Wednesday, March 12, 2008

Debt Rattle, March 12 2008

Ilargi: Well, the real markets are not fooled, so much is evident. Let’s try to sculpt a prediction out of this avalanche of nonsense, shall we?

I’d say it may take until Friday for everyone to understand that TAFs and PAFs and what have you cannot possibly work. Can you say "solvency"? So as early as next Monday we can expect to see the first plans to just start buying the piles of stinky paper outright, with taxpayers' money, the so-called "nationalization of debt". Fannie and Freddie look like the ideal instruments to do that.

The idea is to transfer all the debt one way, from the private to the public sector, while at the same time sending money the opposite way.

Updated 2.30 pm

Ilargi: Dear diary.

I have to admit, even I am a little surprised at how fast the psychology of $200 billion burns through the market place. I mean, that kind of money should at least buy you a day's fun, no? I'm sure even Spitzer would agree with that.

But no, it's Wednesday, 2.30 pm, and all that's left is ashes. I was thinking the appropriate image is something like all of Wall Street swallowing a behemoth morning after pill.

Metaphors aside, I know what's coming now, and so do you: we'll model the economy after Bulgaria. Not pretty. And it won't sell either. So we'll stick with the notion of the ownership society, but without explaining that what every American will soon be the proud proprietor of is their very own chunk of bank debt.

Euro hits record vs dollar as Fed euphoria fades
The dollar tumbled to a record low against the euro on Wednesday as doubts grew about the long-term impact of recent Federal Reserve efforts to pump money into cash-starved credit markets. The greenback rallied a day ago after the Fed said it would lend primary dealers $200 billion in Treasury securities and accept a wider array of mortgage debt as collateral to ease tight credit conditions.

But those gains fizzled out on Wednesday as the euro rose above $1.55 for the first time in its nine-year history as investors wondered whether the Fed's plan would do enough to revive credit markets and boost a struggling U.S. economy.

"There was a knee-jerk reaction on Tuesday, but we're seeing today that these measures haven't really helped mitigate pressure in the financing markets," said Sophia Drossos, senior currency strategist at Morgan Stanley in New York. Matthew Strauss, senior currency strategist at RBC Capital Markets in Toronto, said the dollar's turnaround on Wednesday amounted to "a reality check" for markets.

"The Fed's move addresses short-term liquidity issues but doesn't address underlying credit concerns and the U.S. housing decline, which have not gone away," he said. The euro hit a record peak of $1.5515, according to Reuters Dealing data, before easing to around $1.5488, up 1 percent on the day.

Bonds rise on doubts over Fed's liquidity move
U.S. Treasury debt prices rose on Wednesday on growing doubts the Federal Reserve's latest move to ease credit tightness goes far enough to jump-start a stalled global financial system.

In the absence of major economic data and Fed speeches, bargain hunting emerged, as aggressive traders decided the Fed will still make bold interest rate cuts to forestall an increasingly fragile economy, which some economists consider is already in a recession, analysts said.

"It's a big help, but it's not the panacea that some thought it would be," Andrew Richman, managing director of SunTrust's personal asset management division in West Palm Beach, Florida, said of the Fed's latest liquidity measure. The Fed said on Tuesday it would exchange up to $200 billion of Treasury securities to banks for an extended 28-day span for a range of collateral including riskier mortgage-backed securities, which has been epicenter of the current credit crunch.

"We are not through with the negativity in the housing market, credit turmoil and bank balance-sheet write-downs," Richman said. The lingering pessimistic outlook renewed safe-haven bids for Treasuries, analysts said.

Ilargi: So yes, F&F will be the vehicle to nationalize the Wall Street debt, and you will pay for the process. So will your kids, and their kids. The logic remains stunning: the GSEs are doing really lousy, SO they have to take on more debt.

Fannie, Freddie fall again
Fannie Mae and Freddie Mac came under renewed pressure Wednesday amid increasing worries about the mortgage lenders’ financial health. Shares of Fannie fell 6% and rival Freddie dropped 3% in midmorning action after The Wall Street Journal reported the companies could be forced to raise more capital. The selloff came even after Freddie’s financial chief rebutted the report in a meeting with analysts in New York. “There is no dilutive capital raise plan,” he said, Bloomberg reports.

Wednesday’s selloff helped erase some of the gains made in Tuesday’s marketwide rally. Even after yesterday’s double-digit percentage gains, shares of both Fannie and Freddie have fallen more than 40% in 2008, as house prices have fallen and projected credit losses have risen. Those trends have fueled worries about the strength of the companies’ balance sheets, even after Freddie raised $6 billion and Fannie almost $8 billion late last year.

Worries about the companies’ health have intensified with Washington’s efforts to expand Fannie and Freddie’s role in supporting the housing market by allowing the two to buy bigger mortgages. Those fears lifted briefly Tuesday, when the Fed set plans to let banks and brokers use mortgage-backed securities as loan collateral, but the Journal contends that the sharp decline in the companies’ shares over the past year shows the market already expects a new share issue.

Adding to worries that shareholders will be diluted, the Journal notes that the companies’ regulator, the Office of Federal Housing Enterprise Oversight, has stated its approval of new capital raising at Fannie and Freddie. While Ofheo recently deemed both companies well capitalized as of Dec. 31, director James Lockhart tells the Journal that “raising capital would put them in an even better position to support the mortgage market.”

Updated 1.20 pm

Ilargi: The professors at Minyanville share my views on what will transpire next, and soon.

Breaking: Fed Wants To Buy Your Debt
The Federal Reserve is one step closer to the direct purchase of bad mortgage debt. In time, the Fed will orchestrate asset sales and writedowns for financial institutions at levels they can withstand while remaining solvent.

Professor Depew, Mr. Practical and others in the 'Ville have been covering the nationalization angle for a while now, and the Fed's actions yesterday provide additional fodder. In conjunction with new fiscal policies, the Fed plans to use government sponsored entities Fannie Mae and Freddie Mac to clean up the mortgage mess.

Fannie and Freddie will be charged with a problem that, for all its intricacies, is rather simple. Financial institutions around the world have too much bad mortgage debt on their balance sheets. Federal Reserve Chairman Ben Bernanke's solution is twofold, and involves more than just the elusive notion of nationalizing Fannie and Freddie: The Fed must balance protecting banks and bailing out homeowners, without ignoring moral hazard.

The financial system is a mess and embattled credit markets are preventing banks like Lehman Brothers and Bear Stearns from selling mortgage-backed securities. Yesterday's announcement of the Term Securities Lending Facility, or TSFL, directly addresses this issue. The TSFL lets 28 primary dealers post AAA mortgage credit to borrow Treasuries.

Consumers, on the other hand, are staring down the barrel of resetting adjustable rate mortgages, falling home prices and a recession. Increasingly, borrowers are walking away from mortgages, and according to The Wall Street Journal, Goldman Sachs estimates as many as 30% of American mortgages could be upside down by year's end. But the Fed can't just come out and announce it's going to start buying up delinquent mortgages; chaos would ensue. Already, many are criticizing the Fed's actions. Mike O'Rourke at BTIG had this to say:

"The Fed has moved beyond the realm of moral hazard monetary policy to tee ball monetary policy, where nobody loses. Don't get us wrong, we will be the first to say that the banking and financial system must be protected. We don't want to see the world fall apart. However, there must be a level of accountability for what has transpired."

Latest Trouble Spot for Banks: Souring Home-Equity Loans
Here comes another headache for banks suffering from the mortgage downturn: Losses on home-equity loans are soaring, even at some lenders that avoided big blunders on subprime loans.

When times were good, banks raked in billions of dollars in profit from home-equity loans, which allow borrowers to tap the accumulated value in their property with either a loan for a specific amount or a line of credit. As long as home prices were rising, lenders had little to worry about. But falling home values are leaving banks with little or nothing to collect on many home-equity loans in case of default. Some stretched borrowers are keeping up with their mortgage and credit cards -- but not their home-equity loan.

The problems are already causing trouble for J.P. Morgan Chase & Co. and Wells Fargo & Co., and are expected to hit other large banks when first-quarter earnings results are released next month. The pain is likely to deepen through the rest of 2008, sapping capital levels and resulting in tighter lending standards as banks try to reduce their risk.
"These losses are well beyond what we would have modeled...and continue to get worse," said Charles Scharf, head of J.P. Morgan's retail business.

At a meeting with analysts and investors last month, Mr. Scharf spent more than 30 minutes dissecting the second-largest U.S. bank's $95 billion home-equity portfolio. It wasn't pretty. J.P. Morgan expects home-equity-related losses of about $450 million in the first quarter, up from $248 million in last year's fourth quarter. By the end of 2008, home-equity losses could double from current levels, he said.

