Monday, June 16, 2008

Debt Rattle, June 16 2008: A Screeching Halt and A Perfect Match

Walker Evans Family Portrait Summer of 1936
William Edward "Bud" Fields, wife Lily Rogers Fields and infant daughter Lilian at their sharecropper cabin in Hale County, Alabama.

Ilargi: Well, no full halt yet, let's just say the screeching gets unbearably deafening by now. The economic system has no breaks, no gears and no reverse. The only thing it knows is full speed ahead, picking up speed as it goes along. Just like the human mind. They were made for each other. A perfect match.

Bank of England warns that credit crisis far from over as banks hoard cash
Conditions in the money markets remain "stressed", with banks reluctant to lend to each other for longer than a month, the Bank of England has said. In a further sign that recovery from the financial crisis is still at a very early stage, the Bank used its quarterly examination of the markets to warn that many areas are almost frozen, as banks continue to repair their balance sheets.

It comes after Bank Governor Mervyn King warned that the crisis is not over, and amid fears that central banks around the world are preparing to raise their interest rates. The Bank said: "Conditions in global money markets remained somewhat stressed. In particular, the cost of unsecured bank funding remained elevated and forward spreads indicated this would persist for some time.

"Contacts reported continued limited appetite among banks to lend to each other for periods longer than one month. Instead, banks were opting to hold more liquid assets and to conserve balance sheet capacity, partly as a buffer against corporates drawing on committed lending facilities.

"This was seen as more likely if macroeconomic conditions deteriorated and, in this eventuality, corporate defaults could rise rapidly, putting further strain on credit markets." The cautious behaviour comes despite many commentators' claims that the markets are now through the worst of the crisis.

The Bank said that while sentiment had improved since its last Quarterly Bulletin in March - particularly in the most recent months - conditions were far from normal. Indeed, interbank borrowing rates have remained high in recent months, despite the Bank's Special Liquidity Scheme to pump extra cash into the markets.

Concerns about tight credit have in some quarters been replaced by worries about the soaring price of oil, which recently peaked at just below $140 a barrel. The Bulletin acknowledged that the activities of hedge funds and other investors may have pushed it a little higher, saying: "Speculative activity was not widely thought by contacts to have been the primary cause of upward price pressures in energy markets, although it is possible that it played some role in the short run."

Ilargi: 33 percent in two weeks. That's what you call a nice profit.

Corn Jumps to Record as Floods in Midwest Threaten U.S. Crops
Corn climbed to a record near $8 a bushel as storms pounded crops in the U.S., the largest producer and exporter, and caused what may be the worst flooding in the Midwest since 1993.

Corn rose as much as 3.5 percent, and soybeans, wheat and rice all gained. The flooding in the Midwest will probably cause "hundreds of millions of dollars" of damage, according to the National Weather Service. U.S. corn stockpiles may fall 53 percent to a 13-year low before next year's harvest, the U.S. Department of Agriculture said June 10.

The United Nations estimates global food imports will exceed $1 trillion for the first time this year. In Egypt, the most populous nation in the Middle East, bread subsidies account for 5.5 percent of the national budget. Mexico, Yemen and 31 other nations face social unrest because of spiraling food and energy costs, the World Bank says.

High food prices "are here to stay" as governments divert resources to make biofuels, amass stockpiles and limit exports, Peter Brabeck-Letmathe, chairman of Nestle SA, the world's largest food company, said in an interview in Kuala Lumpur today. Corn gained as much as 3.5 percent to $7.9150 a bushel in Chicago and has advanced 33 percent in the past two weeks.

It's up 85 percent in the past year on record demand for biofuels and livestock feed as rising Asian incomes increase meat consumption. Rice for July delivery rose 50 cents, or 2.5 percent, to $20.80 per 100 pounds as of 11:32 a.m. in London. Rice reached a record $25.07 on April 24 after some exporters curbed exports.

"Elevated commodity prices, especially of oil and food, pose a serious challenge to stable growth worldwide, have serious implications for the most vulnerable and may increase global inflationary pressure," finance ministers from the Group of Eight nations said in a statement released after a June 14 meeting in Osaka, Japan.

United Nations Secretary-General Ban Ki-moon called this month for a 50 percent increase in food output by 2030, saying failure to feed the world's growing population will spark civil unrest and starvation

Ilargi: Gambling 101, Rule 1: Anyone unwilling to leave the crap table in the end loses all winnings, and then some.

Nearly Half of Wall Street Bank Profits Are Gone
Only a year ago, Wall Street reveled in an era of superlatives: record deals, record profit, record pay. But a mere 12 months later, nearly half of the profits that major banks reaped during that age of riches have vanished.

The numbers are staggering. Between early 2004 and mid-2007, a period of unprecedented wealth on Wall Street, seven of the nation’s largest financial companies earned a combined $254 billion in profits. But since last July, those same banks — Bank of America, Citigroup, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley — have written down the value of the assets they hold by $107.2 billion, gutting their earnings and share prices.

Worldwide, the reckoning totals $380 billion, much of which reflects a plunge in the value of tricky mortgage investments. More downbeat news is expected this week, when several big banks, including the ailing Lehman Brothers, are scheduled to report results for the latest quarter. As the tally of losses keeps growing, many bank executives — and their shareholders — keep asking the same question: When will the pain end?

But the finish line just seems to keep moving further away. Even when the losses end, bank executives are looking toward a new era of lower returns, thinner profits and fewer jobs. Greater scrutiny from regulators is forcing Wall Street firms to reduce their use of leverage, or borrowed money, which had fueled profits in good times but backfired when the credit crisis struck last summer. Nearly every finance company is cutting jobs and battening down.

