Thursday, April 10, 2008

Debt Rattle, April 10 2008: Citizens of Troy

Breadline New York City 1935

Ilargi: Yesterday, I said the Fed’s new deliberations mean nothing less than an unparalleled -money- power grab, in While you were sleeping: A financial coup d'état .

In a nutshell, the plan is that the Treasury will lend money to the Fed, instead of the other way around. In other words, the Fed will owe YOU money. Lots of it. And you can't ask for it back. This has never happened before, and it is certainly not the purpose of a central bank. But they will do it, because they can.

Two highly valued commentators, Mike Shedlock and Karl Denninger, addressed the same issues, and my personal impression is that both are slightly missing the point, or at least the whole point. First, Mish, who claims the Fed does what it does because it is in essence simply scared:

The Fed is Terrified
That the Fed officials are having these kinds of discussions at all shows just how terrified [they are] of the perception setting in that we are following Japan, which of course we are.

The Fed is effectively in a position of not to being able to print money to buy Treasuries from banks, because of restrictions mentioned in the WSJ article and also because the banks are insolvent. Simply put, banks do not have the cash to accumulate Treasuries on their books to sell to the Fed this time around. And more writedowns on commercial real estate, auto loans, credit card debt, Alt-A mortgages, and pay option arms are coming. This will require still more capital raising efforts.

Ilargi: Strangely, Mish seems to miss his own point as well, because he also writes:
Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Four:The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Ilargi: And that is dead on, and it is precisely what I said: a power grab. A financial coup d'état. How Mish rhymes that with being terrified, I don’t know. I don’t have an ounce of doubt that this coup has been in the works for a long time. They’ve had this in mind all along, and that’s why they have conducted the policies they have in the recent past. No, it’s not the Fed that IS terrified, it’s you and me that SHOULD be terrified.

We are watching the most important development in the American “democratic” state since 1913, when the Fed was introduced, in exactly the same way that the citizens of Troy opened the gates to welcome the horse that would be their downfall. Today, the money masters might as well be taking over the White House by force. To put it in other words: this means unlimited taxation in America.

As for Karl Denninger, here’s a video he posted yesterday at Ticker Forum. Karl gives a good analysis, as usual, and is right in his assessment that the Fed should never not be borrowing from the taxpayer. He doesn’t yet seem to grasp the enormity of the situation, though.

Is The Federal Reserve Insane? Or Desperate?

Fed Bashed, ECB Spared in Finger-Pointing Match
Wall Street banks are the first to be blamed for the credit crunch. Central banks come a close second, but as the Federal Reserve's image is suffering, the European Central Bank looks as solid as a rock.
Many analysts and traders in the U.S. have cheered the Fed's rapid rate cuts and widening of collateral it accepts in exchange for liquidity for cash-strapped banks, saying that without them the crisis would be worse. The bailout of Bear Stearns also had its fans.

But the voices of those who accuse the Fed of debasing the currency and creating moral hazard are stronger and stronger. Former World Bank chief economist Joseph Stiglitz, eternal bear Marc Faber and renowned investor Jim Rogers accused the Fed of being the source for the global credit turmoil that is crippling financial markets.

Asked what he would do if he were in Federal Reserve Chairman Ben Bernanke’s shoes, Rogers said: “I would abolish the Federal Reserve and I would resign.”

A recession may be a good way to clean up the economy, while trying to prevent one may cost more and actually worsen it, he said. Also, the market should take care of investment banks. “If you bail out an investment bank that gets in trouble, that’s not capitalism, that’s socialism for the rich," Rogers told CNBC Europe. "That’s not the way this system is supposed to work. And why should 300 million Americans suffer so that we can bail out two or three investment banks on Wall Street?”

Stiglitz said some of the statements made by Fed officials over time had contributed to exacerbating the problem. “(Former Fed Chairman Alan) Greenspan, at the very moment interest rates were at the low, advised Americans to go out (and) take these veritable rate mortgages, which have been the source of the problem, when there was a clear bubble,” Stiglitz said.

Not being able to identify the ‘gigantic bubble’ in the housing market and the measures taken to ease the liquidity crisis were also slammed by Faber. “They do not solve the problems, they postpone the problems,” Faber told CNBC Europe. “I think the credit problems took 20 years to build and will take a very long time until they’re solved, and the market, at best, will move sideways.”

Arguably, action attracts criticism as well as praise, and maybe the ECB's stubbornness in not acting has kept its critics at bay, with few exceptions, among whom vocal French President Nicolas Sarkozy. The ECB’s sole mandate to curb rising inflation, unlike its U.S. counterpart which also targets growth, has sometimes been questioned by economists as being too rigid. But it has also earned it admiration.

“I like the way the European central banks have been handling things. I think that they have got their eye on the inflation that, in my opinion, does exist, and they’re trying to hold back (and) keep as many arrows in their quiver as long as they can for as long as they can,” said Bob Iaccino from RWH Financial. Credibility is key in financial markets, and a tough stance is a sure way to achieve it. Ironically, the Fed’s recent aggressive rate-cutting has actually made the ECB more reluctant to cut because “the Fed has, to some extent, lost some of its credibility in terms of commitment to price stability”, said Barclays Capital’s David Woo.