Because J.P. Morgan largely escaped the brunt of the subprime crisis, its ominous tone on home-equity loans has fueled anxious number-crunching. David Hilder, a banking analyst at Bear Stearns, last week cut his 2008 and 2009 earnings estimates for National City Corp., SunTrust Banks Inc., Washington Mutual Inc. and Wells Fargo, citing rising home-equity losses. Each of those lenders has 12% to 19% of its total assets tied up in home-equity loans.

Fitch Ratings predicts that "banks will significantly ratchet up loan-loss provisions against home-equity loans in 2008." Projected losses from home-equity loans aren't anywhere close in size to the carnage caused by the declining value of mortgage-related securities. (Those losses now total more than $150 billion.) But the cascading delinquencies and charge-offs represent one more piece of the U.S. banking industry that is in big trouble after years of bumper-crop profits.

Fed's Redirection, Not Creation, of Liquidity
These short-term financing arrangements (TAF & TSLF) are an attempt by the Fed to redirect liquidity from ordinary channels (fed funds and the like) to the short-term funding of banks and dealers with acceptable collateral. Acceptable collateral varies, with differing haircuts depending on the collateral and the financing program. At this point, Agency MBS and AAA whole loans (not on review for downgrade — presumably that means no negative outlooks from any ratings agency) are encouraged.

What I find most interesting in all of this is how little true liquidity the FOMC has injected in this cycle. The monetary base is flat. What this looks like is an attempt to selectively reflate the economy — help the banks and dealers, but keep total liquidity close to fixed. And, in the face of this, total bank liabilities keep expanding at a 10%+ clip. It almost feels like any source of liquidity is good liquidity to the banks.

Of course, they get a lot of it from the FHLB, which has been the big unconstrained lender in this cycle. Fannie (FNM) and Freddie (FRE) may now be able to make larger loans, which loosens up housing finance a bit, but only the FHLB has the balance sheet to do so in this cycle, and they have done it. Call them the “shadow Fed.” But even their balance sheet is finite, and they are only implicitly backed by the U.S. Government, like Fannie and Freddie.

So where does this leave us? Muddling along. Even the redirection of liquidity will not get the banks and dealers too jazzed, because they are only short term measures, with uncertain long-term funding availability and cost. More attractive than the “free” market for now, but that’s about it.

Fed Liquidity Actions: 28 Days Later
When the TAF program was first announced, it was billed as a temporary facility. The announcement was in December, and some suggested it was intended to help banks meet end-of-year balance sheet needs. Four auctions were announced, two auctions of 20B in December, and two January auctions for an amounts that has not yet determined. An important question at the time was what would happen 28 days later, when loans made via two December auctions expired.

Would the amounts of the January auctions be the same as the December auctions, effectively rolling over the TAF loans (not necessarily to individual borrowers, but to the consolidated banking system)? Would the January loans be smaller, indicating a gradual phase-out consistent the temporary nature of the program? Or would the loans be expanded, suggesting an ongoing intervention of indeterminate scale? Since then, the size of the program has more than doubled, and the Fed has announced explicitly that it intends to continue the program "for as long as necessary to address elevated pressures in short-term funding markets".

In the past few days, the Fed has announced two new programs, and again, we are left to wonder what happens 28 days later. This weekend, I argued that since the Fed cannot retire loans made via TAF and its repo program without adding to those "elevated pressures", the loans should be considered an equity infusion, because they'll be repaid at the convenience of the borrower rather than on a schedule agreed with the lender. Does the same argument apply to the new Term Securities Lending Facility (TSLF)?

On face, it's harder to view TSLF as an equity infusion, since the Fed is giving no one any cash. (In fact, the Fed will withdraw some cash as interest.). Eyes unprotected by green shades will glaze over at descriptions of a kind of asset swap, where some obscure assets are "pledged" to the Fed while other boring securities are lent to firms.

But to firms holding illiquid securities that the Fed is accepting as collateral, the program is equivalent to a not-so-efficient cash infusion, because the Treasuries the Fed is lending are liquid and can be converted to cash easily in private markets. From a cash-strapped firm's perspective, borrowing a treasury, then borrowing cash against that Treasury in ordinary repo markets, is equivalent to borrowing cash directly from the Fed, except that there'll be an extra middleman to pay.

So, this new facility might well be a form of equity, if the Fed is willing to roll it over indefinitely and require payment only at the convenience of borrowers. We'll have to wait and see what happens, 28 days later.

Dollar Falls to Record Low on Concern Fed Package Won't Succeed
The dollar fell to an all-time low against the euro on concern that the Federal Reserve's plan to provide funds to banks won't be enough to break the gridlock in money-market lending and stem credit losses.

An index tracking the dollar against six major currencies fell close to a record low as traders bet the Fed will cut rates by as much as three quarters of a percentage point next week to avert a recession, while the European Central Bank keeps borrowing costs unchanged. The yen advanced against the dollar and the South African rand after a government report showed Japan's economy grew faster than forecast in the fourth quarter.

"It's difficult for the dollar to gain traction," said Paresh Upadhyaya, who helps manage $50 billion in currency assets at Putnam Investments in Boston. "The market is fixated on interest-rate differentials, which are clearly negative for the dollar; the trend is very much in favor of the euro."

The dollar fell to $1.5496 per euro, the weakest since the euro's 1999 debut, and traded at $1.5489 at 9:54 a.m. in New York, from $1.5338 yesterday. The previous historic low was set yesterday. It dropped to 102.36 yen from 103.42, within one yen of an eight-year low. The euro traded at 158.59 yen from 158.61.

The euro's gains were limited after Luxembourg Finance Minister Jean-Claude Juncker said he is "very vigilant" on the euro in current circumstances and that exchange rates should reflect fundamentals. He spoke to reporters in Brussels.

Going, going, gone: a rising auction of scary scenarios
The bigger the damage to the financial sector, the more credit-fuelled personal spending is going to dry up. So what might such overall losses mean for financial intermediaries? In Prof Roubini’s 12 steps to meltdown, he assumed that their losses on mortgages would be $300bn-$400bn, while losses on other assets (consumer debt, commercial real estate loans and so forth) would be another $600bn-$700bn, for a total of $1,000bn. On March 7, Goldman Sachs economists published an even higher estimate of mortgage-related losses, at $500bn, along with $656bn in other losses, for a total of $1,156bn. The mainstream has caught up. But Prof Roubini has moved on.

In reaching its conclusion, Goldman estimated a peak-to-trough house price fall of 25 per cent. In his comments on the FT’s forum, Prof Roubini suggests that, after price falls of 20 per cent from the peak, losses on mortgages could be as much as $1,000bn. With a 40 per cent fall, they could be $2,000bn. He adds another $700bn for other losses, to reach total financial sector losses of close to $3,000bn, or about 20 per cent of GDP.

So how does Prof Roubini reach these much higher figures? The difference between him and Goldman is not so much in assumptions about the house price fall: 25 per cent for Goldman Sachs and 20-40 per cent for Prof Roubini. Both also estimate that lenders would lose half of the loan value after repossession. But Goldman believes that just 20 per cent of households in negative equity would default, while Prof Roubini believes 50 per cent might do so.

For people with poor credit ratings and few assets, apart from their house, walking away does seem to make disturbingly good sense . Buyers with no equity had an option to walk. Now they are exercising it. This was demented finance. Yet, so long as the economy remains reasonably robust, highly indebted people with good career prospects would surely not wish to wreck their credit rating. Nevertheless, markets are pessimistic: the prices of even AAA tranches of securitised loans are collapsing.

Suppose, then, that Prof Roubini were right. Losses of $2,000bn-$3,000bn would decapitalise the financial system. The government would have to mount a rescue. The most plausible means of doing so would be via nationalisation of all losses. While the US government could afford to raise its debt by up to 20 per cent of GDP, in order to do this, that decision would have huge ramifications. We would have more than the biggest US financial crisis since the 1930s. It would be an epochal political event.

Money-Market Rate for Euros Rises After Fed's Action
The cost of borrowing in euros for three months rose for a seventh day, indicating an agreement by central banks to inject about $240 billion into the money markets to revive lending between banks is having little effect.

The euro interbank offered rate, or Euribor, increased 1 basis point to 4.61 percent today, the highest since Jan. 7 and up from 4.38 percent at the start of the month, the European Banking Federation said. The comparable dollar rate fell 2 basis points to 2.85 percent, the British Bankers' Association said.

Rising money-market rates signal a coordinated drive by central banks to encourage lending isn't working. Policy makers in the U.S., U.K., Canada, Switzerland and the euro region agreed yesterday on a second round of emergency-loan auctions to counter the cash shortage. The Federal Reserve said it will lend as much as $200 billion of Treasuries via a new lending tool and widen the collateral it accepts to mortgage-backed securities.