The threats to the broader financial system have receded in large part because of the extraordinary government-led effort to rescue Bear Stearns. And Wall Street seems to have the ability to come back from just about any downturn with new ways to churn even greater riches. That new, new thing may already be brewing across Bloomberg terminals and trading desks.

For now, investors are not holding out hope. They have dumped bank stocks with each round of bad news, and recently the financial sector lost its perch atop the nation’s stock market. The combined value of technology shares, those darlings of yesteryear, has eclipsed that of financial stocks. And the energy sector is not far behind.

Lehman Brothers sent shock waves across Wall Street last week, when the bank disclosed that it expected to post a quarterly loss of $2.8 billion. The bank, which has been struggling to win back investors’ confidence, is scheduled to provide more details of those results on Monday. Lehman executives gathered at the bank’s Manhattan headquarters over the weekend, fueling speculation that the bank might try to raise capital from investors or even seek a buyer.

Lehman, which for months had assured investors that it was managing its risks well, said last week that the loss reflected $4.1 billion in write-downs of its investments. Goldman Sachs is scheduled to report results on Tuesday, followed by Morgan Stanley on Wednesday. Bank of America, Citigroup, JPMorgan and Merrill Lynch release results in July.

Goldman Sachs and Morgan Stanley are expected to have fared better than Lehman did in the latest quarter. They are more diversified than Lehman, which has traditionally focused on fixed income. And the two banks’ commodities traders may have profited handsomely in recent months as the prices for oil and foodstuffs have soared. Even so, many investors are anxious to see whether Goldman, which made money last year even as many of its rivals lost big, has continued to dodge trouble.

The latest round of results is likely to draw special scrutiny because Wall Street firms are disclosing capital levels under new international banking standards known as Basel II. And Merrill Lynch, Citigroup and UBS are also expected to suffer from the ratings downgrades recently issued for MBIA and Ambac, two bond reinsurers.

The more that banks take write-downs, the more they are, in a sense, shredding through the record profits they made when times were good. Citigroup, for example, has written down its mortgage and other loan investments by $37.3 billion or a full half of the handsome profits the global giant pulled in during the boom years.

Merrill Lynch, much smaller in size, has taken write-downs of $32.6 billion — or a whopping 153 percent of its profits from 2004 through last summer. Even if Merrill is given credit for the money it earned in the past year, the bank still had write-downs that translated into losses of $14 billion, and that is two-thirds of its profits in those three and a half years that ended with a pop last July.

“It’s a fairly unique situation, that you would give so much back,” said Alec Young, global equity strategist for Standard & Poor’s Equity Research. “The industry did enjoy real salad days over that period, but now the write-downs and losses have been so huge. It’s a significant percentage of the money generated.”

Monday Brings a Reminder of Loss at Lehman
And Lehman Brothers tries again. The beleaguered investment bank announced its second-quarter earnings Monday in a release that was nearly identical to the one it rushed out a week ago.

The bank stunned Wall Street last week with news that it had lost $2.8 billion in the second quarter and would raise $6 billion from investors. That loss was in large part caused by $4.1 billion in write-downs of the bank’s mortgage investments.

News of the loss sent Lehman’s share price falling, and by Wednesday night, the bank’s president, Joseph M. Gregory, and chief financial officer, Erin Callan, had resigned. Several analysts downgraded the bank’s stock, and Mr. Fuld wrote in an internal memo to employees that “our credibility has eroded.”

This week, Mr. Fuld was more upbeat. In the bank’s earnings release Monday morning, Mr. Fuld said, “we have begun to take the necessary steps to restore the credibility of our great franchise.” Those steps, he said, included completing raising the $6 billion in capital and naming Ian Lowitt, 44, as chief financial officer and Herbert McDade III, 48, president and chief operating officer.

The bank said Monday that it lost $5.14 a share in the quarter ended May 31, compared with net income of $1.3 billion, or $2.21 a share in the quarter a year ago. Analyst surveyed by Thomson Financial had expected a loss of $5.14. Revenue in the quarter dropped to negative $668 million, compared with $5.51 billion a year earlier.

Much of the suspense Monday was whether Mr. Fuld would address shareholders and analysts during its conference call at 10 a.m. Mr. Fuld, who is one of the longest serving Wall Street chiefs, stayed out of the limelight in recent months and was not on the last-minute call last Monday. Instead, Ms. Callan spoke on behalf of the bank, as she had during much credit crisis.

But now Mr. Fuld faces tough questions about the bank’s future earnings potential in an environment with less leverage and about the hefty mortgage assets still on its books.

Our Tarnished Titans
Ever since J. Pierpont Morgan was simultaneously reviled and celebrated a century ago, the titans of banking have enjoyed a special place in the popular imagination.

Their economic clout, political influence and sheer wealth have inspired justified awe; the alumni of a single firm, Goldman Sachs, include the current Treasury secretary, the White House chief of staff, New Jersey's governor, the World Bank boss, the head of Italy's central bank and the Nature Conservancy's incoming president.

Yet there are questions about what modern investment banks do -- and last week's ructions at Lehman Brothers only make these questions trickier. Until about a year ago, the main complaints about investment banks concerned conflicts of interest. By collecting all kinds of financial business under one roof, they created all kinds of opportunities to take advantage of customers.

Investment-bank brokerage departments execute buy and sell orders on behalf of outside clients, supposedly at the best price possible. But the proprietary trading desks make money by trading the banks' own capital; the temptation to use knowledge of outside clients' strategies to boost prop-desk profits is, shall we say, considerable. Long-Term Capital Management, the hedge fund that blew up in 1998, was partly a victim of brokers who were copying its trades, making them impossible to exit in a crisis.

In 2000, the tech and telecom bubble burst, revealing further conflicts of interest. Investment-bank research departments, which advise fund managers on what to buy, were caught pushing stocks that they knew to be worthless -- because the banks collected fees from those worthless companies.