Iceland Raises Benchmark Interest Rate to 15.5%
Iceland's central bank raised its benchmark interest rate for the second time in three weeks, pushing it to the highest in Europe to shore up the krona and damp inflation that is running at three times the target. The key rate was raised by a half point to 15.5 percent, the Reykjavik-based central bank said on its Web site today. Five of nine economists surveyed by Bloomberg had expected rates to be left on hold, while four forecast an increase.

"They're confirming that they're going to react to any inflationary risk," said Kristrun Gunnarsdottir, an economist at Landsbanki Islands hf in Reykjavik. The bank raised the benchmark rate an unprecedented 1.25 percentage points at an emergency meeting on March 25. That increase stalled a slump in the krona that pushed inflation to a six-year high of 8.7 percent last month. The currency had lost as much as 25 percent of its value against the euro this year.

Today's rate increase failed to halt a further decline in the krona because it was not accompanied by measures to boost foreign currency reserves, economists said. The bank needs to raise its reserves to reassure investors it can act as a lender of last resort to banks that own more foreign assets than Iceland's gross domestic product.

"There are no new measures that address the issues we'd hoped they'd address," said Jon Bjarki Bentsson, an economist at Glitnir Bank hf. "It's definitely a disappointment."

Jefferson County, AL Officials Brief Washington On Threat Of $4.6B Bankruptcy On Sewer Bonds
As Alabama's most populous county struggles to avoid bankruptcy on $4 billion in municipal bonds, officials in Washington are listening. County financial advisers from Birmingham met Wednesday with officials from the Bush administration and the Federal Reserve and members of Congress have been told that the severe crisis has the power to harm the national economy as well.

Jefferson County is reportedly unable to make its bond payments because variable interest rates have jumped as high as 10 percent and it has not been able to get anyone to refinance its debt at a lower fixed interest rate, according to Bloomberg news reports. The county has $4.6 billion in debt and if it goes into bankruptcy it would become the country's biggest municipal bankruptcy, according to The Birmingham News.

Jefferson County financial advisors reportedly did not ask for a government bail out as they met Tuesday and Wednesday with Treasury Department, the White House Council of Economic Advisers, the Federal Reserve and with key Democrats and Republicans in Congress. County officials have been negotiating with Wall Street. They say the trip was to let federal officials know about the county's problem and how it relates to larger financial markets.

However, the message was clear that a $4 billion loss in the municipal bond could have a ripple effect similar to that of the subprime mortgage market crisis. Investments in the bond market in general - and specifically municipal bonds - as well as the mortgage market, have traditionally been viewed as safe and have been where people move their money to preserve their invested capital when the stock market becomes volatile. Many pension and 401K plans are also invested in the municipal bond market.

If Jefferson County can't restructure its bond debt, then interest payments on its sewer system debt along might reach $250 million. County Commissioner Bettye Fine Collins told Bloomberg news that amount would be almost twice the $138 in revenue that the sewer system generates.

Compounding the problem is that county sewer rates have increased four-fold since 1997 and county officials don't think residents can pay more. One of the arrangements that county officials are trying to work out would use some of the sales tax that is collected to pay off its school bonds to make up the shortage.

U.K. gets interest rate cut, Europe holds steady
The European Central Bank has left its benchmark rate unchanged at 4 per cent. That decision follows the Bank of England's move to lower its own rate to 5 per cent. The ECB's decision Thursday comes amid rising inflation among the 15 nations that use the euro. Its stance puts it apart from peers such as the U.S. Federal Reserve, which has lowered rates repeatedly.

Earlier, the Bank of England cut its base lending rate by a quarter-point to 5 per cent on Thursday, the lowest level in 17 months. The widely expected Bank of England decision came in the face of contrary pressures from rising inflation and fears about growth due to sagging house prices and falling consumer confidence. The bank's key rate rose as high as 5.75 per cent in July and held there until December. The last time the rate was as low as 5 per cent was November, 2006.

The Bank of England's head of markets, Paul Tucker, last week said rates would fall “gradually” and that the central bank was prepared to tolerate increased slack in the economy to counterbalance inflationary pressures. Bank Governor Mervyn King told a legislative committee last month that a rate cut was probably needed to bolster consumer confidence, and he said he expected inflation to go as high as 3 per cent before retreating.

The Fading American Economy:
Government is the largest employer

According to the Bureau of Labor Statistics, the US economy lost 98,000 private sector jobs in March, half of which were in manufacturing.  Today 13,643,000 Americans are employed in manufacturing, of which 9,849,000 are production workers.   Government employs 22,387,000 Americans, 8,744,000 more than manufacturing.  Even the category leisure and hospitality employs 13,682,000 Americans, slightly more than manufacturing.  There are as many waitresses and bartenders as production workers.

Wholesale and retail trade employ 21,467,000 Americans.  Professional and business services employ 18,036,000 Americans of which 8,368,000 are in administrative and waste services. Education and health services employ 18,699,000 Americans. 
Financial activities employ 8,228,000 Americans. The information sector employs 3,010,000.  Transportation and warehousing employ 4,532,000.  Construction employs 7,338,000, and natural resources, mining and logging employ 751,000. Other services such as repair, laundry, and membership associations employ 5,516,000 Americans. 

This is the portrait of the US economy according to the Bureau of Labor Statistics.  It is an economy in which government is the largest employer.  Manufacturing employment comprises just under 10% of total employment and about 12% of private sector employment.  Everything else is services, and not particularly high level services. Is this a portrait of a super economy?  

