble which then begat the housing bubble? Isn't educating the public about the dangerous lack of regulation, and being skeptical of government and "received wisdom" from those business interests reaping huge gains the fundamental purpose of the Free Press? Yes.

Bottom line: the mainstream and financial media failed the American public, completely, utterly, inexcusably. Their coverage of the inevitable collapse of the housing bubble and the dangers inherent in the lending bubble was a travesty of a mockery of a sham (to quote Woody Allen).

Wall Street Throws A Tantrum
In these turbulent times, traders are the tykes screaming and yelling and writhing on the floor until they get what they want.

Monetary policy, the management of global companies and the workings of Wall Street are indisputably the realms of the mature: one searches the gallery of Federal Reserve chairman portraits in vain for a full head of hair. At the World Economic Forum in Davos, I realized I hadn't seen so much silver hair since the 5 p.m. early-bird special dinner at Le Rivage in Boca Raton, Fla. The presence of all these wizened professionals should instill a good deal of confidence. When you're trying to bring a massive tanker to port amid stormy seas, the last thing you want to see is a 12-year-old apprentice steering the tugboat.

Yet in these turbulent times, Wall Street traders are the infants and toddlers. They're the tykes who stage public tantrums, screaming and yelling and writhing on the floor until they get what they want. Since the markets began to buckle last summer, what traders want is interest-rate cuts and other government measures to bail out banks from reckless and disastrous lending and investment decisions. In response, Federal Reserve chairman Ben Bernanke has done what any exhausted parent does when a child screams for three hours straight: he gives in. In the past two weeks, the Fed cut interest rates sharply twice, taking the Federal Funds rate down from 4.25 percent to 3 percent.

Of course, "giving in to a tantruming child just reinforces the demand," says Dr. Wendy Mogel, a clinical psychologist in Los Angeles and author of the wildly popular parenting tome "The Blessing of a Skinned Knee." And each time you cave to a screaming child, it buys you less quiet. The Federal Reserve's latest attempt to calm the market's tantrums—the half-point interest-rate cut on Wednesday—bought about 90 minutes of market silence. Within hours, as poor economic news continued to materialize, the clamor for further rate cuts began to rise. Mogel puts it in starkly financial terms: "Indulge tantrums and you get short-term gains and long-term loss."

If traders are the toddlers, investment bankers—and the CEOs they report to—are the tweens of the system, plagued by attention-deficit disorder. As we speak, your typical Wall Street managing director is glancing at CNBC in his office, intermittently checking six computer screens, thumbing out e-mails on his BlackBerry, barking out orders to a personal assistant—all the while furiously working out on the elliptical machine. Merrill Lynch, Morgan Stanley and Bear, Stearns take great pains to distinguish themselves from one another. But they all lurch together from hot financial trend to hot financial trend the way tweens ditch yesterday's pop stars for today's (goodbye, Britney; hello, Hannah Montana).

Like proto-teens, bankers are incapable of exercising independent judgment. Which is why every bank—from the staid Swiss to the sharp trading houses on Wall Street—got caught up in the subprime debacle. Alan Hilfer, a child psychologist at Maimonides Medical Center in Brooklyn, N.Y., notes that investment bankers behave like kids in a candy store. "The candy is money. And when they see an opportunity to get more of what they want, they go after it without considering the consequences." The financial system has an upset stomach today precisely because every large financial institution gorged on subprime candy.

Wall Street Wetting Its Pants
Bloomberg recently published a piece that borders on hysterical panic. Only in times of panic do you see the players for who they really are: hyprocritical phonies. “Free-market” advocates who do not want to suffer the risks that come with such a system are now asking that public resources be used to bail out their ultra-speculative bubble. All of this comes with the blessing of IMF and academic economists, who see no problem with exploding deficits because that’s what Keynes would do.

I would recommend everyone to read this article at Bloomberg, which reads like a Wall Street executive peeing in his pants:
Big government may be on the way back as the Group of Seven nations take a more interventionist stance by imposing greater regulation on financial institutions and perhaps even stepping into the private sector to bail out nonperforming mortgage loans.

“There needs to be outside-of-the-box thinking,” says Laura Tyson, a former economics adviser to President Bill Clinton who now teaches at the University of California, Berkeley. “The problem has not been contained, and there’s a continuing risk to the economy.”

How convenient. After two decades of pushing for unabashed deregulation, the crooks on Wall Street are now pushing for a larger government role (READ: BAILOUT).
Russo proposes offering government-backed loans to U.S. homeowners with adjustable-rate mortgages, whether prime or subprime. He also advocates a tax credit for people who buy homes this year that would triple the current benefits mortgage holders receive.

Stephen King, chief economist at HSBC Holdings Plc in London and a former U.K. Treasury adviser, says the crisis may get so severe that governments will be forced to bail out homeowners who fall behind on loan payments and to buy up worthless assets that are hurting banks.