The banks were also capable of tilting the playing field the other way. Initial public offerings were underpriced, meaning that the firms issuing stock were cheated while the banks got to distribute cheap IPO shares to their favorite fund managers. These conflicts smelled bad but fell short of real scandal. The customers were grown-ups who understood the game; if they chose to patronize the banks, they were presumably benefiting from their services.

But the bursting of the credit bubble has conjured fresh concerns: not about banks' treatment of customers, but of their own money. We now know that the models banks have used to measure their investment risks are flawed, to put it charitably. They base assessments of future risk on how markets have performed in the most recent few years, so the inflation of a bubble causes the models to proclaim that the world is growing more stable.

Even more bizarrely, the models factor in market behavior only during normal times -- explicitly excluding the most extreme 1 percent of past experience. As hedge fund manager David Einhorn says, "This is like an air bag that works all the time, except when you have a car accident."

Goldman, Morgan Stanley Profits Conceal Reliance on [Commodity] Derivatives
On Wall Street, where just about everyone has lost confidence in financial assets, Goldman Sachs Group Inc. and Morgan Stanley are making money the old-fashioned way: Buying and selling commodities. Goldman and Morgan Stanley are expected by analysts to report the best second-quarter earnings of the world's biggest securities firms this week, having limited their losses from the collapsing credit market.

They also lead Wall Street in commodities trading, where crude oil futures doubled in the past year and the price of products from gold to corn soared to record highs. Surging prices are attracting investors, as well as companies hedging their positions by buying derivatives. That's played to the strength of Goldman and Morgan Stanley, which dominate the market for commodity derivatives.

The two New York-based companies accounted for about half of the $15 billion of revenue that the world's 10 largest investment banks generated from commodities last year, said Ethan Ravage, a financial-services industry consultant in San Francisco.

Commodity trading "is very large for them, and that is even more important now given what's happening with the rest of the businesses," said Frank Feenstra, a consultant at Greenwich Associates, the Greenwich, Connecticut-based research firm whose survey last month found Goldman and Morgan Stanley were the preferred dealers of corporate users of commodity derivatives. "There are more commodities used, more hedging by companies, and the investor population has increased significantly as well."

Goldman probably will report a 32 percent drop in second- quarter profit tomorrow, and Morgan Stanley may say on June 18 that net income fell 59 percent from a year earlier, according to the average estimate of analysts surveyed by Bloomberg. That's relatively good news for Goldman Chief Executive Officer Lloyd Blankfein, 53, and Morgan Stanley CEO John Mack, 63, when compared with the $2.8 billion second-quarter loss reported last week by Lehman Brothers Holdings Inc.

Bear Stearns Cos. was forced to sell itself to New York-based JPMorgan Chase & Co., the third-biggest U.S. bank, after almost going bankrupt in March. "Fixed-income is really, really tough right now," said Ralph Cole, a senior vice president of research at Ferguson Wellman Capital Management Inc. in Portland, Oregon, which manages $2.7 billion and holds Goldman shares. "The two names that had so much trouble were big fixed-income shops, whereas Goldman obviously has commodities."

Goldman, the only one of the 10 biggest investment banks to show a gain in its stock price last year, fell 17 percent so far in 2008, and Morgan Stanley tumbled 23 percent in New York Stock Exchange composite trading. By contrast, Merrill Lynch & Co. dropped 29 percent and Lehman fell 61 percent.

The earnings declines at Goldman and Morgan Stanley will be driven largely by writedowns of real estate-backed securities and leveraged loans. Goldman probably will take $1.3 billion of such writedowns, and Morgan Stanley may write off $1.6 billion, said David Trone, a New York-based analyst at Fox-Pitt Kelton Cochran Caronia Waller, who has an "in line" rating on the companies.

Morgan Stanley has already taken $12.6 billion of such writedowns since the beginning of last year, compared with Goldman's $3 billion, data compiled by Bloomberg show. Goldman and Morgan Stanley, the two largest U.S. securities firms by market value, don't report commodity revenue separately, lumping it instead into the same line as fixed-income and currency trading. That makes it difficult to assess just how much commodity revenue has cushioned earnings.

Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York, estimates that commodity trading accounts for more than 7 percent of revenue at Goldman and Morgan Stanley. That would have added up to more than $3.2 billion at Goldman last year and $1.9 billion at Morgan Stanley.

Lehman Reduced Mortgage Assets 20% in Second Quarter
Lehman Brothers Holdings Inc., the fourth-largest U.S. securities firm, unloaded real-estate assets in the second quarter, shrinking its mortgage holdings 20 percent to curb further losses from the credit-market collapse. Lehman lost $2.8 billion, or $5.14 per share, during the quarter, in line with the preliminary figures it released last week, the New York-based firm said today in a statement. Leveraged buyout loans were cut 37 percent to $18 billion.

"We have begun to take the necessary steps to restore the credibility of our great franchise and ensure that this quarter's unacceptable performance is not repeated," Chief Executive Officer Richard Fuld said in the statement. Lehman has lost more than 60 percent of its value on the New York Stock Exchange this year amid speculation mortgage-related writedowns will continue to depress earnings.

After disclosing the wider-than-estimated second-quarter loss last week, the firm replaced its president and finance chief. Fuld, the longest- serving chief executive officer on Wall Street, is trying to convince investors Lehman can weather the credit contraction. Lehman rose 44 cents, or 1.7 percent, to $26.25 in New York trading.

The firm shed $147 billion of assets during the quarter, more than the $130 billion it estimated last week. Net assets declined by $70 billion, the bank said today. Its mortgage-backed holdings dropped to $64.7 billion from $80.8 billion in the first quarter. Residential mortgages and related securities dropped 22 percent to $24.9 billion. Commercial mortgages and related bonds declined 19 percent to $29.4 billion. Real estate holdings fell 19 percent to $10.4 billion.