"We are not convinced that yesterday's move will solve all the multiple challenges facing credit markets and the financial system," Goldman Sachs Group Inc. analysts including Fiona Lake in London, wrote in a note today. "We suspect that the markets will not be completely swayed by just yesterday's moves."

"Money-market stresses seem to remain high," Laurence Mutkin, the London-based head of European fixed-income strategy at Morgan Stanley, wrote in a note to clients today. "Credit and counterparty concerns are not being removed by central bank actions."

The Fed May Run Low on Unconventional Ammo
Back in 2003, when the Federal Reserve cut interest rates to 1%, the world worried that the Fed was running out of ammunition and would soon have to turn to unconventional tools. Now, in 2008, it’s worth asking if the Fed could run out of unconventional ammunition. Tuesday’s offer to lend $200 billion of its Treasury holdings to primary dealers in return for mortgage-backed securities both guaranteed by the government-sponsored enterprises (Fannie Mae and Freddie Mac) and not (private-label MBS) means it will have eventually sold or pledged half of its Treasurys, limiting how many more of these tricks it can pull off.

Since August the Fed has announced a series of steps designed to target those pockets of the financial markets facing the most stress rather than rely solely on the blunt instrument of lower short-term interest rates. These steps have primarily involved taking onto its balance sheet something a bit risky — a loan to a bank or a securities dealer, collateralized with paper ranging from corporate loans to private-label mortgage backed securities (i.e. MBS not backed by the federally sponsored agencies Fannie Mae or Freddie Mac).

Left alone, these operations would result in an increase in cash supplied to the banks, boosting excess reserves and pushing down the federal-funds rate. Since the Fed does not want that to happen, it “sterilizes” the operation by getting rid of an equivalent amount of something else on its balance sheet. That something is usually Treasurys. Last December, it announced the creation of the term auction facility under which it auctions off loans to banks against a wide variety of collateral. To keep its balance sheet constant, it decided to let a roughly equivalent amount of its Treasurys mature. Since then, its Treasury portfolio has fallen from $779 billion to $713 billion.

Last Friday, it announced two additional steps: It would expand the size of the Term Auction Facility loans to a total of $100 billion from $60 billion (and the original $40 billion) and lend up to $100 billion to primary dealers in lengthened, 28-day repo operations. To sterilize those operations, Wrightson Associates estimates the Fed will have to shed $100 billion in Treasurys. Friday, it sold $10 billion of Treasury bills, its first outright sale since 1991. It will have to sell or redeem a lot more to keep its balance sheet from ballooning. One of the beauties of the securities lending facility is that it is self-sterilizing: The addition of MBS to its balance sheet is exactly offset by the loan of Treasurys.

From the point of view of normalizing market conditions, it makes sense to replace Treasurys with other stuff because the federal government is having no trouble borrowing right now. Quite the contrary: The flight to safety has driven Treasury yields to unnaturally low levels. In the securities-lending (or repo) market, someone with Treasurys to offer as collateral can borrow at a rock-bottom interest rate. But it does raise the prospect that with a few more similar-sized steps, the Fed will have run out of Treasurys to sell or pledge.

Another Plan to Destroy the Economy
Before you can get in another word, it keeps getting worse. Former Treasury Secretary Larry Summers recently stated, "We are facing the most serious financial stress that the U.S. has seen in at least a generation." It's safe to say the credit crisis has reached unprecedented levels. Before a financial crisis proliferates into an economic collapse, something has to be done. But what?

We've already seen several government bailout proposals thrown around -- none of them too convincing. Back in November, fellow Fool Seth Jayson described how Ben Bernanke's homeowner bailout plan was full of hot air. Last month, I made my own cries that the current stimulus package might stimulate a bigger mess.

But it was Harvard economist and former Reagan advisor Martin Feldstein's plan that really got me going. Last week in The Wall Street Journal, Feldstein proposed that the government lend troubled homeowners 20% of their outstanding mortgage balance to ease pain. The money, he suggested, would come from selling Treasury bills (because those grow on trees) and have a 15-year payoff period. Of course, all interest owed on the government loans would be tax-deductible.

The plan doesn't bail homeowners out -- it simply shifts debt from the private market to the government and its taxpayers. From step one, the plan calls for an attempt at paying off loans that (a) never should have been made in the first place, and (b) were issued using real estate values straight out of Neverland.

That's most of the problem. Regardless of who holds these mortgages -- Bank of America, Goldman Sachs, Countrywide, a CDO, or Uncle Sam -- you're left with one nagging point: The real estate backing these loans is worth much, much, less than it was before. Sure, as Feldstein points out, government loans could lower interest payments, but that, as you'll remember, is how we got into this mess in the first place.

Blame-avoiding bank chiefs need urgent instructions
One of the interesting aspects of the crisis is how some mid-level and lower-level people in the financial institutions are far more coherent and direct than their leaders. It's as if they've already given up waiting for upper management to give a sensible View from the Top.

I could pick out a number of papers and documents from the various banks and dealers, but a pretty good example was published at the end of last month under the auspices of the US Monetary Policy Forum. Called "Leveraged Losses: Lessons from the Mortgage Market Meltdown", it was co-authored by a group including David Greenlaw of Morgan Stanley, Jan Hatzius of Goldman Sachs, Anil Kashyup of the University of Chicago, and Hyun Song Shin of Princeton.

Since the estimates were drawn up more than 15 minutes ago, they're already out of date, but they're not a bad place to start. The group estimates that the losses on mortgage paper will ultimately total about $400bn, with about half of that being incurred by "leveraged US institutions". They go on to estimate that new equity raised so far from investors such as the sovereign wealth funds is of the order of $100bn. A series of calculations based on conventional banking economics leads them to estimate that "under this baseline scenario, the total contraction of balance sheets for the financial sector is $1,9800bn".

This is before estimating any longer term increases in the losses incurred from lending to the corporate sector, or from other consumer lending such as auto loans or credit cards. Furthermore, it is before taking into account the cessation of much securitisation activity, and the consequent requirement for a shift to what the central bank people have described to me as "the new on-balance-sheet world".

It does not, therefore, take much of a leap in imagination to suggest that the US banks need to raise well over $100bn in new Tier One capital, and perhaps more than $200bn. They also need to do it quickly, so as to avoid that spiralling destruction of capital.

A Bailout. For Everyone.
Last week, it was a $200 billion cash-for-bond swap for the banks.This week, it was a $200 billion bond-for-bond swap for the big investment houses. If they keep this up, pretty soon you'll be able to walk into any Federal Reserve bank and hock that diamond brooch you inherited from Aunt Mildred.

Forget all that nonsense about the Bernanke Fed being too timid or behind the curve. In the face of what is turning into the most serious financial market crisis since the Great Depression, the Fed has been more aggressive and more creative in using its limitless balance sheet -- in effect, its ability to print money -- than at any time in history.

We can argue till the cows come home about whether this is a bailout for Wall Street. It is -- but only to the extent that it is also a bailout for all of us, meant to prevent a financial and economic meltdown that drags everyone down with it. In broad strokes, we're going through a massive "de-leveraging" of the economy, wringing out trillions of dollars of debt that had artificially driven up the price of real estate and financial assets, and, more generally, allowed Americans to live beyond their means.

The Fed's goal has not been to impede that process, simply to make sure that it proceeds in an orderly fashion. But even that has required central bank intervention that is unprecedented in scale and scope. And despite yesterday's huge rally in the stock market, Fed officials warn that this de-leveraging is nowhere near finished. The real action is on the credit markets, where, for the third time since last summer, the price of bonds and other complex securities fell and interest rates rose on everything but U.S. Treasury bonds.

Over the previous month, there had been fresh signs that the economy was sinking into recession: a slowing of the growth in corporate sales and profits, a decline in payroll employment and further deterioration in a housing market already in deep distress. Deeper cracks began to appear in the commercial real estate market. And out of the blue, municipalities and nonprofit institutions found that they could no longer roll over their short-term debt on the auction-rate market.

But the real problem began in late February, as several of Wall Street's biggest investment banks prepared to close their books for the quarter and realized they were looking not only at big declines in profit from issuance of new stocks and bonds and fees from mergers and acquisitions, but also another round of write-offs in the value of their holdings. In response, the banks began to hunker down, instructing their trading desks to raise margin requirements for hedge funds and other customers, requiring them, in effect, to post more collateral on their heavy borrowings

In the U.S., the economy and banking are pushing each other downhill
Should we be more worried about the new crisis coming to a head in the financial system or that the United States is self-evidently in recession? Sadly, we don't have to choose. Banks, starved of capital, are calling in their debts, turning clients, notably hedge funds, into forced sellers, as large swathes of the financial markets are caught in a vicious cycle of margin calls, fire sales and further price falls. The U.S. Federal Reserve has tried to break the cycle, again, by offering an additional $200 billion to banks, on easier terms and for longer, but confidence in its ability to succeed has fallen.

