Friday, August 15, 2008

Debt Rattle, August 15 2008: Dead Zones

G.G. Bain Election Night November 2, 1909
Watching the municipal election returns at the offices of the New York Herald and Evening Telegram.
Results beamed out from the projection booth using slides. William Gaynor was elected mayor.

Ilargi: The world economy is contracting, and not a little bit. So it’s not a surprise that Europe gets hit as well as America.

However, pointing to Europe’s recent downturn as the reason for the rise in the US dollar and Wall Street shares, which is all the fashion these days, is risky.

The European Central Bank and the EU’s main economies have said for a long time that they were unhappy with the strong Euro. It cuts into their exports, for one thing.

What not many have noticed, is that Europe’s hands were tied until now by high energy prices. Which are denominated in US dollars.

Now that oil prices are down 20% or more, the ECB can lower the Euro exchange rate. And that’s what it’s doing, primarily by buying dollars. China, Japan and Russia are only too glad to help out.

For the EU, it means more exports, which now get cheaper abroad. For the US, a higher dollar means less exports -which was the last remaining positive issue in the economy-, as well as higher costs in debt payments -of which the US has a mountain and a half.

The EU pays 20% less for oil, and loses 8% of the value of its currency vs the USD. Add in the rising exports, and it’s clear who’s the winner here. The US policy of debasing its currency is over, and that’s going to cost it a fortune.

The higher dollar is at the very best a potentially lethal double-edged sword. It’s just a waiting game to see when investors will figure this out.

And at home in the US?

• Domestic housing numbers keep falling. The media-induced frenzy over inflation is stealthily used to keep wages down.

• Productivity numbers have gone up a tiny bit on the back of the low dollar, but that’s over now. Job losses will follow. Lots.

• The already greatly perverse government role in the mortgage market is about to be pushed even further: now Ginnie Mae "needs" to be expanded. Promoting homeownership is nothing but the biggest scam of all time. All it does is raise prices, and hence the amount of debt owned to banks.

• And American investment bank Merrill Lynch tries to write off its securities losses on the UK taxpayer. For the next 60 years.

But the American economy and banking system are still in a much worse state than Europe’s.

This time, wage slaves can't revolt
With the price of practically everything jumping, you probably wouldn't mind getting a bigger paycheck.

But your employer isn't the only one who's unenthusiastic about that idea. Fed chief Ben Bernanke is counting on a weak labor market to keep employees from demanding wage hikes, which could in turn boost inflation.

With unemployment rising and jobs moving overseas, you're probably not in the mood to push it anyway. So the good news is that the Fed's probably right when it says that we're not headed for a replay of the stagflation of the 1970s, replete with its so-called wage-price spiral. Unfortunately, that means Americans are going to be feeling poorer - with no end in sight.

On Thursday, the government said consumer prices soared 5.6% from a year ago in July, the biggest year-over-year rise in 17 years. Much of that increase was driven by the soaring costs of food and energy, though Bank of America economist Lynn Reaser notes that prices were sharply higher across the board.

"This number was a shocker," Reaser says, adding that practically "the only benign increase was in health care," where prices - after years of strong growth - were a modest 3.5% above year-ago levels. The textbook response to soaring inflation is for the Fed to raise interest rates.

But Fed chief Ben Bernanke has spent the past year slashing rates in a bid to prop up the financial sector, which is laboring under a mountain of bad loans and broken credit markets. Where financial institutions used to borrow heavily in short-term markets such as the repo market, they now get much of their cash via various federal lending programs.

"They can't tighten credit now, because of where banks are getting their funding," says Howard Simons, a strategist at Bianco Research in Chicago. Moreover, the Fed appears willing, for now, to accept a few months of big headline inflation numbers as long as there's no sign of the dreaded wage-price spiral - the 1970s phenomenon in which inflation took root as pinched workers demanded raises.

With the economy slowing, and wages stagnant for most of the past decade, a weak labor market is giving the Fed room to stand pat. Unemployment has risen by more than a percentage point, to 5.7%, since the housing boom peaked in the middle of this decade. The four-week seasonally adjusted moving average of new jobless claims was 440,500 last week - up 40% from a year ago.

Along with the recent decline in energy prices and a rally in the value of the dollar, the soft labor market numbers should ease the pressure on wage growth, Reaser says. She adds that next month's inflation numbers should look better, given the 20% drop in the price of crude oil since mid-July.

But what's good for the Fed, in this case, is bad for consumers. Combine a slack labor market with falling prices for stocks and houses, and it's clear that Americans' finances are getting stretched by the month - with no end in sight.
"The American worker does not have a whole lot of bargaining power right now," says Simons. "We're looking at the impoverishment of the American wage earner." 

Ticking time bomb
Optimists, look away now. Prices in America’s housing market may have slumped, but the pain for a significant subset of homeowners has barely begun.

Even at Barclays Capital, which spotted some improvements, there is still concern. The bank’s Nicholas Strand says that roughly 1.4m households, most of them in California, hold a particularly nasty type of adjustable-rate mortgage called the “option ARM”.

Although the overall value of option ARMs is lower than that of subprime loans—some $500 billion, according to Mr Strand, compared with about $1 trillion in subprime loans—their sting is more venomous. The option ARM allows borrowers to pay less interest than the formal rate for a limited period (the vast majority of customers choose this option).

In return, the unpaid interest is added to the original loan, a process soothingly called “negative amortisation”. While house prices are rising, the product just about makes sense. If borrowers do get into trouble when they start paying off the loan in full, higher property values offer some wiggle-room.

But when house prices are falling and refinancing is difficult, as is now the case, the option ARM is the financial equivalent of a bikini in winter. Homeowners end up owing more on a property that is worth less.
Delinquencies are already rising fast. Write-offs for option ARMs at Washington Mutual, a stumbling thrift, have zoomed from 0.49% in the last quarter of 2007 to 3.91% in the second quarter.

But the real crunch will come when the mortgages “recast”, forcing borrowers to start making full payments. The loans recast after a set period (typically some five years after origination) or when the principal hits a predetermined ceiling. The biggest wave of recasts is due to happen in 2010 and 2011.