Writedowns wiped out revenue for the firm, which said fixed- income revenue was a negative $3 billion. Equity trading dropped 65 percent to $601 million due to writedowns on private-equity stakes. Investment-banking revenue fell 25 percent to $858 million, and asset management rose 10 percent to $848 million.

BlackRock Inc., the largest publicly traded fund manager in the U.S., and Maurice "Hank" Greenberg, the former CEO of American International Group Inc., the world's biggest insurer, bought stakes in Lehman earlier this month and said they remain optimistic about its businesses. Putnam Investments LLC, the mutual fund firm that oversees about $173 billion, invoked the "strong franchise" Fuld has built in his four-decade career.

Fuld, 62, stunned Wall Street on June 12 by replacing Chief Financial Officer Erin Callan and President Joseph Gregory in an effort to reassure investors amid speculation that mortgage- market losses will continue to drag down earnings. The demotions capped a 42 percent drop in Lehman's shares on the heels of a $6 billion cash infusion. Fuld snapped a four-day losing streak Friday, when the stock gained 14 percent in New York trading, the biggest rise since April 1.

Indicting the Credit Crisis: Bear Fund Managers May Face Charges
Back in February, we noted that EDNY prosecutors were asking whether the incongruity between the public and private comments made by a couple of Bear Stearns hedge fund managers could constitute fraud.

Today, WSJ colleague Kate Kelly reports that the feds, following a nearly year-long investigation, have indicated that indictments of former Bear fund managers Ralph Cioffi and Matthew Tannin could be in the offing, though evidence could emerge that would change that.

The indictments would represent the first criminal charges against Wall Street executives arising from the credit crisis that began to come to light around this time last year. During the investigation, however, Cioffi has reportedly said that he and Tannin, who both managed high profile bond portfolios, were grappling with the fast-changing dynamics in mortgage markets just as the rest of the financial world was, and didn’t mislead anyone.

In February 2007, when the subprime-mortgage market began to cool off, Cioffi and a number of his colleagues reportedly remained upbeat, telling investors that a meltdown in the sector was “unlikely to occur.” But the next month, after an index that tracks subprime-mortgage securities had dipped, Cioffi received permission from the firm’s compliance officials to move $2 million of the $6 million he personally had invested in the fund into a separate internal fund called Structured Risk Partner.

In April 2007, Cioffi exchanged emails with colleagues in which he expressed concerns about the credit markets, and wondered how a downturn might affect his investors, according to people familiar with the matter. In an April 25 call with fund investors, however, he sounded an upbeat note, telling participants he was “cautiously optimistic” about his and Tannin’s ability to hedge their portfolio.

Why It’s Worse Than You Think
For months, economic Pollyannas have looked beyond the dismal headlines and promised a quick recovery in the second half. They're dead wrong.

The forgettable first half of 2008 is stumbling to a close. On Friday, the Labor Department reported that American employers axed 49,000 jobs in May, the fifth straight month of job losses—an event that signals a recession sure as the glittery ball dropping on Times Square augurs a New Year. The report, which inspired a 394-point decline in the Dow Jones Industrial Average Friday, was the latest in a run of bad news.

Auto sales, the largest retailing sector in the U.S., were off 10.7 percent in May from the year before. And housing? Ugh. Nationwide, according to the Case-Shiller Index, home prices in the first quarter fell 14 percent. Yet hope springs eternal that the second half will be better than the first. Economists polled by the Federal Reserve Bank of Philadelphia in May believe the economy will grow at an annual rate of 1.7 percent and 1.8 percent in the third and fourth quarters, respectively.

Lawrence Yun, chief economist at the National Association of Realtors, tells NEWSWEEK that "home sales and prices in most of the country will improve during the second half of 2008." (Yun is the Little Orphan Annie of forecasters. He's always sure the sun will come out tomorrow.) Last month, Treasury Secretary Henry Paulson said, "We expect to see a faster pace of economic growth before the end of the year."

The cause for optimism: the U.S. has called in the economic cavalry, which has responded in textbook fashion. The Federal Reserve has aggressively cut interest rates, bringing the Federal Funds rate down from 5.25 percent last September to 2 percent. Earlier this spring, Congress and President Bush, in a rare moment of bipartisan accord, passed a stimulus package, which will shove nearly $100 billion into the pockets of American consumers by mid-July.

But this downturn is likely to last longer than the eight-month-long recession of 2001. While the U.S. financial system processes popped stock bubbles quickly, it has always taken longer to hack through the overhang of bad debt. The head winds that drove the economy into this dead calm— a housing and credit crisis, and rising energy and food prices—have strengthened rather than let up in recent months.

To aggravate matters, the twin crises that dominate the financial news—a credit crunch and the global commodity boom—are blunting the stimulus efforts. As a result, the consumer-driven economy may not bounce back as rapidly as it did in the fraught months after 9/11.

While the treatment of the current malaise has been essentially identical to the reaction to the 2001 slump—aggressive Federal Reserve rate cuts and tax rebates—the symptoms are quite different. In 2001, an implosion in the technology sector and a slump in business investment pushed the economy over the edge. Even though some 3 million jobs were shed between 2001 and 2003, consumers soldiered on through the downturn.

"We had a massive reduction in both long- and short-term interest rates, which set off the housing and consumption boom," says Ian Morris, chief U.S. economist at HSBC. (Remember zero-percent car loans?) This time, it's the opposite. While businesses—especially those that export—are holding up, the economy is being dragged down by the cement shoes of a freaked-out consumer and a punk housing market.