Meanwhile, in the real world, consumers and company managers have gotten the message and are firing each other as, respectively, providers of goods and services and wage-earning employees. U.S. payroll data last week were grim indeed and the retail and consumption figures were little more encouraging. "The Fed's efforts to isolate the effects of the financial crunch from the real economy have clearly failed," said Lena Komileva, an economist at the brokerage Tullett Prebon in London. "We are now seeing the materialization of this new relationship between the financial and real economy where both are now in crisis."

In essence, the negative feedback loop that the Fed fears, with banking and the economy pushing one another downhill, is taking hold. Payrolls in February fell by 63,000, falling for the second consecutive month and by the most in nearly five years. At the same time, banks have become even more unwilling to take risks with their capital. They are asking borrowers to post more collateral against loans, even when those loans are being used to finance investment in supposedly safe instruments like Treasury securities or mortgage bonds backed by Fannie Mae or Freddie Mac.

This is leading some to sell, driving prices down further, a process that risks blowups of leveraged borrowers. It will also certainly mean higher borrowing rates for already shell-shocked homeowners. While it is impossible to know how deep the recession will be, it is reasonable to expect that investors, having seen the strength of the downward momentum, will bet on further erosion in house values, in mortgage and credit card debt, and in the value of the banks themselves.

Foreclosure crisis has ripple effect
The mortgage foreclosure crisis has caused a drop in cities' revenues, a spike in crime, more homelessness and an increase in vacant properties, a survey of elected local officials out today shows. About two-thirds of 211 officials surveyed by the National League of Cities reported an increase in foreclosures in their cities in the past year, according to the online and e-mail questionnaire. A third of them reported a drop in revenues and an increase in abandoned and vacant properties and urban blight.

"There's a reduction in revenues at the same time that more services are needed," says Cynthia McCollum, president of the National League of Cities and councilwoman in Madison, Ala., a suburb of Huntsville. "Because of foreclosures, people are stealing, crime is on the rise and we don't have more money for cops on the street." More than a fifth of city officials responding said homelessness and the need for temporary and emergency housing increased in the past year.

The ills of foreclosures are dominating the agenda of the league's meeting with congressional lawmakers in Washington, D.C., this week to secure federal funding for local initiatives. "The American dream for individuals has now become the nightmare for cities," says James Mitchell, a Charlotte councilman and head of the group's National Black Caucus of Local Elected Officials. Foreclosed homes are the target of vandalism, he says, and there's been an increase in police calls.

In Peachtree Hills, one of the many neighborhoods of starter homes that sprouted around Charlotte this decade, 115 of the 123 homes are in foreclosure, Mitchell says. "The 12 residents left there can't sell their homes and now their property values have decreased," Mitchell says. "It's starting to be a symbol of what we don't want to happen to Charlotte."

Fed Seeks to Limit Slump by Taking Mortgage Debt
Federal Reserve Chairman Ben S. Bernanke's latest attempt to alleviate seized-up credit markets marks his most direct effort yet to repair the mortgage meltdown that poses the biggest threat to the economy. The Fed pledged yesterday to lend, in return for mortgage debt, $200 billion of Treasuries to the securities firms that trade directly with the central bank. Officials told reporters later that the program may escalate from there as the central bank seeks to break the logjam in the home-loan market.

The step goes beyond past initiatives because the Fed can now inject liquidity without flooding the banking system with cash. Bernanke and his colleagues are trying to halt a cycle in which the losses on mortgage investments cause banks to cut their lending, sending the economy into a deeper contraction. "It is a strong attempt to stabilize a crisis," Henry Kaufman, president of Henry Kaufman & Co. in New York and the former chief economist at Salomon Brothers Inc., said in a Bloomberg Radio interview. "It is a further recognition that this credit crisis is deeper and wider, and has been exceedingly opaque, in contrast to earlier credit crises."

Investors' unwillingness to hold mortgage-backed bonds amid record home foreclosures sent premiums on even Fannie Mae and Freddie Mac guaranteed assets to the highest in 22 years this month. The two government-chartered companies are the biggest sources of U.S. housing finance.

The Fed decided to act when the crisis spread beyond the securities backed by subprime loans, officials said on condition of anonymity. Policy makers gathered by conference call the evening of March 10 and voted to set up the new lending tool, spokeswoman Michelle Smith said in Washington.

"They see residential mortgage securities markets as the linchpin," said Stephen Stanley, chief economist at RBS Greenwich Capital Markets Inc., who used to work at the Richmond Fed bank. "If they can get that normalized, it might resolve some of the other problems."

Fed Rally on Garbage Paper!
As we have noted recently, markets have been moderately oversold, with negative sentiment high, and disbelief in the economic recession still surprisingly widespread (Some are even claiming that the credit crunch is a myth). The Fed action came at a time when the markets were ripe for an oversold bounce.

Before we continue, let'sd understand what the Fed actually did: Rather than merely expanding the existing Term Auction Facility (TAF), they went several steps further. They created a new credit facility, the Term Securities Lending Facility (TSLF). Then, they empowered the TSLF to accept a broad range of private collateral -- "AAA" private mortgages in addition to those that are agency paper. Note the quality of the paper the Fed is accepting, via a recent Bloomberg report:
"Even after downgrading almost 10,000 subprime-mortgage bonds, Standard & Poor's and Moody's Investors Service haven't cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments. None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.

If I read the Fed release correctly, this is the junky paper the Fed will be accepting as collateral. Why did they do this?
-New pressures on ALL agency spreads;
-Rising mortgage rates despite FOMC rate cuts;
-Ongoing limited credit availablility;
-Dramatic widening spreads between mortgage-backed paper and US Treasuries

The good news is this will help brokers and banks; the bad news is  it will do nothing to help the Housing market, or stop the decline in House prices. Nor will it help resolve the inverted pyramid of derivatives that sits atop Housing. And, one has to believe it will only add to inflationary pressures. No recession at any cost seems to be the Feds' philosophy in light of the latest massive cash infusion to Banks...

Fannie, Freddie Shares Suffer Hit As Mortgage-Default Fears Mount
Shares of Fannie Mae and Freddie Mac plunged as fears grew that home-mortgage defaults eventually will force the two government-sponsored companies to raise more capital.

Large sales of common stock by the companies would dilute the value of existing shares. In 4 p.m. composite trading on the New York Stock Exchange, Fannie shares fell 13%, or $2.96, to $19.81 apiece, while Freddie shares fell 12%, or $2.26, to $17.39. Anxieties over the companies' prospects have been rising for months and were fueled yesterday by a bearish report from a Credit Suisse analyst and a weekend article in Barron's magazine entitled, "Is Fannie Mae Toast?"

The Bush administration and Congress are counting on Fannie and Freddie to play a big role in propping up the housing and mortgage markets. But they recorded losses totaling about $9 billion in last year's second half, and analysts expect continued losses this year as house prices sink and defaults pile up. Those losses are constraining the companies' ability to buy or guarantee mortgages, even as other investors dump mortgage-backed securities. As a result, mortgage interest rates for consumers have risen in recent weeks despite the Federal Reserve's cuts in short-term interest rates.

Treasury Secretary Henry Paulson last week argued that financial institutions generally should seek to raise capital. Both Fannie and Freddie have said recently they don't have any immediate need for more capital, a stance backed by their regulator, the Office of Federal Housing Enterprise Oversight. But the two companies "would be best off by raising capital," said Frederick Cannon, chief equity strategist at Keefe, Bruyette & Woods. That would allow them to buy mortgage securities whose yields have soared to attractive levels, Mr. Cannon said.

Anatomy of a recession
As early as a few weeks ago, politicians and economists stood on soapboxes assuring us the economic malaise was transitory. "I don't think we're headed to a recession," offered President Bush, echoing recent sentiments by Ben Bernanke, the chairman of our Federal Reserve.

The conventional definition of recession requires back-to-back quarters of negative GDP growth and through that lens they might be right. We should remember, however, that we never entered a textbook recession at the turn of the century despite the S&P suffering an organic two-for-one split. We've already entered a recession, one that's been masked by the lower dollar and skewed by the spending habits of a slimming margin of society. To understand where we are and prepare us for what's to come, it might be helpful to walk through how we got here.

There is a marked difference between economic growth and debt-induced demand. Instead of letting the market take its medicine and enter recession in 2001, the powers that be injected fiscal and monetary drugs to dull the pain and induce stock gains.