To help answer the question, consider that US imports in 2007 were 17% of US GDP, according to the National Income and Product Account tables provided by the Bureau of Economic Affairs.  In contrast, the BEA industry tables show that in 2006 (2007 data not yet available) US manufacturing comprised only 11.7% of US GDP.  

If US imports actually exceed total US manufacturing output by 5% of GDP, it does not seem possible that the US can close its massive trade deficit.  Even if every item manufactured in the US was exported, the US would still have a large trade deficit.
The NIPA and industry tables from which the percentages come are not calculated identically, and I do not know to what extent differences might exaggerate the differences between the percentages.  However, it seems unlikely that mere calculation differences would account for US imports exceeding US manufacturing output. 

If the US cannot close its trade deficit, it is unlikely that the US dollar can remain the world reserve currency.  If the dollar were to lose the reserve currency role, the US government would not be able to finance its annual red ink budget by borrowing from foreigners, as the US saving rate is about zero, and the US would not be able to pay its import bill in its own currency.  The rest of the world continues to hold depreciating US currency, because the dollar is the world reserve currency.  The dollar is certainly not a good investment having declined dramatically against other traded currencies.

From March 2007 to March 2008 the US economy created 1.5 million new jobs (in services).  Legal and illegal immigration and work visas for foreigners exceed US job creation.  During the current school year, 3.3 million high school students are expected to graduate. If we assume that half will go on to college, that leaves 1.6 million entering the work force.  College enrollment in 2007 totaled 18 million. 

If we assume 20% graduate, that makes another 3.6 million job seekers for a total of 5.2 million.  Clearly, immigration, work visas, and high school and college graduates exceed the 1.5 million jobs created by the economy.  Unless retirements opened up enough jobs for graduates, the unemployment rate has to rise.

Goldman Sachs Level 3 Assets Jump, Exceeding Rivals'
Goldman Sachs Group Inc., the most profitable securities firm, reported an increase in hard-to- value assets during the first quarter, exceeding those at Morgan Stanley and Lehman Brothers Holdings Inc. Goldman's so-called Level 3 assets surged 39 percent to $96.4 billion at the end of February from $69.2 billion in November, according to a filing with the U.S. Securities and Exchange Commission today. The ratio of Level 3 to total assets rose to 8.1 percent from 6.2 percent.

Investors are wary of banks and brokerages with difficult- to-sell securities on their books as $232 billion of writedowns and credit losses from the collapse of the subprime mortgage market have crippled earnings. More assets have become difficult to value in the last three months as investors shunned a wider array of credit, reducing trading.

"People are concerned about Level 3 because of possible writedowns, though it isn't necessarily all losing value," said Erin Archer, senior equity research analyst at Thrivent Financial for Lutherans, which holds shares of the three firms in the $73 billion under management. "We aren't out of the woods yet when it comes to writedowns and profitability of the brokers."

Goldman Chief Financial Officer David Viniar said last month the Level 3-to-assets ratio had risen to about 8 percent mostly because some assets classified as Level 2, including commercial real estate loans, dropped to Level 3. The biggest increase in the hard-to-value category was a 59 percent jump in derivative contracts, according to today's filing. Mortgage and other asset-backed loans and securities increased 56 percent in the quarter.

"Just because an asset is defined as Level 3 doesn't mean we're uncomfortable with the value of the asset," said Lucas van Praag, a spokesman for Goldman Sachs. "It also doesn't provide any insight into the relative risk of the underlying asset." Under accounting rules, Level 1 assets are those for which market prices are readily available. Level 2 holdings are valued based on "observable inputs," or prices of similar assets traded in the market. Assets are placed into the Level 3 category when there are hardly any observable inputs, and the firm has to rely on in-house models to calculate potential gains or losses.

Goldman Discloses Auction-Rate Probe
Goldman Sachs Group Wednesday disclosed that it has received requests for information from "various governmental agencies and self-regulatory organizations" relating to auction products and the recent failure of such auctions. Goldman, which disclosed the matter in its 10-Q filing, said it is cooperating with the requests. A spokesman declined to comment. It is the first time Goldman has been linked to widening probes.

Wall Street banks have been under fire as the credit crunch spread to auction-rate securities, a $330 billion market of securities that have been sold to wealthy individuals as highly liquid, cash-like instruments. With debt markets breaking down, many investors have found themselves stuck with securities that suddenly they cannot sell.

The U.S. Securities and Exchange Commission and, according to Monday's Wall Street Journal, the Financial Industry Regulatory Authority are looking into the market. In particular, investigators want to learn what promises brokers made to investors who purchased auction-rate products.

Two weeks ago, Massachusetts' top securities regulator said his office sent subpoenas to UBS, Merrill Lynch and Bank of America Investment Services to determine whether they told investors about the potential risks of these investments. Also last month, two clients filed lawsuits against Citigroup, complaining that the big bank did not disclose the risks of investing in these securities.

Auction-rate securities are long-term bonds that behave like short-term debt and have long been popular with conservative investors because they are tax-exempt. States, cities and other agencies issue these securities, whose interest rates reset frequently. In February, the auctions failed to attract buyers and investment banks stopped supporting these auctions.