Fed’s deliberate inflation threatens Asia
As China's stock market completes an eight-day slide, even a muted new margin-lending initiative to deliver a pre-Olympic boost will struggle to turn the tide in the week ahead. Inflation is now the gorilla in the room for investors. Conventional thinking has said that the subprime crisis was a made-in-America problem and that Asia was the safe haven or even the new institutional "core holding."

As the City in London slashes jobs, new funds in Hong Kong have opened to target markets, consumers and corporates who are debt-light and seemingly far removed from any housing meltdown. But have the U.S. Federal Reserve's interest rate cuts blown open the decoupling scenario?

It's now becoming increasingly apparent that the Fed's rate-cut medicine has been a particularly toxic tonic for China and many other Asian economies, as they are hammered by the worsening inflationary side-effects. And it looks as if these less developed economies and less sophisticated corporations are also not as well positioned to manage profits in such an environment.

Last year, China was viewed as the driver behind rising commodities prices. But blame for the renewed surge in soft commodities and oil is increasingly being laid at the door of Fed Chairman Ben Bernanke for taking the fed funds rate to 2% and unleashing a wave of surplus liquidity looking for a new home. The fallout is now being seen. Countries such as India, China, the Philippines and Indonesia are hiking their own interest rates to rein in rising prices, and others may follow suit.

Vietnam's ridiculous 25% inflation has served as reminder that emerging market risk is still very much alive. With this type of price spiral, the economy struggles to function normally and even the maligned U.S. dollar is starting to rally against the local currency, the dong.

In China, consumer prices increased only 7.7% last month, down from 8.5% in April, but understandably the market is not impressed. With producer prices still rising 8.2% in May, including some hefty increases like coal doubling in price since the beginning of the year, further jumps look to be in the pipeline. Analysts point to an inevitable fuel price reckoning in China which may exacerbate inflation due to various unsustainable price controls and subsidies.

HSBC estimates that if oil prices average $120 a barrel this year, the effective subsidy paid by China to maintain lower domestic prices could reach $27 billion, or 4% of the annual budget. And without true prices being felt, the incentive to conserve to reduce demand is lost. Another phenomenon being linked directly back to the Fed policy is how rate cuts led to a surge in hot money flows into China seeking the deposit yield advantage, as well as speculation on the yuan.

Recent reports say China's huge foreign exchange reserves grew by a record $74.5 billion in April, partly fuelled by huge inflows of speculative capital which add to the liquidity in the financial system. While China has capital controls, they do not look to be working. And even if quotas on bank loans are in place, expectations are that money is ending up getting lent in the grey or informal banking system. Notably, China's M2 money supply measure grew 18.1% last month, much faster than expected, and up from 16.9% in April, according to the central bank.

The oil era reaches its desperate endgame
Saudi Arabia appears ready to cave in to demands from Western governments for the kingdom to make special efforts to increase its production of oil. Analysts forecast that the world's largest producer will shortly raise its output by half a million barrels a day. The United Nations Secretary-General, Ban Ki-Moon, confirmed this impression at the weekend after emerging from talks with the Saudi monarch, King Abdullah.

But there are also indications that the Saudis will make their own counter-demands when oil producers and consumers meet at an emergency energy summit next weekend. One such requirement might be for Western governments to play their part in adapting to the higher prices by relaxing their domestic taxes on fuel. This represents a considerable shift from Saudi Arabia.

Up until now, the country's rulers have blamed the soaring oil price on speculation in Western financial markets – a phenomenon driven, they say, by a false perception of a shortage of global capacity. There is little doubt that speculation is playing some part in pushing up the price of oil to an unprecedented $140 a barrel. Yet the fact that inventories have been at normal levels suggests this is not the driving force behind price rises.

Growing demand is the far more likely culprit. It is often asserted that Saudis still have vast oil reserves. But there is no independently verified proof of this. We have no choice but to rely on what they choose to tell us. If the kingdom really thinks the present price is the result of a speculative bubble driven by misinformation about its reserves, it ought to open up its oilfields to independent inspection to dispel the doubts. Of course it will not do this. But, for now at least, it looks ready to increase production.

An increase in Saudi oil pumping might well have the desired effect of bringing down the price somewhat. But what if it does not fall low enough to ease the pain of the world economy? How long before our political leaders return to Saudi and its Opec allies to plead for more? And what will be the political price extracted for this? What we are seeing in this desperate horse-trading is the endgame of the oil age.

Even if we have not yet reached the inevitable moment of "peak oil", when production begins its inexorable decline, it is abundantly clear that the age of cheap fuel is over. The economic leaps forward by China and India represent a step-change in energy demand. The rate of discovery of new oilfields has failed to keep pace with the speed at which nations are joining the global economy. That means the price of oil will remain considerably above the level to which we have historically been accustomed.

EU set to crack down on rating agencies
Brussels is to unveil “targeted regulatory measures” for credit rating agencies operating in Europe over the next few months in response to anger over their role in promoting the sale of complex structured investments. The moves, to be outlined by Charlie McCreevy, EU internal markets commissioner, in a speech in Dublin today, are partly aimed at addressing potential conflicts of interest in the rating agencies’ business model.

Although the proposals are at an early stage, they appear to go significantly further than anything in force in the US or elsewhere. Mr McCreevy is to make clear that nothing short of oversight will do. “I am now convinced that limited but mandatory, well-targeted and robust internal governance reforms are going to be imperative to complement stronger external oversight of rating agencies,” he will say.

“I have concluded that a regulatory solution at European level is now necessary to deal with some of the core issues.” The announcement comes just weeks after the International Organisation of Securities Commissions proposed changes to the industry code of conduct, a code Mr McCreevy will make clear falls far short of what is needed. In withering language, Mr McCreevy will describe the code as “a toothless wonder” and point out that “no supervisor appears to have got as much as a sniff of the rot at the heart of the structured finance rating process before it all blew up”.