By some estimates, borrowers’ monthly payments will then surge by 60-80% (see chart), at a time when property values may still be at, or close to, their trough. Rating agencies were unusually alive to the dangers of option ARMs: they demanded more collateral to protect holders of securitised-mortgage bonds.

Banks were slower to wake up to the danger. An option-ARM product called Pick-a-Pay (a name that gave fair warning it could lead to trouble) accounts for 45% of consumer lending at Wachovia, a large bank. Wachovia stopped originating loans that allow negative amortisation in June, and is setting aside heftier reserves to cope with expected losses.

It has also waived prepayment penalties for existing product-holders and is marshalling its employees to help move these customers on to conventional mortgages. Such efforts are welcome. But they also signal just how protracted America’s housing woes are likely to be.

US banks in self-reinforcing credit spiral
The second half of 2008 looks like it will put the "self-reinforcing" into "self-reinforcing credit spiral."
Banks in the United States are cutting back drastically on credit to individuals, making mortgages and consumer loans tougher to get and more expensive.

Borrowers in turn are missing more payments, leading to additional write-downs and leaving the banks with still less to lend.
Securitization, once celebrated as the shadow banking system where lenders could pass on repackaged debt to eager investors, is little more than a memory, with the exception of the government-supported Fannie Mae and Freddie Mac markets for buying mortgages.

All of these factors are magnifying one another. And the banks themselves say it is going to get worse. The Senior Loan Officer survey carried out by the U.S. Federal Reserve in July, one of the best indicators of on-the-ground conditions, showed broad and deep tightening of conditions for a range of consumer and housing loans, even in the face of slackening demand.

About 75 percent of U.S. lenders tightened their standards for home buyers, even the best borrowers, in the second quarter. That's a huge majority and up from 60 percent of lenders in the April survey. And if you want a home equity loan, forget it. About 80 percent of banks have raised their hurdles for making loans.

But the most striking tightening was in consumer lending, where about 65 percent of banks made it tougher to get credit card loans, more than double the 30 percent reading in April. Many banks said they would continue to tighten for the rest of this year and into 2009.

"It looks both worse and more broad-based than the crunch in the early 1990s," said Peter Possing Andersen, a senior analyst at Danske Bank in Copenhagen. "You are seeing a second round now where credit tightening is showing up strongly in consumer and business loans."

And of course this will make it worse for consumers and for banks, and demonstrates that the Federal Reserve's unprecedented measures to try to break the cycle have yet to work. The Fed has cut rates, it has orchestrated bailouts and it has provided huge amounts of liquidity through new lending programs. But liquidity and capital are two different things, and what banks lack, and can see dwindling further, is capital.

At the same time, recent announcements from financial companies show that, even putting their constrained capital positions aside, banks are absolutely right to be making credit more scarce and expensive. Consumers are struggling to pay interest on their debts while also coping with high food and energy prices, house prices are still falling and loans thought to be better bets than subprime are going bad at alarming rates.

JPMorgan said it had lost $1.5 billion so far this quarter on mortgage-linked assets, as credit markets deteriorated. It also said that it saw further credit deterioration in its consumer portfolio this year, which will mean they must take more reserves against losses.

It also said charge-offs on home equity loans could keep rising this year, while prime and subprime mortgage charge-offs were likely to rise "significantly." The bank was aggressive in buying market share in 2007 by continuing to lend even as many competitors had to draw back, a gambit that clearly did not work out and has been noted by other lenders.

Fannie Mae, which last month needed government assistance, said last week it would wind down its Alt-A business, which makes loans to borrowers just above subprime in creditworthiness. The lender, which recorded a $2.3 billion loss for the second quarter, said it was being hit hard by increasing defaults and by the increasing costs of those defaults as falling property prices, especially in bubble markets like California, leave them less to recover through foreclosure sales.

It's not an economy that will inspire banks to lend, at least not until the housing markets show signs of bottoming. It is just about possible at this point to construct an argument that says that most of the losses have been concentrated among either foolish, overstretched borrowers or ones unlucky enough to get involved in housing markets that were hugely inflated.

But credit is not just tightening for the foolish or the those in Florida, it is tightening for everyone, and in a weakening economy where it's harder to keep a job. It won't last forever, but the worst part of the crunch is still to come.

Banks leap from foolish risks in mortgages to none at all
Sometimes what appears to be best for every individual is bad for the group. Now is such a time in the banking business.

Banks that took foolish risks in the mortgage business now want to take no risks at all. A similar risk aversion is growing at Fannie Mae and Freddie Mac, the two government-sponsored enterprises - perhaps government-guaranteed enterprises would now be a more accurate description - that dominate the mortgage market.

JPMorgan Chase kicked off the latest downdraft in bank share prices this week when it said in a filing with the U.S. Securities and Exchange Commission that it expected a lot more losses before the mortgage situation stabilized. And what will it do about that? "In response to continued weakness in housing markets," it told the SEC, "loan underwriting and account management criteria have been tightened, with a particular focus on MSAs with the most significant housing price declines."

MSAs, for those of you not up on the jargon, are metropolitan statistical areas, which means areas like Los Angeles or Las Vegas. JPMorgan said it would clamp down on auto loans and credit cards, as well as mortgages, in areas where home prices are falling.

That vow not to lend where the money is needed the most came a few days after Fannie Mae announced a strategy of selling foreclosed properties as rapidly as possible, and of trying to force banks to share some of its losses. Daniel Mudd, Fannie Mae's chief executive, told investors that it was "using a lot of innovative ways to get the property out the door." This is not, he said, a good time to be holding on to foreclosed properties "and hoping for a better day."

I'm not sure what those "innovative ways" were, but I suspect they involved price cutting. RadarLogic, a firm that monitors home sales, tries to separate out what it calls "motivated sales," chiefly by looking at whether a bank or foreclosure service firm is the seller. It says that in such hard-hit markets as Miami and Las Vegas, the motivated sale prices are about 25 percent lower than other sale prices.

Fannie and Freddie are trying to earn their way out of this mess by jacking up the fees they charge to banks for buying or guaranteeing loans. Their expected profit margins on new business is at the highest level in years, and borrowers who can get loans are paying higher rates as a result.