Ilargi: The Citi deal moves sheer financial nuttiness a good deal closer to the edge. Of course there’s people saying"It demonstrates that there is a market for this paper”, but in reality nothing has been truly sold. Citi found a new way to move shaky paper of its balance sheet, that’s all.

Citi itself financing its $12 billion sale of loans
Citigroup Inc's plan to sell $12 billion of loans and bonds made to private equity firms is seen as a positive for the bank and the loan market, but the deal will leave the largest U.S. bank with exposure to those private equity firms even after the sale.

That's because Citi is financing much of the sale itself, according to a person familiar with the deal. It is lending some money to the private equity firms, which will combine it with some of their own money to purchase the debt. Essentially, Citigroup is re-lending money, but on different terms. The new loans are obligations of the private equity firms, and Citi is selling the original loans to the firms at somewhere around 90 cents on the dollar.

"The bank still has some of the same risk, but they have a lot of equity in front of them, and it's not on their balance sheet anymore," said David Bailin, head of alternative investments at Bank of America, speaking at the Reuters Hedge Funds and Private Equity Summit. Bailin had no direct knowledge of the Citi deal.

After the sale, Citi would no longer have to mark down the original leveraged loans if their value falls further, a real possibility in the currently disrupted credit markets. It also allows the bank to confirm the recorded values of other leveraged loans in its portfolio.

"It demonstrates that there is a market for this paper," said Marshall Front, Chairman of Front Barnett Associates in Chicago, which owns about 450,000 Citi shares. "This whole process of credit unfreezing, which started with the Federal Reserve opening the discount window to investment banks, is beginning to play out."

Merrill Likely to Write Down Up to $6.5 Billion More
Merrill Lynch is likely to post a first-quarter loss on further writedowns of between $6 billion and $6.5 billion, according to senior executives at the company. Unlike earlier writedowns at Merrill and other Wall Street investment banks, the latest round of writedowns is not solely tied to subprime loans, but instead is linked to commercial real-estate debt exposure and other types of loans, these people said.

Merrill so far has written down $24 billion worth of investments related to the troubled U.S. mortgage market. Merrill is scheduled to report its first-quarter results on April 17. On average, analysts surveyed by Thomson Financial are expecting Merrill to post a loss of $1.90 a share. However, the estimates range from a loss of $3.00 a share to a loss of 68 cents a share.

Merrill recently asked its trading desk to unload inventory in an effort to reduce the size of its balance sheet and shore up its credit rating, CNBC has learned. Merrill's bond rating is now secure, these executives said.
Merrill's efforts follow comments by Chief Executive John Thain, who said Tuesday that the investment bank does not plan on raising any new capital.

Thain spoke at a briefing in Tokyo and said that he expected writedowns would continue to impact Merrill's balance sheet. However, he said, he didn't think the firm would need to raise more capital because it had already raised more capital than it lost.

Lehman Liquidates Three Floundering Funds
Lehman Brothers Holdings has liquidated three floundering investment funds that lost value and ended up taking $1 billion of assets onto its balance sheet, according to a filing with the U.S. Securities and Exchange Commission.

The bank blamed the liquidation on "market disruptions that occurred in the second half of the 2007 fiscal year and further deterioration in the 2008 quarter," according to the quarterly filing on Wednesday.

In Europe, Lehman Brothers shares were down 4.1 percent from their last close in Frankfurt at 25.50 euros.
Lehman's announcement comes at a time when losses from subprime and other mortgages have rocked several banks and dealt a blow to their balance sheets.

Morgan Stanley: More Assets Illiquid or Hard to Value
Morgan Stanley said on Wednesday that more of its assets became illiquid or hard to value during the turbulent first quarter. Shares of Morgan Stanley were down more than 2 percent on the New York Stock Exchange, leading a decline in bank stocks.

According to its quarterly filing with the Securities and Exchange Commission, Morgan Stanley classified $78.2 billion of assets as "Level 3" at the end of February, up from $73.7 billion at the end of November.
In both periods, Morgan Stanley said these assets represented 15 percent of total assets, measured at fair value, or 7 percent of total assets.

The second-largest investment bank said it downgraded $2 billion of corporate and other debt from Level 2 to Level 3, driven mostly by loans and loan commitments for leveraged buyouts. The changes reflect "a reduction in recently executed transactions and market-price quotations for these instruments," the bank said.

Ilargi: I’ve left the airline problems alone until now. Not that I don’t follow the issue, but I know it’ll soo get so ugly and out of hand that we’ll be talking about it all the time anyway. We haven’t seen nothing yet.

Fuel Costs Just Part of Airlines’ List of Woes
Even before the recent flight cancellations, airlines and passengers were facing a new wave of travel misery. Record-high fuel prices and the industry’s fragile finances have led to a new round of bankruptcies among smaller carriers in recent weeks, including ATA Airlines, Skybus and Aloha Airgroup.

Bigger airlines are shrinking their fleets to cut fuel costs, even as demand for travel remains strong — meaning flights are growing more crowded and unpleasant. And layoffs are beginning again for a business that, to many of its customers, is already suffering service problems. It feels that way to airline workers, too, and as the industry’s decline accelerates, passengers can expect harried and grumpy gate agents and flight attendants.

Moreover, all across the air travel system in the United States, equipment — air traffic control systems, airplanes, airline computer systems — is aging and in many cases overtaxed. That means breakdowns and weather problems become more disruptive.