He will say that he is “deeply sceptical” about its usefulness. “Many of the recent IOSCO task force recommendations do not appear enforceable in a meaningful way,” he will suggest. He will also call for “robust firewalls” to protect those responsible for the integrity of the process from executives whose priority is “to drive forward” earnings.

EU Quarrels Over Fate of New Treaty After Irish Snub
European Union foreign ministers quarreled over the fate of the bloc's new governing treaty after a veto in Ireland slammed the brakes on moves toward a more politically united Europe. EU ministers showcased their disagreements over how to respond to Ireland's rejection of the treaty, which would create the post of full-time president with the goal of upgrading Europe's role in world affairs.

"It would be risky to say that we are going to bring the treaty back to life when we face a blockade," Slovenia's Dimitrij Rupel told reporters in Luxembourg today before chairing a meeting of EU foreign ministers. Ireland's veto in a referendum last week brought the EU's internal discord to the fore, overshadowing matters ranging from the nuclear standoff with Iran to the bloc's response to soaring food and energy prices.

The treaty can only take effect once all 27 EU countries endorse it, giving the 862,000 Irish who voted "no" a veto over political life in a bloc of 495 million people. So far, 18 countries have ratified it through parliament. Ireland's rebuff is a "cold shower" for Europe, said Italian Foreign Minister Franco Frattini, a former European justice commissioner.

Officials from three countries yet to ratify -- Britain, Italy and Sweden -- pledged to press on with the process, saying that their views shouldn't be stifled by the Irish rejection. "We don't see any reason to abstain from having our voice just because they had their voice," Swedish Foreign Minister Carl Bildt said.

The debate reflected conflicting views of what the EU is for, with Britain and some countries in eastern Europe seeing it as an economic arrangement and a core group led by France and Germany intent on more political unity. Finnish Foreign Minister Alexander Stubb insisted "the treaty is not dead," while President Vaclav Klaus of the Czech Republic -- another country yet to ratify -- hailed the defeat of an "elitist artificial project."

The Czech Republic looms as another obstacle to the treaty, which has been held up in court and faces growing opposition in the upper house of parliament. Klaus's signature may also be required on the ratification document. Irish voters have rejected an EU treaty once before, in June 2001. The solution then was to put out a declaration that the EU wouldn't infringe on Ireland's military neutrality, and the Irish voted "yes" in a second referendum a year later.

Ireland's vote leaves the euro in limbo again
To judge from global markets, Ireland's rejection of the Lisbon Treaty is deemed a trivial event. The euro slipped a notch against the dollar in early trading, then recovered. The spreads on Irish bonds nudged up one tick against German Bunds.

This is nothing like the earthquake on the currency markets in 2005 when France and the Netherlands threw out the treaty, then known as the European Constitution. "When France voted No, people were worried that the whole EU would freeze up," said David Woo, currency chief at Barclays Capital.

"Germany was the Sick Man of Europe and there was a fear that disenchantment could cause the euro to fall apart. But three years have gone: nothing has frozen, and Germany is strong," he said.

The truth is that Ireland is considered too small to count. Never mind that Lisbon is legally null and void if one member state fails to ratify. Traders are betting that Europe's clever lawyers will find a way to slip the text through as adjunct to Croatia's accession treaty.

But the euro-elites will have to handle [last week’s] upset with extreme care. It will rankle if bully the Irish, or move too flagrantly to disregard their verdict. There are already signs that Nicolas Sarkozy plans to use France's EU presidency to steamroll the treaty through by "legal" measures. This sort of behaviour could destroy the union altogether.

Once again, it has been revealed that the EU political class cannot secure popular assent for further advances of the European Project whenever it's put the test. The only two countries to vote on the euro - Denmark and Sweden - both said 'Nej'. The only country to vote on the Nice Treaty - Ireland - said no. Now the only country to vote on Lisbon has said no. The British would almost certainly have done the same, so might the Poles, French, Dutch and Scandinavians.

Wise heads in Brussels - including the European Commission's president, Jose Manuel Barroso - warned against this second attempt to ram through the constitution. They said it was time for the EU to lie low, clean up its act, and do fewer things better. The leaders of France and Germany pressed ahead. They lost their gamble and will have to resort to shabby methods that will further sap the democratic legitimacy of the EU. This is dangerous.

Ireland is now the victim of a triple shock: the soaring euro, the collapse of the credit bubble, and the abrupt downturn in its key markets in North America and Britain. A decade ago, the head of Germany's Bundesbank told the Irish that they could expect no mercy from the European Central Bank if they joined the euro and then got into trouble."The ECB will be blind to Ireland's needs, and deaf to cries of help," he said.

Prescient words. Under EMU, Irish interest rates fell to 2pc and remained below zero in real terms for most of this decade. The result has been a property boom, now turning to bust. Household debt has reached 175pc of GDP. Property prices have already fallen 9pc over the last year. Fitch Ratings predicts a drop of 22pc from top to bottom.

The Irish government cannot do much about it. The ECB calls the shots. It made matters worse last week with talk of rates rises, driving up Euribor by over 30 basis points. This triggered another round of mortgage rises. "Ireland will not escape a severe recession," wrote Bernard Connolly, global strategist at Banque AIG.

Barclays looks to Asia to raise £4bn
British banking giant Barclays is close to raising £4 billion in a placing with some of the world’s biggest sovereign wealth funds. The move is the latest in a series of capital raisings around the world by banks that have been hit hard by the credit crisis.

Marcus Agius, the bank’s chairman, and his chief executive John Varley are expected to come under pressure tomorrow to clarify the fundraising in a stock-exchange statement. The confirmation will put an end to the uncertainty surrounding the bank while the City has waited for details of how it will raise new capital.