Fannie also vows to force banks to buy back defaulted loans if there is evidence of fraud or violations of procedures. Mudd said that such recoveries were up fivefold and that he expected them to keep rising. Fannie also will stop buying so-called Alt-A loans, which were originally designed for borrowers with clean credit records but without normal documentation of what they earned. Freddie says its portfolio of loans will not grow this year.

It is easy to understand why this is happening. A year ago, when Mudd had a similar conference call with investors, the mortgage crisis was just starting to mushroom, and he conceded Fannie would be hurt. But he had no idea how much hurt there would be. "We fundamentally held our standards," he said. Fannie lost market share in the wild days, but the loans it did make "remained Fannie Mae quality loans," he said, adding, "So we feel pretty good about that."

Those good feelings are gone. Fannie measures its credit losses in basis points - hundredths of a percentage point - of outstanding mortgages. A year ago, Mudd forecast an annual loss rate of 4 to 6 basis points, and scoffed when one questioner suggested the rate might rise to twice that level. Fannie's latest forecast for 2008, raised last week, is 23 to 26 basis points.

Foreclosures are soaring. In 2006, Fannie and Freddie between them acquired 52,967 properties, a figure that leaped 36 percent, to 71,961, in 2007. During the first half of this year, there were 66,420 foreclosures. Not only are there more foreclosures, the losses are much larger.

In 2005, Fannie lost an average of 7 percent of the unpaid principal when it sold a foreclosed property. So far this year, the figure is 26 percent, and in California it is up to 40 percent. In all of 2006, Fannie foreclosed on 93 California homes. The current rate is almost 1,000 per month.

In the year since Mudd said that Fannie had held its standards high, both Fannie and Freddie shares have lost nearly 90 percent of their value. Freddie says it plan to raise $5.5 billion in new capital. With a current market capitalization of under $4 billion, that may not be easy.

Every bank is now acting rationally. They need to conserve capital, so they raise prices, tighten standards and sell foreclosed properties quickly. But when all do those reasonable things, which should have been done years ago, they deepen the crisis for homeowners, and for themselves.

Ginnie Mae's New Role Spurs Concerns
Ginnie Mae, the oft-ignored relative of Fannie Mae and Freddie Mac, has stretched itself thin playing a key role in the federal response to the mortgage mess. A government corporation that helps ensure investor appetite for federally backed mortgages, Ginnie Mae has seen its business quadruple in the past year while its staff has remained nearly flat at 62 people.

Though Ginnie Mae has weathered the strain well so far, some on Wall Street worry that it is becoming overburdened. Adding to the concern: Ginnie will soon take on an even bigger role, due to a federal law that casts the government as the primary cure for the ailing housing market.

"The industry would like to see support for more Ginnie Mae staff," said Allen Jones, the top government lending executive at Bank of America Corp., which became the largest issuer of Ginnie Mae securities after its purchase of Countrywide Financial this year. "They need to have an ability to respond to what is an unprecedented demand for their products."

The government agency's boom has coincided with the collapse of the housing market, which has spurred a huge increase in demand for mortgages insured by the Federal Housing Administration, or FHA. Roughly 97% of FHA loans are packaged into Ginnie Mae securities and sold to investors. Ginnie Mae guarantees the timely payment of principal and interest on the loans, but private companies issue the securities.

The Ginnie Mae guarantee makes them popular with investors. Issuance of Ginnie Mae mortgage-backed securities, or MBS, hit $27 billion in June and $26 billion in July, more than triple the volume for the same period in 2007. Ginnie Mae also guarantees securities backed by the Veterans Administration and rural development loans, bringing total issuance to roughly four times last year's level.

Ginnie Mae securities now account for 30% of the MBS market, up from 5%-7% last year, according to Ginnie Mae President Joseph J. Murin. "We don't know how much higher this volume spike is going to get," Mr. Murin said in an interview. "It is taxing us."

Two decades ago, Ginnie Mae posted huge losses amid defaults of some of the issuers in its program. Today, this isn't as much of a concern. That's because the credit quality of the loans backing Ginnie Mae securities has improved as the FHA has ballooned to meet growing demand.

Still, Ginnie Mae must be prepared to handle a troubled issuer, Mr. Jones argued: "They need to have the staff to send teams on site." The Department of Housing and Urban Development, or HUD, where Ginnie Mae is located, is seeking money from Congress to increase its staff in response to the new housing law.

A portion of the funds would be steered to Ginnie Mae, HUD spokesman Lemar Wooley said. In addition, HUD is speeding up the process to fill existing slots at Ginnie Mae. But, without congressional action, Ginnie Mae will be able to increase its staff to just 69, compared with the 76 that HUD had requested for fiscal-year 2009, agency spokeswoman Terry M. Carr said.

Ginnie Mae is poised to become even more active with the new federal housing law, which will establish a program to refinance as many as 400,000 borrowers into FHA loans and also revamp the FHA, making it more attractive to lenders. The FHA's loan limit, now at close to $730,000, will drop to $625,500 on Jan. 1, 2009. Before Congress raised them, the FHA's loan limits had been nearly $363,000.

Merrill Lynch Faces Cuomo Suit on Auction-Rate Debt
Merrill Lynch & Co. faces an "imminent" lawsuit from New York State Attorney General Andrew Cuomo, who said the brokerage's offer to buy back $10 billion of auction-rate securities doesn't adequately protect investors.

"We have not been able to reach satisfactory terms," Cuomo said today while discussing a settlement in a similar case with Wachovia Corp. "I want them to do it my way." Merrill said Aug. 7 that it would buy back about $10 billion in frozen auction-rate securities at face value, starting in January. Cuomo said at the time that he was evaluating New York- based Merrill's proposal.

Merrill has drawn Cuomo's ire for refusing to reach settlements similar to those he has negotiated with Citigroup Inc., UBS AG and JPMorgan Chase & Co. Cuomo said today that Merrill's buyback proposal doesn't "really protect investors." Earlier this week, he criticized a similar voluntary plan by Morgan Stanley before announcing a settlement with that firm.

"Some institutions have `voluntarily' announced plans," Cuomo said. "I don't think voluntary is the appropriate word when customers were clamoring for this."