King believes that governments should bail out homeowners. And what about renters? Should the government bail out or subsidize renting as well? More interestingly, this plan has nothing to do with keeping homeowners in their houses as millions of Americans are finding out every day. These silly ideas are all meant to protect investors from taking massive losses on mortgage loans. Notice the emphasis is on buying worthless assets that are hurting banks, not on homeowners.

Clear your debt, get saving and prepare to meet thy doom
Most of us worry only occasionally about what we would do if we lost our job and where we would find the money to pay the bills. But given the stock market turmoil of the past month, and warnings about an impending recession, we might now be getting a bit more concerned. So is there anything we can do to copper-bottom our finances?

The short answer, says Tom McPhail at independent financial adviser (IFA) Hargreaves Lansdown, is no. "It is virtually impossible to make yourself immune from the effects of a recession." But, he adds, you can live with it. "The trick is to protect yourself as much as possible."

Of course, how capable you are of withstanding a downturn depends partly on your personal circumstances. For instance, those in their 20s living in rented accommodation may be less vulnerable than a couple with kids and a mortgage to pay, as they have fewer financial commitments. Protecting yourself is largely a function of what you have to protect in the first place. But regardless of personal circumstances, Mr McPhail says the first thing to do is draw up a budget and focus on clearing debt.

European stocks rise, SocGen jumps on bid talk
European stocks were slightly up around midday on Wednesday, pausing after the previous session's sharp decline as buoyant utilities and telecoms offset falling banking and mining stocks. French bank Societe Generale bucked the trend in the banking sector, rising 6 percent as traders speculated about a potential bid by HSBC ahead of SocGen's planned capital increase. HSBC declined to comment. SocGen, hit by a massive rogue trading scandal, has been the subject of bid speculation over the past two weeks.

At 1204 GMT, the FTSEurofirst 300 index of top European shares was up 0.2 percent at 1,317.59 points in choppy trade.
The index, which tumbled 3.1 percent on Tuesday after weak U.S. macroeconomic data sparked a fresh wave of selling on bourses around the world, has lost nearly 13 percent since the start of the year and is down about 20 percent since reaching a multi-year high last summer. Many analysts consider a fall of 20 percent from a peak as signalling a bear market. Banking shares, hammered over the past six months by the debacle in the U.S. subprime mortgage market, fell on Wednesday, with Credit Suisse down 4.1 percent, UBS down 3.1 percent and Royal Bank of Scotland down 2.6 percent.

"Further "first-round" markdowns look inevitable as the contagion broadens. But "second-round" earnings pressure will increasingly dominate through both market-sensitive revenues and credit costs," ABN AMRO analysts wrote in a note. "Monoline rating downgrades have opened another source of potential writedowns but could also destabilise the "shadow", or off-balance sheet financing," they wrote.


peakto said...


I agree it will eventually be deflationary...and horrifyingly deflationary.

Not that you were addressing me or anything, but inflation seems to be the short term rule(as in Ben seems happy to print money like mad)

The question for me is when does it cross the line into collapse, which is utterly, with all finality, deflationary.

Until that line is crossed, they seem content to inflate with all means at their disposal, which is more and more limited as of late.

I see one problem which moves the line closer to now, global wage arbitrage essentially guarantees we will NOT see any meaningful inflation driven wage increases.

This in my mind pushes the limits of western society very close to collapse. How much financial strain can they endure with no REAL wage increase?!

goritsas said...

peakto said:

... inflation seems to be the short term rule(as in Ben seems happy to print money like mad) …

The Fed is not "printing" money at all right now. The supply of money in circulation is quite constant at this time. While it may appear the Fed is trying to stimulate things by reducing the cost of borrowing, if consumers and businesses don’t borrow then it matters not one whit. We are deflating now and unless the Fed starts printing notes today at a rate that would clear every forest in the US, there will be no inflation. The net supply of money and credit is contracting. Even if the Fed is “printing” money it will fail to keep up with the credit repudiation now taking place.

As for when will the line be crossed, it has been and it took place in August 2007. We are deflating now. Not tomorrow, not by the end of the year, not sometime in 2009, but right now. The US economy is in recession. With every day new revelations appear that seem to augur for a depression that will easily exceed the scope of the “Great Depression.”

In ten or twenty years when we look back at this from an historical perspective, we are going accord the Great Credit Crunch of 2007 the same reverence we now accord the Great Stock Market Crash of 1929.

The longer one waits to see inflation the more time they’ll waste in taking protective action. So stop waiting for inflation because it just doesn’t seem anywhere near as probable as a deepening of the deflationary period we’re already in.

Anonymous said...

This is cheating by using Consumer price index instead of actual money and credit figures but --the US had a nasty deflationary period for ten years following Sept. 1929 with CPI down -18.5%. That contained within the Federal Reserves reign 1914 to 2007 when consumer prices are up 2000%!