The placing, to be completed within a fortnight, will involve issuing new shares to investors at a premium to Friday’s closing price of 318p. This valued the bank at £20.9 billion. The intention is to ensure that the value of shares owned by existing investors in Barclays is not diluted. It is likely they will be offered the chance to buy the same percentage of shares in the placing, but it will be underwritten by the sovereign funds.

It is thought that at least six potential investors are in talks with Barclays and it is likely that three of these interested parties will be selected. The first opportunity is being offered to the China Development Bank and Temasek, a Singaporean government investor. Both of these funds have already bought shares in the British bank at a price far higher than 318p and are sitting on big paper losses. This will give them an opportunity to buy in at a lower price.

According to an adviser acting for a sovereign wealth fund, all the interested parties are carrying out due diligence and the fundraising could be completed within the next 14 days. Barclays is the last of the big British banks to raise capital. Royal Bank of Scotland has already raised £12 billion and HBOS, which was formed out of the merger of Halifax and Bank of Scotland, will this week publish its rights issue document to raise £4 billion.

Unlike RBS, Barclays does not require this capital to shore up its balance sheet, and does not intend to cut its dividend, which currently yields 10%. It is thought the bank’s profits are in line with City expectations. However, Barclays does want to increase its core tier-one capital ratio to over 5.25% compared with its present level of 5.1%.

Barclays Jumps in London Trading, May Sell New Shares
Barclays Plc jumped in London trading after the bank eased concerns that selling more stock will hurt current shareholders and said earnings last month were better than a year earlier.

Barclays, the U.K.'s fourth-biggest bank by market value, gained as much as 13 percent after saying in a statement that existing investors may be able to participate in a share sale to select investors. Pretax profit last month was "well ahead" of a year ago, the London-based bank said.

The bank may need as little as 4 billion pounds to shore up capital and may let existing shareholders "claw back" stock on the same terms offered to sovereign wealth funds, analysts at Keefe, Bruyette & Woods said today. That sum would be a third as much as Royal Bank of Scotland Group Plc, Britain's second-biggest bank, added to capital. Banks worldwide have raised almost $310 billion to help cover losses of $392 billion since the collapse of the U.S. mortgage market roiled credit markets.

"Their backs are not against the wall like others," said Mike Trippitt, a London-based analyst at Oriel who has a "buy" rating on Barclays stock. "Looking at the dividend, asset growth and getting in a sovereign wealth fund are all cards they can play before they consider a rights offer," said Trippitt.

Barclays gained as much as 40 pence, the most since September 1992, and traded up 4.4 percent to 332.25 pence at 1:30 p.m., valuing the bank at 22 billion pounds. The shares have fallen 33 percent this year, underperforming the 22 percent decline of the eight-member FTSE 350 Banks Index.

Barclays could bring its core equity Tier 1 capital, a measure of financial strength, to about 6 percent without selling more than 4 billion pounds of new stock, analysts at Keefe Bruyette, Deutsche Bank AG and Collins Stewart analysts estimated. "This is clearly less dilutionary than a rights issue and also solves the capital shortfall perception," said Alex Potter, a London-based analyst at Collins Stewart in a note to clients today. Potter's "sell" rating on Barclays is under review.

Credit writedowns at Barclays were less than those at RBS, which raised 12.3 billion pounds ($23.4 billion) in new capital and wrote down 5.9 billion pounds this year. HBOS, which is seeking 4 billion pounds in a rights offering, marked down 2.8 billion pounds.

Up to 1 in 4 garages could run dry today as petrol drought worsens
Up to 1 in 4 petrol stations are expected to run dry as the four-day pay strike by tanker drivers enters its final 24 hours. But there are hopes of an end to the dispute after union leaders announced that fresh talks will take place today. The negotiations were welcomed by employers, ministers and the oil company Shell. However, fuel shortages will continue until supplies resume tomorrow.

By lunchtime yesterday, some 647 filling stations had run out of fuel  -  about one in every 14, and far more than had been expected. Some introduced rationing, allowing drivers only £10 of fuel to protect dwindling stocks. Retailers predict there could be more than 2,000 dry garages  -  nearly one in four of the 8,700 total  -  by the time the strike ends in the early hours of Tuesday.

Ray Holloway, of the Petrol Retailers' Association, said: 'At this rate we could be looking at more than 2,000 garages running out of fuel before the strike is over.' There has not been widespread panic, however, and the shortages are less than the strikers had predicted, making the chances of a settlement more likely.

The South-West and North-West of England are two of the worst affected areas, with retailers accusing flying pickets of strangling supplies by preventing fuel leaving terminals at Plymouth and Stanlow in Cheshire for Texaco and other non-Shell garages.

The strike involves 650 tanker drivers belonging to the union Unite and employed by Shell contractors Hoyer UK and Suckling. They demanded a 13 per cent pay rise but rejected an improved two-stage offer that would have taken them to £41,500 a year. Unite has given notice of another strike from Friday, but tonight it said: 'Formal talks will take place with the management.

'It would take very little extra money now to resolve this dispute  -  less than an hour's profits from Shell. We are very close. Where there's talk, there's hope.' Shell's £13.9billion annual profits equate to around £1.6million an hour. Tony Woodley, joint leader of Unite, had blamed the dispute on Shell's 'corporate greed'. Shell runs one in ten of the country's filling stations, but industry sources suggest its market share could be around 14 per cent.

Business Secretary John Hutton said: 'I'm pleased the parties are resuming negotiations. 'This is an encouraging step. I hope it's possible for the two sides to reach an agreement to avoid any repetition of this weekend's disruption.' With fuel costs rising, 40 per cent of smaller firms say they will have to cut jobs in the next 12 months, a study shows.

Florida builders balk at mortgage appraisals
Appraisers are adding insult to injury in a tough market by not properly recognizing the value of a new home compared with one that's been empty and baking in the Florida sun for a year or two, some Lee County builders say. But appraisers, and the lenders who depend on them to determine property values, say they're doing nothing wrong and that developers are victims of a glutted market with houses priced below what a developer can offer.