In the near term, airlines cannot raise fares fast enough to cover rising fuel costs; oil settled at a record price on Wednesday, $110.87 a barrel. That has plunged the industry back into the red after a brief two-year run of profits. A Merrill Lynch analyst, Michael Linenberg, expects the industry to lose $1.9 billion this year. One bad sign: a handful of airline shares are cheaper (Frontier, $1.79; Expressjet, $2.21; Mesa Air, 96 cents) than an airport beer.

Years of cost-cutting on maintenance and, to some critics, a lax regulatory approach by the Federal Aviation Administration, appear to be catching up with domestic airlines and their customers. American Airlines and its domestic competitors have been scaling back maintenance spending for years. Some airlines sent work overseas in search of cheaper labor. Some also cut wages of mechanics in the United States and reduced their number. Others quickened the pace of work at maintenance facilities.

“They let too many people go,” said Kevin Cornwell, an MD-80 captain at American who is also a pilots union official. “They sold spare parts years ago to raise cash. Things don’t get fixed as fast.” The industry’s biggest problem is the price of jet fuel. It follows the price of oil, which has more than doubled since dropping to $52 a barrel in January 2007.

With current air fares, a lot of planes simply cannot operate profitably. Though airlines raised fares on a broad scale 10 times in the first quarter of 2008, four of those increases failed to hold. And on many routes, the increases that did hold were ineffective because discount airlines had refused to match the increases. Southwest Airlines, the most influential carrier on domestic fares, raised its average fare just 2 percent last year, to $106.60. And consumers have become surprisingly adept at shopping on the Internet for the lowest fare, frustrating the industry.

So major carriers like Northwest Airlines, Delta Air Lines and United Airlines have responded in part by grounding older, fuel-guzzling planes. But the planes most vulnerable to higher fuel prices may be regional jets that seat 50 or fewer passengers. Smaller jets became more prominent in recent years as major carriers withdrew their larger planes from many smaller markets.

Most of the smaller jets are operated by regional airlines under contract to major carriers. And the major carriers are looking for ways to rid themselves of some of these money-losing arrangements. Mike Boyd, an aviation consultant, expects the North American fleet of 1,675 regional jets to begin shrinking this year to 1,042 by 2013. That would reduce service to many smaller cities and could eliminate flights to some markets altogether.

Ilargi: It’s starting to feel like we provide a daily update of George’s book tour. My hope is that he has enough clout and gets enough response to start a serious debate on CDS. G-d knows we need one.

Worst from credit crisis yet to come: Soros
The credit crisis is far from over, billionaire financier George Soros warned Thursday, urging regulators to move faster to contain damage from the collapse of the housing finance markets. “I think the situation is more serious than the authorities admit or recognize,” Soros told journalists in a conference call.

Measures taken so far to slash interest rates and stimulate the economy were “necessary but not sufficient,” he said. “Because of that, I think the situation is going to get worse before it gets better.” Mr. Soros is promoting a new book, “The New Paradigm for Financial Markets: The Credit Crisis and What It Means.” He has urged regulators to move more aggressively to improve market oversight to curb risks from excessive reliance on debt for financial speculation.

He said he agreed with the International Monetary Fund's estimate of more than $1-trillion in losses linked to the collapse of mortgage-backed securities. Losses disclosed by financial institutions so far are related only to the decline in value of those financial instruments, Mr. Soros said. “They do not reflect in any way a possible decline in the value of the loans held by the banks,” he said. “We have not yet seen the full effect of the possible recession.”

Mr. Soros pointed to the potential for massive losses from complex investments linked to the U.S. subprime mortgage market, such as credit default swaps, or CDS, which allow investors to put bets on the likelihood that companies will default on bond payments. He described as a “Sword of Damocles” the $45-trillion worth of credit swaps.

“That's more than five times the entire government bond market of the United States. It's almost equal to the entire household wealth of the United States,” Mr. Soros said. “This $45-trillion market is totally unregulated,” he said.

Double-bubble econony will burst
There are two views of the financial crisis. The first is that we face the bursting of a real estate bubble, a product of loose monetary policy, no-doc loans and alphabet-soup financial securities. The second is that we face the bursting of that bubble plus a terrifying long-term one that has been building since the Reagan era.

 This second bubble is the product of a quarter-century expansion in borrowing, excessive confidence in the dollar and an overblown faith in markets. The chief partisan of this double-bubble diagnosis is George Soros, hedge-fund manager extraordinaire. His latest book, published electronically last week, predicts the deflation of the second bubble, with chilling implications. You don't have to agree with every part of Soros' argument to embrace his prescription. It's not enough to respond to the real estate bubble in this crisis; the long process of credit expansion must be brought under control.

Between 1950 and 1980, total lending in the United States inched up slowly, relative to the size of the economy. Then, in the early 1980s, it took off. Every dollar of capital was "leveraged" aggressively: Private equity wizards loaded firms with debt; hedge funds bought securities on margin; banks lent prodigiously on thin cushions of capital.

All this leverage boosted rewards in good times, because a thin capital cushion means fewer shareholders to divvy up the profits. But a thin capital cushion has the opposite consequence when a shock comes. There are fewer shareholders to absorb losses and still repay lenders. Bankruptcy beckons.