The Federal Reserve understands the market is the world's largest thermometer and the driver of a finance-based economy. On the back of the tech bubble, in the aftermath of 9/11, following the invasion of Iraq and into the election, they administered stimulants with hopes that a legitimate expansion would take root.

Is this a conspiracy theory from tin-foil types sitting on a grassy knoll? The only difference between intervention and manipulation is communication, as we're apt to say, a fine line that's been all but erased in recent years. Hank Paulson recently highlighted The Working Group as a policy tool, an admission that effectively exposed the wizard behind the curtain. While government policy set the stage for the underlying imbalances, our immediate-gratification mindset exacerbated them.
Consumers bought goods with no money down and financed those obligations at zero percent.

Many used homes as collateral and flipped into adjustable-rate mortgages at the urging of Alan Greenspan. Total debt in this country rose to more than 400% of GDP as societal spending habits lost all semblance of consequence.
As Americans raced to keep up with the Dow Joneses, seeds of discontent percolated under the seemingly calm financial surface. All the while, the cumulative imbalances grew as society chased the bigger, better thing.

Buyout Industry Staggers Under Weight of Debt
With their big paydays and bigger egos, private equity moguls came to symbolize an era of hyper-wealth on Wall Street. Now their fortunes are plummeting.

Celebrated buyout firms like the Blackstone Group and Kohlberg Kravis Roberts & Company, hailed only a year ago for their deal-making prowess, are seeing their profits collapse as the credit crisis spreads through the financial markets.

Investors fear that some of the companies that these firms bought on credit could, like millions of American homeowners, begin to buckle under their heavy debts now that a recession seems almost certain. The buyout lords themselves suddenly confront gaping multibillion-dollar losses on their investments.

On a day in which the stock market tumbled to its lowest point in two years and rumors flew that a major Wall Street firm might be in trouble, Blackstone said Monday that its profit had plunged. The firm said earnings tumbled 89 percent in the final three months of 2007 and warned that the deep freeze in the credit markets — and, by extension, in the private equity industry — was unlikely to thaw soon.

“They see the handwriting on the wall,” said Martin S. Fridson, a leading expert on junk bonds, said of buyout firms. “They’re staring into the jaws of hell.”

Ambac Aided By Spitzer
According to sources within the industry, Governor of New York, Eliot Spitzer, has played an instrumental part - behind the scenes of course - in gaining the bail-out deal that kept Ambac it’s AAA credit rating. Apparently Spitzer continuously called senior bankers in order to pressure them into aiding the bond insurer during the last six weeks.

Spitzer is a former attorney-general and has often had a volatile relationship with Wall Street in the past due to his denouncement of their research methods. Some of the largest bonds insured by Ambac are in New York state, and it was this that urged Spitzer to aid the company in keeping their rating as it props up billions in bonds. According to sources, Spitzer was calling Eric Dinallo, insurance superintendent for New York, and departmental adviser Perella Weinberg on a daily basis. Ambac only raised the required $1.5bn equity last week and over 30% of that is still owned by at least seven banks.

Calls to senior bankers from Citigroup, UBS, Bank of America, and Credit Suisse were made by Spitzer, though his spokesperson has stated that this is because he was just trying to avert a crisis for Ambac and that due to his time as attorney-general he knew many of those involved so naturally enough made many personal phone calls.

This is the largest of these bail-out attempts since the New York Federal Reserve pressed banks to rescue the well known hedge fund, LTCM. A controversial meeting was appointed by Spitzer on January 23, to which many of those attended who faced significant writedowns and exposures to hedges if Ambac and MBIA lost their AAA ratings.

Dinallo has stated that Spitzer’s actions merely spoke of the need to cement relationships between the banks, ratings agencies, and Ambac. All this has narrowly avoided a loss in AAA credit ratings from agencies like Moody’s Investors Service and Standard & Poor’s, as the prospects for future ratings for the company do not look good. This is indicative of the tumultuous housing market in the U.S.

House's Frank Says Muni-Bond Ratings Are 'Ridiculous'
U.S. Representative Barney Frank said it is "ridiculous" that bond-rating companies apply tougher standards to local government debt as he prepares to hold a hearing on the soaring interest costs of municipalities.

California Treasurer Bill Lockyer and other state officials are calling for Standard & Poor's, Moody's Investors Service, and Fitch Ratings to change a system they say costs taxpayers by exaggerating the risk that states and cities will default on their debts. Every state except Louisiana would be AAA if measured by the scale used for corporate borrowers, according to research by Moody's Investors Service.

"This notion of having a separate standard for the municipals because they would do too well on the other standard is ridiculous," Frank, the Democrat who chairs the House Financial Services Committee, told reporters in Washington yesterday.

Frank's committee today opens a hearing into how states, local governments and other tax-exempt borrowers, which have $2.6 trillion of debt outstanding, are being hurt by the crisis in confidence in U.S. financial markets. The interest costs on auction-rate securities, a type of debt used by municipalities, has almost doubled since January and investors have also demanded higher yields on tax-exempt bonds backed by insurers that are struggling to maintain their own credit ratings.

Frank said he plans to pressure bond insurers and rating companies to ease the problems in the municipal bond market, without specifying how. "I am going to say to the rating agencies and to the insurers: they have about a month to fix this," he said. "We're going to tell them they have to straighten it out."

Drake considers liquidating all hedge funds
Drake Management, which manages nearly $5 billion in hedge fund assets, told investors on Wednesday that it is considering liquidating all three of its hedge funds, citing "challenging market conditions."

The New York-based fixed income trader, which was founded in 2001 by PIMCO and BlackRock executives, said it has been hammered by volatile credit markets, pushing down returns in its flagship, $3 billion Global Opportunities Fund and its smaller Absolute Return Fund. Global Opportunities was down 24.55 percent in 2007, while Absolute Return was down 14.36 percent, according to investors who have seen the results. Those two and another fund, Low Volatility, are overseen by managers Anthony Faillace and Steve Luttrell.

The New York-based firm said in a letter to investors that Global Opportunities has had "sharply negative performance" in the face of "extreme volatility of certain capital markets over the last six months."
Drake said it is polling investors for input on whether it should continue the fund, start new funds, or wind down Global Opportunities. It said it is considering similar options for the other funds. Drake manages $10 billion overall, about half in hedge funds.

"Given the challenging market conditions, Drake is also considering substantially similar options for its other hedge funds," said Drake said in the letter obtained by Reuters. Drake said that despite its travails, it isn't facing margin calls from lenders -- a factor that has sent other funds into liquidation in recent weeks, such as Peloton Partners in London. Drake has cut back on leverage in recent months.

Citi commits $1 bln to prop up two muni bond funds
Blue River reportedly liquidating as recent muni bond disruptions take toll

Citigroup Inc. is injecting $1 billion into two internal municipal bond hedge funds that were hit hard by recent disruptions in fixed-income markets, a spokesman for the giant bank said on Wednesday. Citigroup launched ASTA Finance, LLC and MAT Finance, LLC in 2002 to trade muni bonds. ASTA made leveraged investments in fixed-rate munis and tried to hedge the interest-rate risk of those positions. MAT focused on arbitrage, sniffing out anomalies between tax-free munis and similar taxable bonds.

The two funds had roughly $2 billion in capital and through leverage, or borrowed money, had about $15 billion in assets.
The normally placid muni bond market has been thrown into turmoil in recent weeks as the mortgage crisis has spread into a full blown credit crunch. At the end of February, some muni arbitrage hedge funds were forced to sell assets to meet margin calls, leading to huge losses that month.

Blue River Asset Management, 1861 Capital Management and Duration Capital were among those hardest hit. Blue River's main fund, which had roughly $1 billion in assets, is liquidating, Reuters reported this week, citing unidentified sources familiar with the situation. The firm plans to open a new domestic fund, the news service added.

ING New Zealand Suspends Withdrawals From Two Funds
ING (NZ) Ltd. suspended withdrawals from two funds that own collateralized debt obligations, saying they are being affected by the global "credit crunch." Withdrawals from the ING Diversified Yield Fund and the ING Regular Income Fund were halted to protect investors, Marc Lieberman, chief executive officer of ING (NZ) in Auckland, said in an e-mailed statement. About NZ$520 million ($417 million) was invested in the two funds at the end of February.

Since August, rising defaults on U.S. subprime mortgages triggered a global sell-off of CDOs, which are fixed-income securities backed by the loans. The value of the Regular Income Fund fell 25 percent in the year ended Feb. 29 while the Diversified Yield Fund dropped 22 percent, according to the company's Web site. Prices are falling amid nervousness in global investment markets and as more investors attempt to withdraw their money, Lieberman said.