Either way, the result is the same: A buyer trying to get financing for new construction can find it's tough to convince a lender the house is worth the agreed-upon price. "It's hard enough to get a contract to build a house, let alone making sure it appraises," said Richard Durling, owner of Fort Myers-based Marvin Development and president of the Lee Building Industry Association.

"I've got willing buyers who'll come in and buy the house, we have a contract, and then along comes the appraiser and says it's not worth X, it's worth Y because you can buy a house one block over that's 50 percent less." However, longtime appraiser Michael Maxwell of Maxwell & Hendry Valuation Services said appraisers are comparing apples and apples.

The problem, he said, is there are a lot of houses on the market these days: About 15,000 of them are listed for sale by Realtors in the county. That drives down the price, especially with a recent wave of houses for sale by banks that took them in foreclosure and have them back on the market, Maxwell said.

The median price of an existing single-family home sold with assistance of a Realtor reached its all-time high of $322,300 in December 2005. In April 2008, the last month available, it was down 37 percent to $198,900, according to the Florida Association of Realtors.

China's output rises despite global downturn
China has shrugged off the global economic downturn to report rapidly growing industrial-production output on the back of rising exports. Output rose 16 per cent in May from a year earlier after gaining 15.7 per cent in April, China's statistics bureau said today. The figures signal that the world’s fourth-largest economy is weathering the shocks affecting the global economy caused by the credit crunch.

Growth in retail sales is close to its highest level in a decade, and overseas shipments surged in May. Output from factories appeared untroubled, despite the earthquake that hit Sichuan province and killed around 33,000 people. The province’s small role in manufacturing meant the disaster had little effect on production. The reconstruction work has even boosted output of some products, with state-owned steelmaker Baosteel Group making more colour-coated sheets.

China’s output figures come in the wake of the global slowdown caused by the record price of oil. However, fears that global growth was at risk because of high fuel prices eased today, as oil prices fell for a second day on speculation that Saudi Arabia will increase production.

Meanwhile, China’s output growth is more than double of that of India, the world’s second-fastest growing economy, which saw production rise 7 per cent in April compared with a year earlier. Earlier this month, the Organisation for Economic Co-operation and Development (OECD) said that global economic growth will fall to 1.8 percent this year, a 6-year low. The OECD said China's economy will ease to a 10 per cent expansion after growing 11.9 per cent in 2007.

House Prices, the Wealth Effect and the Cash-in-Hand Effect
House prices are collapsing, which means that homeowners' equity in their houses is plunging. According to Federal Reserve flow-of-funds data, homeowners' equity dropped by $399 billion quarter-to-quarter in Q1:2008 and $880 billion year-over-year - both record absolute declines (see Chart 1). The drop in homeowners' equity contributed significantly to the $1.7 trillion decline in household net worth in the first quarter (see Chart 2).

Economists refer to something called the "wealth" effect. It is hypothesized that households tend to spend relatively more of their income when their wealth is increasing and vice versa. Mind you, households do not have any more cash in hand to spend when the value of their stock portfolios or houses go up. They are just wealthier "on paper."

In this past cycle, it had become very easy for households to turn their increased "paper" housing wealth into actual cash by borrowing against their increased home equity. This borrowing is called mortgage equity withdrawal, or MEW. Active MEW can be defined as mortgage equity withdrawal consisting of refinancing and home equity borrowing. In contrast, inactive MEW consists of turnover.

At an annualized rate, active MEW peaked at $576 billion in the second quarter of 2006. Active Mew has slowed to only $114 billion in the first quarter of this year - the smallest amount since the fourth quarter of 1999 (see Chart 3). There is no doubt in my mind that active MEW, which actually puts additional cash into the hands of households, played an important role in boosting consumer spending in this past expansion.

And there is no doubt in my mind that the recent and likely continued decline in active MEW will play an important role in retarding consumer spending in this recession. Because it has been easier to borrow against the increased wealth in one's house than in one's stock portfolio, dollar-for-dollar, falling house prices will have a more important negative effect on household spending that will falling stock prices.


cj said...

I wonder what is going through the minds of central bankers and political gangsters? There must be either total disbelief or utter terror. Do you raise interest rates or do you cut? It seems that they are between a rock and a hard place. Damned if you do damned if you don't. I wonder what further desperate measures, what insanity they might embrace to prevent what cannot be prevented? Human beings have a very hard time with absolutes. For some reason there is the conviction that there is always some way out. Probably how someone sitting on death row feels as the time ticks down. Funny though, because that same thing is present amongst most everyone in this country. Even though we have been living a life based in everything but reality, we feel that the charade will continue, someone will magically pull the rabbit out of the hat! Presto, everything is back to normal Whew! We got away with it again! When the full impact of what is coming begins to arrive, when the circumstances that fill our lives begin to reflect what we ourselves have created, I suspect that rational behavior is unlikely to be much in evidence.

Anonymous said...

What is a commodity derivative? I know what derivatives from mortgages are, but how do you make up a commodity derivative? Are they futures rolled up into a financial "instrument" and then sold, or what? Thanks.

Anonymous said...

Goldman Sachs Group Inc. and Morgan Stanley are pure scum.

Their greed helped in large part to precipitate this current financial crisis and now they are making up some of their losses by starving people and causing untold human suffering.

Where Karma when you need it, a day late and a dollar short.

. said...

The bank implosions are interesting from the perspective of having been through two publicly held company bankruptcies. I see the new names at Lehman and if it was another sector I'd be Googling a bit to find out if they were M&A specialists or operations wind up guys ... but with them being an investment bank they have internal talent to draw upon no matter which way they need to go.