Ginnie Mae And FHA Come Out To Play
Dowdy old Ginnie Mae and the staid Federal Housing Association have stepped up to the plate now that the subprime mortgage industry has struck out. With quietly expanded authority to support loans for borrowers far up the economic scale from their traditional low- and moderate-income mandate, the U.S. government-backed agencies are, at least for now, counteracting the downward pressure on American home prices.

New rules for FHA loan eligibility were evident on Wednesday, when the Mortgage Bankers Association reported a 12.9% jump in applications for loans backed by U.S. government programs such as the FHA and the Veterans Administration last week. This barometer rose to 375.2, nearly three times the previous year's level. Bill Glavin, special assistant to FHA Commissioner Brian Montgomery, said he "isn't surprised" by the spike. In February, a congressional stimulus package passed and gave the FHA 30 days to come up with new loan limits. In March, the FHA increased its loan maximum to $729,750 from $362,790 for single family-homes and opened up the agency's services to a richer crowd.

Glavin said "newly eligible people are just starting to catch on and apply for these loans." He also said the FHA expects "the number of applications to grow a lot more in coming months." Glavin said, "It's a group that is buying more expensive houses, though there are a lot of people that don't consider themselves affluent who live in $700,000 homes."

As a part of the congressional mandate, the FHA was told to look at the 3,200 metro areas in the United States and offer mortgages up to 125% of the median home price. Glavin said that this has lead to a lot of interest from people in expensive areas like New York, Aspen, San Francisco and coastal California. In 75 areas, the loan limit doubled.

To make the loans possible, Ginnie Mae whipped up a new multiple-issuer pool designated “M JM” that will absorb "certain higher-balance loans eligible for FHA insurance through Dec. 31, 2008." Veteran's Administration loans may be pooled in any appropriate Ginnie Mae pool regardless of principal balance. As of April 7, loans larger than $999,999 became eligible for pooling into securities.

Ginnie Mae takes pools of government-guaranteed loans targeted to lower-income households and military veterans and turns them into securities that are sold to investors. The same general structure led to a global financial crisis when mortgage brokers made loans to noncreditworthy borrowers and packaged them into bonds.

Ilargi: Look, this is the FHA which, as per the article above, is encouraged to hand out 125% mortgages. Who do you think will end up paying for that?

The FHA’s Financial Woes
Although both Democrats and Republicans are looking to the FHA to rescue homeowners in trouble, there is some question as to whether or not the agency is equipped to deal with the foreclosure crisis. By its own estimates, the FHA will be operating in the red this year. Congressional officials are projecting a $1.4 billion shortfall in fiscal 2009 for the agency. If this happens, American taxpayers will be forced to subsidize the FHA for the first time in its 74-year history.

Some housing officials are now blaming the bad ink on an FHA program that allows seller-financed down payment loans. Under the program, sellers arrange to cover buyers’ down payments. The seller concessions are generally added to the total cost of the loan. Only 2 percent of FHA insured loans were seller-financed down payment loans in 2000, but they grew in popularity during the boom and the FHA did nothing to keep the program in check. By 2007, seller-financed down payment loans accounted for a whopping 35 percent of all FHA loans.

The problem with this is that the foreclosure rate on seller-financed down payment loans is two to three times that of other loans, putting the FHA’s portfolio in a very precarious position. Already, the FHA backs 3.8 million loans worth approximately $365 billion. If Congress and the Bush Administration have their way, the agency will be greatly expanded.

Since the FHA has a government insurance fund of only $20 billion, and statistics show that 25 percent of FHA insured borrowers go into default again after a workout, there is almost no doubt the agency will have problems handling all the loans that do end up in foreclosure.

Fed's Kroszner Says Home Loan Writedowns Needed
The soaring volume of homes worth less than the mortgages on them means that banks need to consider writing down the value of the loans, Federal Reserve Governor Randall Kroszner said Wednesday. "The fact that many troubled borrowers have properties that are now worth less than the principal amounts ... suggests that lenders and servicers should give greater consideration to the use of principal reduction as one of the loan modification options in their tool kit," Kroszner told the House Financial Services Committee.

He said home foreclosures in 2008 will top the 1.5 million of 2007 and noted that in January some 24 percent of subprime adjustable rate mortgages were behind on payments, double the fraction that were delinquent a year earlier. Kroszner said that given the scale of the nation's housing woes, "it is in everyone's interest to develop prudent loan modification programs." "In this environment, servicers and investors may well find principal reductions that restore some equity for at-risk homeowners to be an effective means of avoiding delinquency and foreclosure," Kroszner said.

He suggested that writedowns of loans could be "targeted" through means such as limiting them to people who had high debt payment-to-income levels so that they would be available only to those who genuinely needed them. Kroszner urged Congress to speed up action on proposals to modernize the Federal Housing Administration, the Depression-era agency that insures mortgages issued by FHA-approved lenders.

That would "increase its scale and improve the management of potential risks borne by the government" as it copes with the housing market's distress. "Separately, the GSEs -- Fannie Mae and Freddie Mac -- could be asked to do more," Kroszner said. He said it would be "an especially appropriate time" for those government-sponsored enterprises to quickly raise capital so that they can take advantage of recent moves to let them buy bigger loans and play a larger role in mortgage markets.