Regulators have been investigating how banks and Wall Street firms sold auction-rate securities before the $330 billion market collapsed in February. The investments have been frozen in customer accounts since firms backed away from the market, leading to claims by customers and investigations by the U.S. Securities and Exchange Commission, the states of New York and Massachusetts, and a nationwide task force of state securities regulators

Wachovia to buy back auction-rate securities
State and federal regulators said Friday that Wachovia Corp. has agreed to a preliminary settlement related to the sale of roughly $9 billion in auction-rate securities, the market for which collapsed earlier this year.

Charlotte, N.C.-based Wachovia is the latest high-profile bank to agree to repurchase auction-rate securities hit by the credit crunch. Under the settlement, Wachovia will offer to buy roughly $5.7 billion of auction-rate securities held by individual investors, small businesses and charitable organizations, the Securities and Exchange Commission said.

The bank will also offer to purchase about $3.1 billion of securities held by all other Wachovia investors, according to an SEC news release. The settlement includes investors who bought the securities through Wachovia Securities LLC and Wachovia Capital Markets LLC.

The SEC said the proposed charges are a result of "alleged misrepresentations made by Wachovia to thousands of its customers about the liquidity risk" associated with auction-rate securities. The agency said Wachovia marketed the securities as "cash alternatives."

"We continue to work with state regulators and others to bring real relief to investors who were not given the forthright information they needed in the process of purchasing auction-rate securities," said Linda Chatman Thomsen, head of the SEC's enforcement division. "This agreement in principle with Wachovia, if approved by the Commission, will permit tens of thousands of Wachovia investors to get their money back."

The SEC said the settlement was reached with the help of Missouri's secretary of state, the North American Securities Administrators Association, New York's attorney general and the Financial Industry Regulatory Authority. The regulator's investigation into the auction-rate securities market is ongoing.

"We understand that unprecedented market conditions have created difficulties for our clients, particularly those holding auction-rate securities," said Robert Steel, Wachovia's chief executive, in a statement. "We are pleased to announce a comprehensive solution for the liquidity needs of clients who purchased auction-rate securities at Wachovia and to resolve this matter with federal and state regulators."

Wachovia neither admitted nor denied allegations of wrongdoing. "Today's settlement is a major step towards making these investors whole," said Missouri Secretary of State Robin Carnahan on Friday. "I am pleased that six months of uncertainty and worry is over and that these investors will soon get their money back." New York Attorney General Andrew Cuomo on Friday said Wachovia would pay civil penalties of $50 million.

Auction-rate buybacks top $48bn
JPMorgan and Morgan Stanley on Thursday joined other Wall Street banks in agreeing to repurchase auction-rate securities, a type of long-term debt which has lost a lot of their value, bringing the total size of the industry buyback to $48bn. But in a notable difference from previous settlements, the US Securities and Exchange Commission was not party to the latest bank agreements with Andrew Cuomo, the New York attorney-general, and a taskforce of 12 state securities regulators.

ARS are long-term debt instruments sold by municipalities and other issuers, whose rates are periodically reset at auctions. The sector started to falter when liquidity began to dry up and Wall Street banks stepped back from supporting the market. Regulators have accused banks of misrepresenting ARS as liquid, cash-like instruments.

JPMorgan and Morgan Stanley have agreed collectively to buy back about $7bn worth of ARS from retail investors, and pay fines of $25m and $35m respectively. They would also compensate investors who sold ARS at a loss and consent to a public arbitration process to resolve claims.

The agreements came a week after Citigroup and UBS made deals with regulators to buy back more than $26bn of ARS, and Merrill Lynch, in a voluntary offer, said it expected to buy back about $10bn in ARS – a plan that is being reviewed by regulators. Linda Thomsen, the SEC enforcement director, said the agency’s investigations were “ongoing”.

Mr Cuomo said the settlements were the “latest victory” for investors. He said: “The industry is taking responsibility for correcting a problem they helped create, and that’s a good thing.” But banks’ pledges have not ended action against them. New Hampshire’s securities regulator, which was party to the UBS settlement, filed a civil lawsuit against the bank on Thursday, alleging that it failed adequately to disclose to a seller of ARS that the market was at risk.

The latest suit from New Hampshire claims that UBS, which advised the state’s Higher Education Loan Corporation in the sale of ARS, told the issuer to “increase the interest paid on the bonds to attract buyers to the market, a recommendation which jeopardised the financial well being” of the organisation.

UBS said: “We will vigorously defend ourselves against this complaint as we believe that we worked in the best interests of our investor and issuer clients. This complaint attempts to link a single client interaction with overall market conditions which affected all student loan issuers, and as such we believe there is no basis for these specific allegations.”

Regulators are continuing investigations into numerous banks. Ms Thomsen of the SEC said: “Our investigations are ongoing, and include both potential corporate and individual violations of the federal securities laws. In the event that any such violations are established, the terms of today’s [Thursday’s] settlements would be taken into account.”

Auction-Rate Securities And the Ugly Truth
The big Wall Street firms are finally coming clean about the collapse of the auction-rate-securities market -- now that New York Attorney General Andrew Cuomo and other regulators have put a gun to their heads. The truth is even uglier than I suspected.

Auction-rate securities were sold by nearly all the big firms as a slightly higher-yielding, but safe, alternative to money-market funds. They proved anything but when the auction markets froze in February, stranding thousands of investors with more than $300 billion in illiquid holdings.

As regular readers know, I was among the victims. My shares were issued by BlackRock, the asset-management firm almost half-owned by Merrill Lynch. I've since heard from hundreds of others. Wall Street's reaction was to offer to lend investors their own money -- using our other assets as collateral and charging us market rates. It was insult on top of injury.

It's not like we were clamoring to buy these securities. Like other victims I've heard from, I got a call urging me to take advantage of an offer that was being extended to valuable clients. My pleas to firms to do the right thing and reimburse their clients went unheeded.

Representatives of firms I spoke to either refused to comment or said their balance sheets, already under strain from the credit crisis and their own lending practices, couldn't support such a move. They maintained that they, too, were victims of an unforeseeable crisis.

Thanks to a wave of subpoenas, lawsuits or threatened lawsuits, and the prospect of public disclosure, three of the biggest sellers of auction-rate securities agreed last week to reimburse clients. Citigroup led the pack by reaching an agreement with Mr. Cuomo and the Securities and Exchange Commission to stave off a lawsuit. Merrill Lynch, also under investigation, announced that it would reimburse clients.