Stoneleigh said...


I agree with Goritsas that deflation is already underway. Confidence is a prerequisite for liquidity, and confidence is evaporating by the day, along with trust. Without trust and confidence, there's nothing Bernanke or other central bankers can do to increase liquidity. Whatever they manage to inject is overwhelmed by what is withdrawn through writedowns and money being taken off the table.

IMO the counter-trend rally in the markets appears to be over, which should lead to much greater losses in the near future. At some point a rush for the exits is likely.

Nope, That’s Not Money

"Prudent Bear’s Doug Noland has for years been pointing out that one of the drivers of the credit bubble has been the ever-broadening definition of money. As the global economy expanded without a hic-up, more and more instruments came to be used as a store of value or medium of exchange or even a standard against which to value other things—in other words, as money. Thus mortgage-backed bonds and even more exotic things came to be seen as nearly risk-free and infinitely liquid. In Noland’s terms, credit gained “moneyness,” which sent the effective global money supply through the roof. This in turn allowed the U.S. and its trading partners to keep adding jobs and appearing to grow, despite debt levels that were rising into the stratosphere. For a while there, borrowing actually made the world richer, because both the cash received and the debt created functioned as money.

With a few months of hindsight, it’s now clear that debt-as-money was not one of humanity’s better ideas. When the U.S. housing market—the source of all that mortgage-backed pseudo money—began to tank, hedge funds found out that an asset-backed bond wasn’t exactly the same thing as a stack of hundred dollar bills. The global economy then started taking inventory of what it was using as money. And it began crossing things off the list. Subprime ABS? Nope, that’s not money. BBB corporate bonds? Nope. High-grade corporates? Alas, no. Credit default swaps? Are you kidding me?

No longer able to function as money, these instruments are being “repriced” (a slick little euphemism for “dumped for whatever anyone will pay”), which is causing a cascade failure of the many business models that depend on infinite liquidity. The effective global money supply is contracting at a double-digit rate, reversing out much of the past decade’s growth."

Anonymous said...

I found this awesome article:

In reading a history of major depressions in the U.S. from 1830 on, I was impressed with the following:

(a) All were set off by a deflation of excess credit. This was the one factor in common.
(b) Sometimes the excess-of-credit situation seemed to last years before the bubble broke.
(c) Some outside event, such as a major failure, brought the thing to a head, but the signs were visible many months, and in some cases years, in advance.
(d) None was ever quite like the last, so that the public was always fooled thereby.
(e) Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits.
(f) Credit is credit, whether non-self-liquidating or self-liquidating.
(g) Deflation of non-self-liquidating credit usually produces the greater slumps.

Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan - for business start-up or expansion, for example - generates the financial return that makes repayment possible. The full transaction adds value to the economy.

Non-self-liquidating credit is a loan that is not tied to production and tends to stay in the system. When financial institutions lend for consumer purchases such as cars, boats or homes, or for speculations such as the purchase of stock certificates, no production effort is tied to the loan. Interest payments on such loans stress some other source of income. Contrary to nearly ubiquitous belief, such lending is almost always counter-productive; it adds costs to the economy, not value. If someone needs a cheap car to get to work, then a loan to buy it adds value to the economy; if someone wants a new SUV to consume, then a loan to buy it does not add value to the economy. Advocates claim that such loans "stimulate production," but they ignore the cost of the required debt service, which burdens production. They also ignore the subtle deterioration in the quality of spending choices due to the shift of buying power from people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily a superior ability to consume (debtors).

Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts.

Stoneleigh said...

Cid Yama,

You can make links live by using [a href="URL"]Title[/a], where the square brackets are replaced by < and >.

I've read pretty much everything the author of that article (Robert Prechter) has written for at least the last 10 years. I'd recommend Conquer the Crash from 2002 if you'd like to know more, and there's a lot more to know.

Credit expansions, which borrow from the future by their very nature, all end the same way - with a credit deflation that removes the illusory wealth from the system. Unfortunately it also highlights the extent of the malinvestment that occurred as a result, revealing that much of what has been called investment will simply prove to have been the conversion of capital to waste through years of negative added value (eg suburbia).

The readjustment phase is the depression that follows, with the depth of the depression being roughly proportionate to the scale of the excesses that preceded it. This depression should be the worst in recorded history by that measure, as the excesses have exceeded the Roaring Twenties, the South Sea Bubble (1720s) and the Tulipmania (1630s). For example, the aftermath of the South Sea Bubble arguably lasted for decades and culminated in a series of revolutions.

Lindsay Went said...

Just a technical comment here :)

Could you more clearly differentiate the font you use for your own comments and the fonts you use for your article excerpts?

It can be difficult to tell which is which.

Enjoying the blog immensely.