The bust begins
Housing-market woes spread to Britain

For years the housing market in Britain has defied gravity. For a few months in 2004 and 2005 house prices moderated, before taking off again. But now, finally, tighter credit and overstretched household budgets are pulling prices down. A collective shudder ran down the spines of British homeowners on Tuesday April 8th when Halifax, a part of HBOS and the country’s biggest mortgage lender, revealed that house prices fell in March by 2.5%.

The monthly decline recorded by the Halifax house-price index was the biggest since September 1992, when the housing market was enduring an agonisingly prolonged bust. In fact, monthly house-price figures are notoriously erratic and should be taken with a big grain of salt. The more important finding from the index was that the annual rate of inflation—comparing the first quarters of 2008 and 2007—has fallen to 1.1%, the lowest since March 1996, when it was 0.3%.

That fits with the picture painted by the house-price index of the Nationwide Building Society, another big lender. This has now recorded five consecutive monthly declines, lowering the annual rate to 1.1% in the year to March. Mortgage lenders are reluctant to talk down the market, so it says something that both the Halifax and Nationwide are predicting “modest” declines in house prices this year. Forward-looking indicators suggest a gloomier picture.

The number of mortgages approved for house purchase was almost 40% lower in February than a year before. According to the Royal Institution of Chartered Surveyors, estate agents have been grappling with the worst conditions—measured by the ratio of completed sales to unsold stock—since September 1996.

Last week a study by the International Monetary Fund found that Britain’s housing market was the third most over-valued of 17 developed economies, narrowly behind Ireland and the Netherlands. House prices were almost 30% higher than could be explained by fundamental factors such as disposable income, interest rates and working-age population.

These findings are not shocking given the extraordinary house-price boom of the past decade. Between the first quarter of 1997 and the first quarter of 2007, house prices rose by 214%. This was the third highest among 20 countries covered by The Economist. It contrasts with a rise of 135% in America up to its peak in 2006.

ABCP bailout angers larger investors
Corporate investors who say they have been shortchanged by a $32-billion ABCP restructuring proposal intend to ask the judge overseeing the effort to give them a veto in the process, which took a major leap forward yesterday when Canaccord Capital Inc. unveiled a plan to ensure most individual investors see a full return of their money.

Canaccord, a brokerage that sold asset-backed commercial paper, said it has arranged a buyout for 1,430 of its clients who hold less than $1-million apiece at 100 cents on the dollar. That generated cheers from many investors and may ensure majority support for the proposal in a key vote scheduled for April 25.

However, the Canaccord buyout plan doesn't include 28 corporate holders and 15 individual investors with more than $1-million of the paper in accounts at the firm. Instead, the big corporate holders will be eligible for loans secured by their holdings. Similarly, National Bank of Canada bought out smaller holders last year but investors, many of whom were corporate clients, were only offered loans as compensation if their holdings were worth $2-million or more.

The fact that smaller holders are getting bought out at par has left corporate holders fuming at what they view as lesser treatment. It has them planning court challenges that could hold up the restructuring plan engineered by a committee of big ABCP investors, such as the Caisse de dépôt et placement du Québec. "The restructuring as it's currently proposed does not give a fair shake to our clients, and we either need it significantly amended or it needs to be set aside and the committee needs to go back to the drawing board," said Peter Linder, a Calgary lawyer who is representing seven oil companies saddled with frozen ABCP.

While most corporate investors have more money at stake than retail investors, the financial institutions that sold them the notes have less incentive to bargain because corporate holders lack the same leverage. Retail investors represent the largest group of ABCP investors with an estimated 2,000 holders and can control the restructuring vote, forcing banks and other institutions that would be hurt if the restructuring plan failed to play ball.

The number of corporate holders is much smaller, giving them little sway in the vote. Yet companies such as New Gold Inc., Redcorp Ventures Ltd. and Universal Uranium Ltd. have hundreds of millions of dollars locked up since the ABCP meltdown in August, forcing them to scramble for alternative financing arrangements to pay their bills.

Some corporate holders are considering launching lawsuits against those who sold and structured the troubled notes.
Others plan to ask Mr. Justice Colin Campbell of the Superior Court of Ontario — who is presiding over the restructuring — as early as today to declare the corporate investors a separate class of creditors, giving them more leverage because the restructuring could not succeed without support from a majority of the corporate class.

"They feel left out of the process, and rightly so," said Colin Kilgour, an adviser to corporate holders as well as to Canaccord clients. "The mega-investors have been looked after because they built the [restructuring] plan and the micro-investors are for the most part looked after. Now you've got the guys in the middle saying, 'This absolutely doesn't work for us. We don't have the luxury of time, we need the cash to run our business, and no one's going to step up and buy us out, so what are the options available to us?' "

Ottawa hears ABCP investors still not satisfied
A day after Canaccord Capital Inc. tabled an offer to repurchase stalled asset-backed commercial paper from its retail clients, many of those investors say it's not enough. "We will not be happy until all the other individual noteholders get paid too," said Wynn Miles, a self-employed Victoria woman with her life savings tied up in illiquid notes.

"I want my savings returned -- I also need to know that clients of National Bank [Financial] and the other investment dealers are made whole." Ms. Miles made the comments at a special House of Commons committee hearing into the ABCP debacle. In the wake of the credit crunch and the failure of the $35-billion ABCP market, many investors allege it was flawed and never should have been sold in the first place.