And UBS settled a pending lawsuit by agreeing to reimburse clients and pay a $150 million fine. Those firms said they will buy back a total of nearly $40 billion in the securities, a sum that, while large, can indeed be absorbed by their balance sheets.

What's really shocking are the allegations and evidence that some executives may have known that the auction-rate market was about to collapse even as they pressed their brokers to push the product on unsuspecting clients.
Mr. Cuomo's complaint against UBS is a withering portrayal of what he calls a "multibillion-dollar consumer and securities fraud."

At UBS, top bank executives unloaded more than $21 million of their personal holdings of auction-rate securities as they realized the market was in trouble, the complaint alleges. In December, UBS's trading desk manager sent an email to the global head of municipal securities saying, "The auction product does not work." Other emails referred to the securities as a "huge albatross" for the firm and a "scary and delicate" situation.

Yet the firm kept peddling them to clients. According to the complaint, within "hours" of learning of trouble in the auctions, one UBS executive instructed his personal broker that "I want to get out of arcs [auction-rate certificates]" and sold off all $250,000 of his holdings.

More than 50,000 UBS customers ended up owning more than $37 billion of the illiquid securities, according to the complaint. Mr. Cuomo characterized UBS's actions as a "flagrant breach of trust." Katrina Byrne, a spokeswoman for UBS, responded: "We categorically reject any claim that the firm engaged in any widespread campaign to move auction-rate-securities inventory from our own books into private client accounts."

As for the emails, she said, "We were disappointed the New York attorney general released details on certain transactions when we conducted our own internal investigation with the assistance of external counsel. We found no evidence of unlawful conduct by any employees." She added that "there may have been cases of poor judgment," and said UBS is evaluating what, if any, disciplinary actions might be appropriate.

"UBS is not alone in this scheme," Mr. Cuomo maintained. Citigroup, in response to its settlement, issued a statement saying, "Our most important focus continues to be on helping our clients," and added that it would neither confirm nor deny that its officials knew about troubles with the auctions as it continued to sell the securities as cash equivalents.

Merrill Lynch won't comment on whether it continued to sell auction-rate securities after its officials knew the market was in trouble, but an official there told me that he hasn't heard any such allegations. Merrill remains under investigation, and although Mr. Cuomo said he welcomes its offer to reimburse clients, the terms fall short of the Citigroup and UBS standards.

This week, Mr. Cuomo said his probe had been extended to include Morgan Stanley, J.P. Morgan Chase and Wachovia, and there's no indication it will stop there. Monday, Morgan Stanley announced it would buy back $4.5 billion in auction-rate securities -- a move that Cuomo calls "too little, too late."

At least one firm, HSBC, deserves credit for acting more proactively to protect its clients. The firm offered to buy back its clients' auction-rate securities June 20 and completed the purchases by the end of July. HSBC said some customers didn't participate, and the firm is "continuing to address the needs of the few remaining customers." HSBC hasn't disclosed the total amount involved.

I'm glad that I and thousands of other unwitting investors appear likely to get back our money, albeit not for months. But that's not going to restore the trust that's been destroyed. We need to know the truth. We need to know who is taking responsibility. We need to know there has been accountability. And we need to know how we can be sure it won't happen again.

Citigroup, UBS Settle With `Gossip Girl' Investors
Get ready for the auction-rate securities settlement backlash. The major dealers of the once-popular securities are lining up to make their individual investors whole, and pay fines to state regulators besides. Now the question, at least among the more crusty bankers who like to grumble, is: "Why?"

I have already heard from some of them. Their criticism of the settlements is a simple one: I bought this stuff for years, and it was described adequately to me, and last year when I heard the participation at the auctions was getting thin, I sold. People knew about the problems with this market. Why should dealers have to buy any of it back?

This is a viewpoint, albeit a minority one, and deserves at least some consideration. One thing it does is illustrate the huge gap in the level of knowledge between the people who work in the securities business -- you can see they do feel a degree of solidarity -- and everyone else.

If you think about it, this gap is responsible for problems as diverse as the bankruptcy of Orange County, California, back in 1994, to the mass property foreclosures in evidence in certain states today. "Company news is the pornography of business journalism," a colleague said to me the other day. That's what we all call stocks coverage these days: "Company news."

So on the one hand, you have this group of people who crave company news in all its forms. These are your so-called sophisticated investors. How many of them are out there? Let's call it thousands, perhaps tens of thousands. On the other hand, you have the people who are apparently obsessed with Blake Lively and Taylor Momsen of the "Gossip Girl" television show.

This group is numbered, I don't know, in the millions. And never the twain shall meet. I have to admit, when I first heard about the auction market freezing up, I was in the hard-liner camp. Of course, the first I heard about it was when states and municipalities started to pay high penalty interest rates because auctions failed. How terrible! The Port Authority of New York and New Jersey is paying 20 percent!

I waited to hear the moaning and wailing from government finance officers -- and didn't. It turns out, of course, that they knew exactly why they were paying penalty rates. For years, the auction market had done very well by this group -- they had borrowed long-term and paid short-term interest rates. They had saved millions of dollars for the taxpayers.

Great! They also understood that having dealers routinely provide support bids at auctions wasn't a given, even though only a handful of auctions had been allowed to fail in more than two decades. States and municipalities didn't balk. The larger question for them -- and for all taxpayers -- is why they agreed to the egregious penalty rates in the first place. I also didn't have much sympathy for the investors in the stuff, at least not in the beginning.

Didn't they look at what they were buying? Didn't they pore over the prospectuses and the offering documents and all the rest of it before putting down their $25,000 and $50,000 and $250,000? Didn't they know they were relying on market convention rather than contractual obligation when it came to the auctions? Surely they knew all about the Securities and Exchange Commission's two- year investigation into the market in 2004?

And the answer is: No, no, no, and no. That's why the big securities firms -- Citigroup Inc., UBS AG and Merrill Lynch & Co. among them -- are offering, a little belatedly, to provide investors with 100 cents on the dollar. After the dealers stopped supporting the market they had built in February, investors couldn't get their hands on their money.