"The decision to suspend withdrawals is a prudent action that seeks to protect the interests of investors," he said. "Continuing to allow withdrawals to satisfy a minority of investors could significantly reduce the overall quality and value of the portfolio to the detriment of all."

Two Rubicon funds in race to pay off short-term loans
Two of Allco Finance Group's troubled Rubicon real estate operations are attempting to pay down their big portfolio of short-term loans owed to Credit Suisse. The move follows consecutive margin calls by the investment bank demanding immediate repayment of almost $35 million.

Both Rubicon America Trust and its sister European fund said yesterday that they would be able to scrape together enough cash from available funds and the payment of an outstanding loan to Rubicon Europe Trust to relieve the financial pressure applied by Credit Suisse.

With financiers to every part of the Allco empire scrambling to ensure they will be able to recover the money owed to them, the latest problems to affect the two Rubicon funds occurred in swift succession, with Credit Suisse marking down the value of their individual loan portfolios. As part of the terms, the funds have been obliged to meet part of the differences in the lower valuations: the American trust was told on Saturday to repay $US17.2 million ($18.5 million) by yesterday - since extended to tomorrow - and the European fund given until next Tuesday to find €9.9 million ($16.4 million).

Rubicon Europe initially told the Australian Stock Exchange yesterday that it was not in a position to meet the cash call in full. But it later said a loan repayment of €34 million due to take place on March 20 would cover its debt to Credit Suisse - if the bank agreed to wait.
As for the American trust, it reassured investors in a separate statement that it had now had enough money available to meet its margin call.

Like the debt-ridden Allco, the Rubicon funds are engaged in a battle against time to sell offices and commercial premises across the US, Europe and Japan to reduce their huge liabilities.

GO Capital Halts Redemptions From Global Hedge Fund
GO Capital Asset Management BV blocked clients from withdrawing cash from its Global Opportunities Fund, at least the seventh hedge fund in the past month forced to take steps to protect itself from falling markets. Frans van Schaik, the former head of equity research at ABN Amro Holding NV who founded the Amsterdam-based fund in 2000, wrote to investors that the fund is not leveraged and not facing margin calls. The fund, which bets both on rising and falling prices, has assets of about 570 million euros ($881 million).

"A temporary suspension of redemptions is the best defensive measure to protect the interests of the participants," van Schaik and other members of GO Capital's management said in a letter posted on their Web site and dated March 11. "Current market circumstances do not allow the fund to sell investments at a reasonable price."

At least six hedge funds totaling more than $5.4 billion have been forced to liquidate or sell holdings since Feb. 15 as contagion from the U.S. subprime slump spreads for a seventh month. Others include Peloton Partners LLP's $1.8 billion ABS Fund, Tequesta Capital Advisor's mortgage fund and Focus Capital Investors LLC, which invested in midsize Swiss companies. GO focused mostly on listed European equities, although it was not restricted in investments it could make, the Web site says. The fund planned to make bets on between 10 and 30 stocks and looked for "situations of overreaction or stress," according to the Web site.

The fund, which targeted returns of 15 percent a year, is down 7.7 percent through the end of February, according to net asset value figures on its Web site. It gained 2.1 percent last month, reversing a 9.5 percent drop in January. The fund rose 3.3 percent in 2007, 22.4 percent in 2006 and 69 percent in 2005.

High Finance Backfires on Alabama County
In 2002, a banker named Charles E. LeCroy arrived here with a novel pitch to ease taxpayers’ burden. Some Wall Street wizardry, he said, could lighten their load. Six years on, officials here are still struggling to untangle the financial web that Mr. LeCroy and his fellow bankers spun. Jefferson County is teetering on the brink of bankruptcy after a series of exotic bond deals that the bankers concocted went wrong, and the interest on its debts, rather than shrinking as the bankers had promised, has ballooned like a bad subprime mortgage.

Officials from Birmingham, the county seat, are trying to persuade Wall Street creditors to let them soften the terms of the deals. If they fail, the county could sink into in one of the biggest public bankruptcies in American history. The running credit crisis and looming recession are squeezing communities across the country. But perhaps nothing else comes close to the financial fiasco unfolding here.

During the last few years, Jefferson County entered into a series of complex transactions, called swaps, worth a staggering $5.4 billion. The accusations and recriminations are flying. Talk of Wall Street tricks — and local corruption — has captivated residents and left many wondering how the county will pay its bills. “There are 101 messes up there, and they are not all cleaned up yet,” said Jim White, the president of the Birmingham law firm of Porter White, which is advising the county on its finances.

At the heart of this story are Mr. LeCroy, who arranged many of the transactions; a Montgomery investment banker, William Blount, whose firm, Blount Parrish & Company, earned larger fees than any other adviser on the transactions; and Larry P. Langford, the local official who signed off on the deals. As a managing director at JPMorgan Chase, Mr. LeCroy persuaded the county to convert its debt from fixed interest rates to adjustable rates. He also recommended that the county use interest-rate swaps that he said would protect it if interest rates rose.

Mr. LeCroy, however, is no longer in the bond business. He landed in prison for three months in 2005 in connection with a municipal corruption case in Philadelphia. He has left JPMorgan Chase and declined to comment for this article. Mr. Langford, now the mayor of Birmingham, previously oversaw the county’s finances. He says he had no idea what Mr. LeCroy and the many other bankers on the deals were doing, and he asked for Mr. Blount’s help in vetting their proposals.

“I needed somebody to be able to tell me what all that stuff was,” Mr. Langford said in a deposition in June. “And even when they told me, I still don’t understand 99 percent of it.” Mr. Langford, though, faces legal troubles of his own. The Securities and Exchange Commission is investigating whether he steered bond underwriting business to Mr. Blount’s company in return for payments, a claim he has denied.

Mr. Langford has a history of financial problems, including an ill-fated plan to build a local amusement park called VisionLand, and a self-professed propensity to shop. “I like clothes,” Mr. Langford said in his deposition.

Merrill Lynch: Recession to Be Worst Since 1970s
Merrill Lynch economist David Rosenberg, one of the most bearish Wall Street economists, says to look past the 1990-91 recession as a guide to the current downturn. The key difference: the depth of home-price declines. Mr. Rosenberg says in a note to clients that the current downturn is hitting more broadly than the credit crunch and real estate meltdown in the 1990-91 recession, which lasted eight months (as did the mild 2001 contraction).

Home prices today are falling in 85% of the country vs. 40% during that period, he notes. When prices hit bottom in 1992, the inventory of new and existing homes for sale was at 7 months of supply. Now it’s at 10 months’ supply “with no improvement in sight,” says Mr. Rosenberg, who was among the first economists to forecast a 2008 recession. He sees average prices nationwide dropping 20% to 30% more, on top of the 11% decline since the 2006 peak.

The mid-1970s recession “not only saw a sharp and sustained rise in food and energy prices, as is the case today, but also saw a very similar consumer balance sheet squeeze from a simultaneous deflation in residential real estate and equity assets, which never happened in the 2001 recession, the 1990-91 recession or the recessions of the early 1980s for that matter,” he writes. “The last time we had more than one quarter of outright contraction in the value of both asset classes on the household balance sheet was in the 1973-75 recession.”

401(k)s tapped to save homes
Struggling to save their homes from foreclosure, more Americans are raiding their 401(k) retirement accounts to pay their bills — and getting slammed with taxes and penalties in the process, according to retirement plan administrators. Rather than borrow money from their 401(k) accounts, which would have to be paid back, a growing number of beleaguered families have been cashing out, plan administrators say.

This is happening even as borrowing from 401(k) accounts remains fairly flat. Fewer still are borrowing from 401(k) plans to buy homes. By contrast, new figures from plan administrators show the number of 401(k) "hardship withdrawals" is up in early 2008 compared with the same period last year. The main reason? The need to stave off foreclosure or eviction.

Consider Tamara Campbell, who raided her 401(k) after her husband was laid off from his job as an occupational technician, and they fell behind on their mortgage for several months. "If I hadn't done that, we would have been foreclosed on last year," says Campbell, who lives in a Denver suburb. Such hardship withdrawals began rising last year and, by January this year, had exceeded January 2007 levels.

During the first month of the year, as the economic slowdown tightened pressure on mortgage holders, hardship withdrawals rose 23% at plans that Merrill Lynch (MER) administers, compared with the same period in 2007, says Kevin Crain, managing director of the Merrill Lynch Retirement Group. The 401(k) withdrawals are rising mainly because people such as Campbell and her husband want to save their homes. Merrill Lynch found that the primary reason for the rise in hardship withdrawals was to prevent foreclosure or eviction, based on its sampling of applications filed in January.