A group of institutions led by the Caisse de depot et placement du Quebec is working to restructure the notes. They say their plan is the best way to prevent further losses, but they need the support of people such as Ms. Myles. That's because retail holders vastly outnumber institutional and corporate holders, and in order to go ahead, the workout must win approval from a majority of investors.

Canaccord's buy-back offer to 1,400 of its retail clients was a key step in bringing the individual investors onside, but it may not be sufficient. There are roughly 400 additional retail investors who are not covered under the offer. Most are clients of Credential Financial Inc., a brokerage owned by a group of credit unions, but there are also clients of other chartered banks that have not been made whole. Noteholders are set to vote on the restructuring on April 25.

Brian Hunter, an oil and gas engineer in Calgary with about $658,000 tied up in illiquid ABCP, has said he will continue to pressure the backers of the restructuring to make a similar offer the remaining retail investors. "It is my understanding that there are plenty of customers of the chartered banks that hold this paper too," said Mr. Hunter, who set up a Facebook site to help organize retail noteholders.


Anonymous said...


Anonymous said...

I am continually amused at how the ABCP deal so closely resembles a sinking ship, and everyone is trying to throw everyone else into the water so they can get into a lifeboat.

Greyzone said...

Ilargi and Stoneleigh,

I see some curious things going on. As we all know, the markets are as much psychology as hard fact. I see the Citigroup "sale" (ha! what a scam!) of bad paper as mostly psychology. I also see lots of players in the market want to believe. ("You gotta believe!")

While the factual underlying fundamentals are bad, I can see more institutions trying the same or similar sleights of hand and I see this prolonging the crash in a much slower manner than many here may have been originally thinking.

Consequently, I am starting to agree with those who are expecting an actual rally of some duration (a few weeks to a few months). It's not something that I'd feel comfortable betting on at all because under the surface is pure rot. But that won't stop it from happening. And a rising market may forestall or slow the economic downturn for at least a while, leading to continued consumption. And if that's the case we may see gold back over $1000 and oil hitting $120 or even $130 before the real implosion begins.

That's the picture I am seeing emerge, largely because of people wanting to believe in the tooth fairy. At the end, we still fall down and go boom but the end may not be right now. But how do you two see this?

scandia said...

Just been reading " Mish" and comprehending his comments on counterparty risk. Thanks to TAE!
Note that trust has not been rebuilt one iota!
To-day I came across some new jargon on Minyanville- Article head-lined- "Turn and Breakout Being Set Up" What is a breakout? Is this a snooker/pool term?
I am noticing as well that some articles are about macroeconomics and others are about microeconomics. There is a difference! One needs specific knowledge to assess the microeconomic situation. The devil does appear in the details, in the fine print!

scandia said...

Me again...Ilargi/Stoneleigh. I've just been reading Roubini's prediction that the recession will ease mid 2009. I find that hard to accept in light of the enormous derivative debt yet to be exposed and set right. What am I failing to understand? Once/if there is transparency can health return relatively quickly as in a year?

Stoneleigh said...


Roubini has revised his predictions several times, always to become more pessimistic. I expect he'll revise this one too. I wouldn't anticipate a lasting bottom until at least 2012 (and I don't think even that will prove to be the ultimate bottom). Personally, I think his view of housing price declines is also still far too optimistic given the resetting of pay option ARMs, the huge overhang of inventory, and the loss of jobs impacting on people's ability to pay their mortgages.

Stoneleigh said...


I agree that the rally doesn't seem likely to be over yet. So far it's retraced about the minimum percentage of the preceding decline that one might expect (38%), but a much deeper retracement (eg 50%, 62%, 78%) would be more common. A common pattern for a counter-trend rally is advance-pullback-advance, and my guess is that we're beginning the pullback phase. I would think the rally would then continue to a new recovery high, but my guess is that it would last weeks (from the March 17th low) rather than months. I wouldn't lay any bets on it either way though. The rally should be over just as everyone is proclaiming the Fed victorious.

snuffy said...

Its odd,I have just received word that the "contractors book"..the book of local bids to be let in this construction market has grown by a factor of three from where it was a couple of months ago.This indicates the trend has reversed ,at least for the moment.All I can think of is that the only construction going on,in the usa is here in Oregon.Weird.
That "as you slept"article was gut-wenching.There are times I have wondered at the moods of darkness that sometimes comes over my wife,who was a native of Mexico city,until she was 21.I am sure she has seen death up close and personal many times.She is a Mestiza,with a little hooked Toltec
nose,and a temper you really dont want to be on the wrong side of.There is such a mix now in mexico,from the computer kids to the stone age indios of the hills.And the coming petrocollapse,along with the economic damage we have done,as bad as it is,it will get worse.
The payback,we as a nation we have coming as blowback from the actions of the current administration is breathtaking.I can't help but wonder if all these actions that the fed,and treasury,and so forth are simply re-arranging deck chairs on the titanic,before the coming war with Iran blows everything all to hell.If its down to gunfights at the local gas station for fuel,I am not going to be caring who is putting their name on the next few currencies they try.I hope someone in the justice dept,and a few congresscritters are paying attention to their games over there.I worry that they are so used to being soothed by greenspan that they don,t recognize that the peons and peasants are preping torches and sharpening pitchforks