They sent me e-mails by the score. Nobody ever told them about auctions. The brokers who sold them on auction-rate securities told them that they were every bit as safe as money- market funds, and were cash-equivalents. These investors also got in touch with the SEC, their state attorneys general, anyone who would listen.

Their stories are told in the complaints that have been filed against Merrill and UBS, again and again. They didn't know what they were buying, and their brokers, many of them, really didn't appreciate the risks of what they were selling, or even, in some cases, how it worked.

The dealers, it seems, agree that this stuff was being misrepresented by their own brokers. So back off, grumblers.

What the Auction Rate Securities Settlement Doesn't Do
The New York State Attorney General and the other regulators participating in the auction rate securities [ARS] settlement talks are surely to be commended for their action and diplomacy. Auction rate securities clearly were fraudulently marketed to investors and without the regulatory pressure and investigations; there would be no light at the end of the tunnel.

And lest anyone think Wall Street is owning up to its mistakes, know the real reason banks have come to the table are the potentially ruinous emails and evidence that would have surfaced had an investigation continued. The emails that surfaced at Merrill Lynch and UBS showing ARSs were sold to unsuspecting investors while internally it was clear the market was poised to collapse is the tip of the iceberg in all likelihood.

But putting Wall Street’s disingenuous generosity aside for the moment, based on details of that have emerged, it seems to fall short of true retribution for the fraud which occurred…and I’m not referring to Goldman Sachs’ apparent non-participation.

First off, though it appears that brokerages will be buying back auction rate securities over the course of the next year, clients that suffered consequential damages are left out in the cold. Many of our clients were not able to close on transactions such as homes and tuitions because of the ARS market’s collapse. Non-profits were not able to meet their philanthropic obligations as well. Cases seeking to recover these consequential damages are likely to continue in arbitration.

Secondly, ARSs were fervently pitched to corporations as “cash equivalents,” so many very sophisticated CFOs and comptrollers tied up their free cash flows in these securities. Payrolls were missed, financing opportunities passed by and business operations were hampered. These claims will likely proceed as well.

Thirdly, some investors were able to sell their ARSs in the secondary market, usually at steep losses. It’s currently unclear whether they will be compensated for their losses. And importantly, many angry investors moved their accounts to other firms; and burned brokers, switched firms because their brokerages pressured them into buying and selling auction rate securities.

This seems to be a grey area as well. For example, if an investor left Merrill Lynch after getting ensnared in its ARS offerings, and moved his/her account to competitor, it is unclear whether that investor will be made good.

Finally, it appears that Wall Street will be customarily let off the hook by not admitting any wrong doing. At the very least, senior managers who oversaw the ARS market and were responsible for its marketing should be held responsible. Indeed, when the dust settles on the auction rate securities settlements, its likely Wall Street’s problems won’t go away. As they say, the devils in the details.

Goldman Balks at Helping Rich Clients Recover From 'Auction Rate' Securities
For once, Wall Street isn't bending over backward for its richest clients. That is causing new controversy for investment banks, which have already committed to reimburse mom-and-pop investors, charities, and small businesses for more than $40 billion in illiquid "auction rate" securities. Wealthy clients, institutions and corporations have been largely left out of those pacts.

The quandary is acute for Goldman Sachs Group Inc., which caters only to the wealthy. While a string of large Wall Street brokers announces daily settlements in the billions, Goldman has been mum about its plans, so far refusing to buy back clients' auction-rate paper.

Goldman was a key player in the auction-rate markets, as the No. 5 underwriter of the securities by dollar amount between 2003 and 2007. The firm is regarded as a key contributor to halting the market in February, after it pulled out of auctions supporting the securities. Goldman's well-heeled clients also bought up auction-rate paper, which today has virtually no buyers save for red-faced issuers looking to make good with their customers.

Carl Everett, an adviser to venture-capital firm Accel Partners and a former Dell Inc. and Intel Corp. executive, has been a Goldman private-client group client for several years, and has been satisfied with the firm's service until now. Mr. Everett has investments in auction-rate securities that became illiquid with the rest of the market in February, some of which have been marked down to below their face value.

"The firm has been working with clients to address their liquidity needs," said Goldman spokeswoman Andrea Raphael. "We are cooperating fully with all regulators and it would be inappropriate to say anything further at this time" Regulators say Goldman could come to the negotiating table in coming weeks. But as recently as Friday, Goldman Sachs told Mr. Everett that it will not buy back his auction-rate securities, Mr. Everett said.

"That's disappointing to me -- my expectation is for the Goldman Sachs brand," said Mr. Everett. "My expectation for that is they would honor their position and statement of these securities as cash and cash equivalents."

That has been the recent posture of many Wall Street firms and banks, including Merrill Lynch & Co., Citigroup Inc. and UBS AG, which after months of legal wrangling, agreed to settle most customer claims. New York Attorney General Andrew Cuomo, however, was keyed on the claims of small investors. That left the wealthy, institutions, and corporate buyers of the auction-rates out in the cold.

"Regardless of the settlements, the reality is the investment banks owe equal fiduciary obligations to both retail and institutional investors," Ron Geffner, a partner Sadis & Goldberg LLP, and former enforcement attorney with the Securities and Exchange Commission.

Auction-rate securities are a type of short-term debt that gained popularity because they offered investors slightly higher yields than money-market funds or other fixed-income investments. They also allowed issuers, including municipalities, student-loan organizations, corporations and charities to borrow for the long term, but at lower, short-term interest rates.

The rates reset in weekly or monthly auctions conducted by Wall Street firms. What swelled to a $330 billion market stopped functioning in February when Wall Street firms stopped supporting it with their own bids. "The image of firms being dragged to the table is destabilizing," said Arthur Levitt, adviser to Carlyle Group and a former SEC chairman. "Very few issues have shaken public confidence in the integrity of our markets as much as this."

Mortgage Insurers' Losses Mount
Large mortgage insurers have reported $2.6 billion in losses so far this year, sparking concerns that rising foreclosure rates could force the industry into a money crunch and ultimately make the home-buying process even more difficult.