Likewise, in the first month of the year, compared with January 2007, Great-West Retirement Services saw a 20% increase in hardship withdrawals to save a home. And Principal Financial (PFG) reports that in January it received 245 calls from participants who inquired about 401(k) withdrawals to prevent a foreclosure or eviction, up dramatically from 45 similar calls it received in January 2007.

Investors act like drunken hogs
Investment managers, spooked by falling stock markets, are seeking alternative investments. Unfortunately, they are like drunken hogs: as they flee one mess, they create another. The comparison comes from an old tale of farm life. Decades ago, a farmer bought spoiled batches of beer from a local brewery to feed his hogs. It is a good source of calories. When giving hogs beer, however, one must be judicious.

One Sunday, the farmer and his wife went visiting. Their adolescent sons stayed home to play ball with neighborhood boys and do chores, including feeding the hogs. Their friends were amazed by the hogs' zest for beer. "Give them some more," they demanded when the first barrel was gone. The hogs slurped down barrel after barrel, until it was all gone.

Some hogs settled in the shade for a good snooze. But others, of roughly the same maturity level as frat boys, had excess energy to expend. Fences posed no obstacle. They rushed from garden to granary to flowerbeds. What Attila did to Rome was mild compared to what these hogs did to that farmstead. Like the hogs, some Wall Streeters happily kept their noses in the stock market trough as long as the boys at the Fed poured in liquidity, pushing the market higher and higher. But when the flow tapered off, they rushed off for better alternatives. Yes, some sought tranquility in the soft, clean straw of T-bills or safe money market instruments. This has helped push down short-term interest rates.

But others rampaged out into commodity markets. Commodities are hot. Prices of grains, fuels and metals have all risen dramatically over the past few years. Many bullish investors who bought futures contracts successfully sold out later at higher prices. Commodities have beaten the performance of many other investments. And so the herd is pushing into this profitable alternative to corporate stocks or to new, sophisticated and suddenly risky derivatives like collateralized mortgages.

Standoff in Japan Over Central Bank Nominee
A political showdown is blocking Japan from selecting the next leader of its central bank, increasing the chances that the post could sit vacant at a time of growing financial turmoil. The government of Prime Minister Yasuo Fukuda is at odds with the largest opposition party over the choice of the next governor of the central bank, the Bank of Japan. A successor is supposed to be named before March 19, when the current governor, Toshihiko Fukui, is scheduled to step down.

Finding a successor in time now looks increasingly unlikely, after the opposition-controlled upper house of Parliament voted on Wednesday to reject the government’s nominee, Toshiro Muto, currently a deputy governor at the bank. The new governor must be approved by both houses of Parliament.

Later the same day, members of Mr. Fukuda’s ruling Liberal Democratic Party vowed not to give up, suggesting the government may renominate Mr. Muto and try again. The government’s top spokesman, Nobutaka Machimura, the chief cabinet secretary, criticized the upper house vote as “incomprehensible.”

Economists and political analysts said the stalemate could drag on, with neither side willing to give in for fear of losing face. Economists also warned a vacancy at the bank could be a major embarrassment for Japan, creating a leadership vacuum at a time when central banks around the world are struggling to calm jittery markets amid a global economic slowdown. “The selection has been turned into a game of chicken,” said Hideo Kumano, chief economist at Dai-Ichi Life Research Institute. “Until one side flinches, Japan’s ability to make economic policy is greatly hampered.”

Darling Raises Borrowing, Taxes as U.K. Economy Slows
Chancellor of the Exchequer Alistair Darling said the U.K. government will raise taxes and borrow an additional 20 billion pounds ($40 billion) in the next four fiscal years as higher credit costs slow economic growth.

The Treasury estimates the deficit will total 140 billion pounds in the years through March 2012, wider than the 120 billion pound gap estimated in October. Tax measures will raise 2.5 billion pounds over the next three years.

Bonds fell, pushing up interest rates on government debt after the Treasury said it planned sales of a record 80 billion pounds of gilts. Darling said economic growth would slow after a surge in borrowing costs depressed house prices and put the economy on track for its worst performance since the end of the last recession in 1992.

"Turbulence in global financial markets, which started in the American mortgage market, has affected all economies from the United States to Asia, as well as Europe," Darling said in his annual budget statement to Parliament in London today.

Societe Generale Says Another Employee Held by Police
Societe Generale SA, the French bank stung by a record trading loss of 4.9 billion euros ($7.6 billion), said a second employee has been taken into police custody as part of the investigation into unauthorized trades. Police also searched the La Defense headquarters, just outside Paris, of France's second-biggest bank today and took some documents, Societe Generale spokeswoman Laura Schalk said in an interview.

The latest development widens a probe that began after the bank said in January that 31-year-old trader Jerome Kerviel amassed 50 billion euros in unauthorized trades backed by fake hedges and false documents. Unwinding his bets resulted in the biggest trading loss in banking history and forced Societe Generale to replenish depleted capital.

"A broker at a subsidiary of Societe Generale is now being questioned by police," Isabelle Montagne, a spokeswoman for Paris prosecutors, said today in a telephone interview. She declined to name the broker or the subsidiary. She said the broker was taken into custody mid-morning and would be held for 24 hours. The detention could be extended to up to 48 hours.

Kerviel, who admitted to exceeding his trading limits and faking documents to show his bets were covered by hedges, has been interrogated six times since he was taken into custody on Feb. 8. He has been charged with hacking into the bank's computers, falsifying documents and breach of trust. The latest development comes just two days before a hearing at the Paris appeals court to consider his release.

China's oil reserve build-up adds to global demand
China's plans to build its strategic petroleum reserves to at least 100 million barrels by 2010 could add more pressure to crude prices which have already been at record highs.

The world's second-largest oil consumer already has built two underground storage reserves in east China and will put into use two more storage bases soon, a senior Chinese official said over the weekend, according to China's official Xinhua news agency. "Although China is not the only source of rising oil prices, it has consumed the largest share of the global increase in oil demand in the last seven years," said Donald Straszheim, chairman of Straszheim Global Advisors and an expert on Asian economies. "Building reserves will of course add more pressure on global oil prices."

China's goal is to build strategic oil reserves equivalent to 30 days of imported oil by 2010, says China's top economic planning administration. That's about 100 million barrels based on China's current import level and about 120 million in 2010 based on estimated growth rates.

China's move followed similar steps in the United States, the world's top oil consumer. By 2010, China's reserve amount will still be only about one seventh of the U.S. level, but China is likely to increase its reserves at a faster pace, thus adds more impact on world's oil demand, analysts said.


Anonymous said...

Hi ilargi,

Monday we can expect to see the first plans to just start buying the piles of stinky paper outright, with taxpayers' money. Fannie and Freddie look like the ideal instruments to do that.

If that happens what could we expect the US dollar to do and what effect would that poisonous meal have on Fannie and Freddie?

Ilargi said...


I just posted an update, the first article of which comes from Minyanville, where the views are identical to mine: nationalization and outright purchases are imminent.

The US dollar might at first gain quite a bit of strength, I think, since this will signal a form of free for all, where all ugly debt can be passed on to the public. The full weight of the US government does still count for something, after all. There'll be a lot of fast gains for foreign investors, and they'll take those.

Beyond the short term, there is however only one way for the buck to travel: downhill. Those same foreign investors will bluntly refuse to keep even a penny in US dollar denominated investments over a longer period than, say, a few months.

F&F would be bankrupt instantly, if not for the fact that nationalization makes that impossible. We're talking en entirely new game here.

The US financial system has become one giant black hole, complete with, as I said yesterday, a forbidding event horizon. The $200 billion pumped in this week have already vanished for good, as we speak.

We are now ready for the ultimate dump. I expect the first fresh signals on Monday, though that would require for the Dow to plummet. It's up right now, and there's two days left in the week, it might hold more or less steady into next week. In that case the announcements will come next Wednesday or Thursday.

. said...

Looks like helicopter Ben has himself a fan over at ...

Unknown said...

Madame Merriweather's mud hut in Zimbabwe is looking better as a counter party now.

Instead of US paper being guaranteed by the US government, it will be for all practical purposes be guaranteed by some welfare queen living in Detroit.

Tell me again why anyone would leave a cent in the US? or stay in the US for that matter?

Bigelow said...

“Given that some analysts now estimate that financial institutions need to raise $1 trillion in new capital, this program is the equivalent of offering strong cups of coffee to a cocaine addict. It’s just not the same Pixie Dust rush. Pixie Dust addicts need to loot something, not run fullback hand offs up the middle for three yards.”
Pixie Dust Versus Turf Dirt

Anonymous said...

Thanks ilargi,

Just back from late coffee in the Land of Innocence and see the Canadian dollar is up a bit on the US but down on the Euro. Vortexes have always scared me when in a little boat, if and when you have moment, a comment on the Loonie would be of much interest. Time to start rowing like hell towards Europe?