These insurers make up a critical part of the mortgage industry, taking on the risk when borrowers make small down payments. They are facing record delinquency rates that have sent them scrambling to stem losses and to improve their capital reserves. Those losses have also dinged their relationships with mortgage-financing giants Fannie Mae and Freddie Mac, which the insurers depend on for business.

"What they're battling is a lack of public confidence," said Guy Cecala, publisher of trade journal Inside Mortgage Finance. "They feel like they have enough capital, but nobody really knows." The mortgage insurance industry is dominated by a half-dozen large firms that insure loans when a buyer makes a down payment of less than 20 percent of a home's purchase price.

If the borrower defaults, the insurers pay the lender a portion of the loss. The industry has already paid more than $6 billion to cover claims on foreclosed homes this year, including $3.8 billion during the second quarter, Cecala said. This year's $2.6 billion in losses includes $1.7 billion during the past three months, he said.

If the industry loses its footing, it could transform the way consumers buy homes, either with a return to 20 percent down payments or a shift of even more of the market to the Federal Housing Administration. With FHA mortgages, which require as little as 3 percent down, the government provides the insurance.

Insurers "are a relatively unknown portion of the mortgage market, but could be another wrinkle for mortgage lending," said Steve Stelmach, an industry analyst with Friedman, Billings, Ramsey Group. Challenges facing the industry are significant. Credit-rating agencies, including Moody's Investors Service, have downgraded some of the largest players.

One firm, Triad Guaranty Insurance Corp., is going out of business. Shares of Radian Guaranty, Triad and PMI Mortgage Insurance have lost 90 percent of their value in the past year. For instance, after trading at a 52-week high of $36.25 a share last August, PMI closed yesterday at $2.79.

The industry's future could hinge on whether the economy pushes an unexpected number of homeowners into foreclosure, said Michael F. Grasher, an analyst with Piper Jaffray. The industry currently has enough resources to pay projected claims, he said, "So that's today. What happens a year from now? That is the concern out there, that these companies will face more problems ahead."

The companies say that they are secure despite growing losses. Milwaukee-based Mortgage Guaranty -- the industry's largest player -- lost $97.9 million during the second quarter, but its $4.2 billion in reserves is enough to pay claims and pursue new business, said vice president Mike Zimmerman. The industry has entered a time of uncertainty and much could turn on the rate of delinquencies on loans written in 2007, he said.

Radian expects about 14 percent of the first-lien loans -- which include home mortgages, but not home equity lines -- it currently insures to eventually default. It has set aside $421.8 million to pay out claims this year. But the Philadelphia firm is working to avoid some claims. Radian will advance lenders up to 15 percent of the value of a potential claim to work out an alternative with the homeowner.

"We have an interest in trying to cure as many of these loans as possible. The more loans that are cured means we'll have to pay fewer claims," said Rick Gillespie, a company spokesman. The industry is also tightening its standards to avoid more losses on new loans.

In parts of the country hit hard by the housing downturn, that means that a buyer must have a larger down payment, up to 10 percent, as well as a higher credit score. They will also pay higher mortgage premiums. For a while, it seemed private mortgage insurers could become obsolete.

During the housing boom, many borrowers avoided paying for mortgage insurance by taking out two loans, one that covered 80 percent of the purchase price and the second, a "piggyback," to cover the rest. That was considered a cheaper alternative to insurance premiums.

Facing competition, the industry began to provide insurance for subprime loans bundled by lenders and sold to investors, analysts said. The insurers lowered their underwriting standards to compete, they said. "That to a great extent is where I would say their higher risk exposures came from," said Arlene Isaacs-Lowe, a senior vice president at Moody's Investors Service.

One of the industry's biggest challenges involves its relationship with Fannie Mae and Freddie Mac. The mortgage-finance giants often buy loans with a less than 20 percent down payment and then offset the risk with an insurance policy.

But after being downgraded by credit-rating agencies, several of the insurers fell out of compliance with Freddie and Fannie requirements to do business with them. Both have continued to treat the firms as if they met those standards despite the downgrades but say they are monitoring things closely.

"The current weakened financial condition of many of our mortgage insurance counterparties creates an increased risk that our mortgage insurer counterparties will fail to fulfill their obligations to reimburse us for claims," Fannie Mae said in an Aug. 8 Securities and Exchange Commission filing. During the first six months of this year, Fannie Mae received $830 million from its insurers, up from $547 million during the same period last year.

A strong relationship with Fannie Mae and Freddie Mac is critical to the industry's survival, Cecala said. "All you have to do is say they are no longer eligible to do Fannie, Freddie business and they are out of business," he said of the mortgage insurers' future.

America’s infamous debt clock, near New York’s Times Square, was switched off in 2000 after the national burden started to fall thanks to several years of Clinton-era budget restraint. However, it was reactivated two years later as the politically motivated urge to splurge once again took over.

The debt has since swollen to $9.5 trillion, with the value of unfunded public promises (if you include entitlements such as Social Security and Medicare) nudging $53 trillion—or $175,000 for every American—and rising. On current trends, these will amount to some 240% of GDP by 2040, up from a just-about-manageable 65% today.

David Walker, who until recently ran the Government Accountability Office, has made it his mission to get the nation to acknowledge and treat this “fiscal cancer”. His efforts form the core of a new documentary, “I.O.U.S.A.”, out on August 21st.

The message is simple enough: America’s financial condition is a lot worse than advertised, and dumping it on future generations would be not only economically reckless but also immoral. The biggest deficit of all, the film contends, is in leadership: politicians continue to duck hard choices. It hints at dark consequences.

As America has become more reliant on foreign lenders, it warns, so it has become more vulnerable to “financial warfare”, of the sort America itself threatened to wage on Britain, a big debtor, during the Suez crisis. Warren Buffett, America’s investor-in-chief, pops up to warn of potential political instability.

The film is part of a broader effort to popularise the issue. In 2005 Mr Walker set off on a “fiscal wake-up tour” of town halls; sparsely attended at first, it now attracts hundreds to each meeting (though some may be turned off by the giant pie chart strapped to the side of his tour van).

The young are being drawn in too, even forming campaign groups; Concerned Youth of America’s activists “crusade against our leveraged future” wearing prison suits. Mr Walker is talking to MTV, a music broadcaster, about a tie-up. His profile has been lifted by a segment on CBS’s “60 Minutes” and an appearance on “The Colbert Report”, a satirical TV show, which dubbed him the “Taxes Ranger”.