Anonymous said...

Do you see a long term slump for precious metals,before a hyper- inflation spike?I have been thinking going to a half greenback half gold split for my limited resource to try and save as much capital as possible?Is this a rational course?

Anonymous said...


From Ilargi:
"The US financial system has become one giant black hole, complete with, as I said yesterday, a forbidding event horizon."

By "forbidding event horizon", do you mean the derivities markets in general? Or F&F plunging? Or...

There are so many things going on that I have so trouble pinpointing your meaning.

Thanks for everything,

Anonymous said...

Musashi, on your way out of the US how about joining us for an apres le deluge dinner the Mrs. has invited a nice Canadian girl for you:)

Ilargi said...


I use the term event horizon because the US banking system is so deep in debt, you can throw in a trillion dollars, and it'll just evaporate, nothing will ever be heard of it again. All this extra credit injection stuff is simply used to plug existing holes, and is not nearly enough to "restart" banks into any sort of health.

The banks are much worse off than the media reports suggest. By not marking their paper to market, they can keep up appearances for a bit longer, but liquidity still isn't solvency, and never will be. It's drops of water on a steaming hot plate.

Anonymous said...

Where does this leave the whole deflationary hypothesis? If the Fed really is willing to buy up crap with its infinite balance sheet, there isn't really much of a limit to the amount of crap it can buy. 100 billion a little while ago, this week 200 billion next, maybe soon 400 billion, or heck if it is needed maybe 800 billion next month. And it might be needed. And we'll call them 28 day loans, as long as we can. It now looks like the Fed has the means to keep things notionally afloat, and the willingness to actually do it. (At least until derivatives crash).

If that is the situation, then it looks like serious deflation can be kept at bay by a race for the Fed to auction off loans quicker than the money can disappear. But then dollar-money-supply will remain roughly flucuatingly constant, while the actual value of the dollar falls further and further, right?

Not quite Zimbabwe yet, the US isn't isolated or irrelevant enough yet. But this is consciously choosing the marching-to-Zimbabwe path, right? Heck, even if derivatives crash, the Fed could just accept 500 trillion dollars of derivatives as collateral against rotating loans, and nationalize the damn shadow banks too, and the only cost would be further devaluing the dollar, but hey everyone would stay solvent! I mean if this IS a solvency crisis, and your buddies are the bankers, not the people, then the solution is to nationalize the bad debt, move your buddies assets to something that will survive the shitstorm, maybe abroad, and hunker down right?

I hate to say it, but this action makes it look like we are skipping quickly over the deflationary phase of the game and heading for the crack up boom phase like all those Misesians keep saying. Or am I missing something?

Oh and why stay in the US? Because some of us love it and have roots here as f'd up as it is. Some of us damn welfare queens need to stay back and salvage whatever is left when the dust starts settling. US paper has always been gaurenteed by nothing more than the hope that the American people could somehow get over the demographic hump of the Baby Boomers becoming retirement queens. Besides it's spring, time to do noble, foolish things for love... Stay and help us clean up, unless that Canadian girl turns out well...

Ilargi said...


I don't see any hyperinflation anytime soon. As long as the finance system functions on an international basis, no amount of Fed money could cause inflation while credit and cash are scraping the gutter.

In an isolationist situation, it would be more feasible, but that will take a while to come to fruition.

Gold is likely good long term, but too much prone to manipulation before that. The US dollar starts becoming a risky bet, I think. For now, Europe looks resigned to dealing with a low dollar. Unless China rears its head, the buck will keep falling.

peakto said...

Brian m.,

I initial figured that the FED could re-flate, then carry us into a hyper-inflation depression.

But, it is starting to look like that the system is going to suck up any amount(568 BILLION in the last 3 weeks, give or take) just to keep a float, plug the sink so to speak.

In this case, deflation is ruling...and can and probably will lead to a deflationary depression. Which could turn in the longer term into a hyper-inflationary depression.

There are many counter points to all this, meanwhile we have price inflation in commodities, and asset deflation en masse.

I am pretty much 100% positive that it's going to be ugly which ever way it goes.

Ilargi said...


Or am I missing something?

Yes, you are.

Why would you think the Dow closed negative today, after a $2-300 billion handout?

Because people realize that it's nowhere near enough, of course. The Fed cannot and will not prop up things to a level where deflation could possibly be avoided. The $200 billion got a one day rally, and now it's over.

I posted, what, 4-5 articles on collapsing funds today, which combined take out more in one day than the Fed injected Tuesday. Go through everything I put in today's Rattle, and then tell me you think the Fed's actions have a snowball's chance in the Sahara.

Personally, I think the Fed knows this very well, and what is really happening is a simple transfer of debt to J6P. That's you.

Anonymous said...

Hello Ilargi,

You've got an excellent blog here. Losing The Oil Drum is no great loss, this blog is much better than what you were doing there.

I just have one question:

* Was the collapse of the Soviet Union deflationary or hyperinflationary, or some mixture of the two?


peakto said...


Just thinking aloud here...but I cannot see any way this can work out...nationalizing the debts and helicopter drops further have no logical outcome. ie. they cannot increase taxes in this state either.

If they drop another $1 Trillion, it still is a drop in the bucket against the accumulated derivative liability!

There is no way out of this except deflation now.

This is going to be a hard crash.

Or do you see it differently?

Anonymous said...

Ben 'Dover' Bernanke is like a man who has lit his hair on fire, and then tries putting it out with a hammer.

scandia said...

Musashi, I've been looking around the world for an affordable place to hide out from the collapse of our " age of waste". I live in Ca where the gov't shamelessly blows off a billion in overruns for a war in Afganistan. In the meantime the homeless numbers grow. Asked my son where I could go to miss the not so pretty picture unfolding. He answered, " with the penguins. "No war ,no economy? Scandia

Anonymous said...

So the Fed tries 50 Billion and it isn't enough, and then 100 Billion and it isn't enough, and then 200 Billion and it isn't enough. The funds are all collapsing and we are down 568 Bill in the last 3 weeks, So next week the Fed hands out 400 Billion, and the week after that 800 billion, and if that isn't enough it hands out 1.6 Trillion. Who is gonna stop them? J6P? Congress? Their conscience? And when it is 3 trillion, or 6 or 12?

They don't want to hand out 500 trillion to pay off the damn derivatives bubble if they don't have to because it will water down too much. But they'd probably do even that rather than face 500 trillion dollars worth of deflation. It's hard to even imagine that magnitude of deflation. The dollar would be collector's curiosity rather than a living currency with a fraction of that. The Fed sure seems to be allowing deflation, while pouring in just enough to look like they are trying to fight it. But HOW MUCH deflation will they allow?
Hey if they can shift some debt to a sucker, great, but that is not the main issue. They have to be thinking about the derivative monster too. 200Billion is a penny ante sideshow next to that. This all looks like Act I Scene II to me.

I'm not saying deflation can be avoided, heck its already here. I expect to go through a deflationary phase, which we are already in, before hitting something else. But how deep of a deflation? and how long? I don't think the FED has a snowballs chance of reflating enough to avoid deflation and I doubt they are trying. But we should expect some choppiness of money-supply if there are problems several orders of magnitude larger in the shadow-money-supply. Maybe yoyoflation is the right idea, deflate, inflate, deflate, inflate, then around the world. 568 Billion of deflation in 3 weeks looks bad now, but its just the noise and froth of more or less steadiness, next to changes in the 500-700 trillion derivatives market.

I know I don't understand and I am sorry I keep bothering you guys, both Il and Stone, and the other commentors. I do admire your analysis and work, and I am trying to understand. And I see the deflationary pressures, I do. But 500 trillion, even the lazy Americans of the US will act when that hammer comes down. And maybe it will be legislation, or legal challenges, or civil war, or giving up on the dollar entirely, or who knows. Maybe someone will declare all those derivatives contracts unenforcable. But anyone with power and more than 10 years of lifespan left, including big tracks of the government, has got to be scared and planning on the derivatives front. What does the US government's own debt look like after 500 trillion dollars of deflation? It looks meaningless.

Ah I ramble, ah well, I'm sure you'll have a nice fresh batch of perspective tomorrow for us to try to understand.

Unknown said...

sounds good, when I lived in Mexico I had a French Canadian GF and she was fun to be around.

Now and then I think about Canada, I like Vancouver Island, but if that's the way to go I would most likely go to one of the places where I qualify for instant citizenship.

Unknown said...


Don't know what to tell you.
Right now it's just gears turning in my head, but I can move at a moments notice as long as I have a laptop and a connection.

Don't know about penguins either, they are into cold weather, I'm thinking further North.
Google "Punta del Este" or "San Carlos de Bariloche"