Promisingly, the new film was well received at the Sundance Film Festival. Some even wonder if it might do for the economy what Al Gore’s “An Inconvenient Truth” did for the environment—perhaps with this comparison in mind, Mr Walker and his supporters talk of a “red-ink tsunami” and bulging “fiscal levees”. But, unlike the former vice-president, he is no heavy-hitter.

And, even jazzed up with fancy graphics, punchy one-liners and a splash of humour, courtesy of Steve Martin, tales of fiscal folly are an acquired taste. Still, “I.O.U.S.A” is a bold attempt to highlight a potentially huge problem. “The Dark Knight” it may not be, but for those who care about economic reality as much as cinematic fantasy, it might just be the scariest release of the summer.

Home Equity Frenzy Was a Bank Ad Come True
“Live Richly.”

That catchy slogan, dreamed up by the Fallon Worldwide advertising agency, was pitched in 1999 to executives at Citicorp who were looking for a way to lure Americans to financial products like home equity loans. But some in the room did not like it. They worried the phrase would encourage people to live exorbitantly, says Stephen A. Cone, a top Citi marketer at the time.

Still, “Live Richly” won out. The advertising campaign, which cost some $1 billion from 2001 to 2006, urged people to lighten up about money and helped persuade hundreds of thousands of Citi customers to take out home equity loans — that is, to borrow against their homes. As one of the ads proclaimed: “There’s got to be at least $25,000 hidden in your house. We can help you find it.”

Not long ago, such loans, which used to be known as second mortgages, were considered the borrowing of last resort, to be avoided by all but people in dire financial straits. Today, these loans have become universally accepted, their image transformed by ubiquitous ad campaigns from banks.

Since the early 1980s, the value of home equity loans outstanding has ballooned to more than $1 trillion from $1 billion, and nearly a quarter of Americans with first mortgages have them. That explosive growth has been a boon for banks.

Banks’ returns on fixed-rate home equity loans and lines of credit, which are the most popular, are 25 percent to 50 percent higher than returns on consumer loans over all, with much of that premium coming from relatively high fees.

However, what has been a highly lucrative business for banks has become a disaster for many borrowers, who are falling behind on their payments at near record levels and could lose their homes.

The portion of people who have home equity lines more than 30 days past due stands 55 percent above its average since the American Bankers Association began tracking it around 1990; delinquencies on home equity loans are 45 percent higher. Hundreds of thousands are delinquent, owing banks more than $10 billion on these loans, often on top of their first mortgages.

None of this would have been possible without a conscious effort by lenders, who have spent billions of dollars in advertising to change the language of home loans and with it Americans’ attitudes toward debt.

“Calling it a ‘second mortgage,’ that’s like hocking your house,” said Pei-Yuan Chia, a former vice chairman at Citicorp who oversaw the bank’s consumer business in the 1980s and 1990s. “But call it ‘equity access,’ and it sounds more innocent.”

Many experts say the ads encouraged Americans to go deeper into debt. “It’s very difficult for one advertiser to come to you and change your perspective,” said Sendhil Mullainathan, an economist at Harvard who has studied persuasion in financial advertising.

“But as it becomes socially acceptable for everyone to accumulate debt, everyone does.” A spokesman for Citigroup said that the bank no longer runs the “Live Richly” campaign and that it no longer works with the advertising agency that created it.

Citi was far from alone with its simple but enticing ad slogans. Ads for banks and their home equity loans often portrayed borrowing against the roof over your head as an act of empowerment and entitlement. An ad in 2002 from Fleet, now a part of Bank of America, asked, “Is your mortgage squeezing your wallet? Squeeze back.” Another Fleet ad said: “The smartest place to borrow? Your place.”

One in 2006 from PNC Bank pictured a wheelbarrow and the line, the “easiest way to haul money out of your house.” In 2003, one from Citigroup said a home could be “the ticket” to whatever “your heart desires.” It continued: “You’ve put a lot of work into your home. Isn’t it time for your home to return the favor?”

In 2004, Banco Popular said in its “Make Dreams Happen” ads: “Need Cash? Use Your Home.” “Seize your someday,” a Wells Fargo ad advised in 2007.

It might seem hard to believe, but not long ago people borrowed money to buy a home with the expectation that they would eventually pay off the debt. A mortgage had a finish line. You mailed your check to the bank every month for 20 or 30 years, paying interest and principal, and bit by bit, at the end you owned your home free and clear.

The newly mortgage-free even used to throw mortgage-burning parties to celebrate their financial freedom. In 1975, Edith and Archie Bunker torched their mortgage on “All in the Family.” Two years later, the Walton family burned theirs on “The Waltons.”

Now the idea of paying off the mortgage and owning a home outright is disappearing. One reason is that many people make smaller down payments on homes than they once did, so it takes longer to pay off their debt.
But another reason is that banks now enable homeowners to keep borrowing. In fact, they encourage it.

Little by little, millions of Americans surrendered equity in their homes in recent years as home prices seemed to rise inexorably from one peak to the next. As a result, the United States has become a nation of half-home owners. For the first time since World War II, the portion of home value that Americans own has fallen to less than 50 percent. In the 1980s, that figure was 70 percent.

After $29 billion loss, Merrill set to avoid UK tax for decades
Merrill Lynch is unlikely to pay corporation tax in the UK for several decades after $29bn (£16bn) of losses suffered by the US investment bank were charged to its London-based subsidiary.

The figures, published in Merrill’s regulatory filings, emphasise how the meltdown in the US subprime mortgage market is undermining tax receipts for governments far beyond America’s borders. They also offer a rare glimpse into the tax management policies of a global financial institution.

The losses arose because almost all of Merrill’s global activity in the market for collateralised debt obligations – complex debt securities, often backed by subprime mortgages – has been channelled through Merrill Lynch International, its UK-based subsidiary.

Merrill has suffered heavy losses on its holdings of CDOs as a result of the credit market turmoil. It offloaded securities with a nominal value of $30bn last month to Lone Star, the US investment group, triggering more writedowns. After the latest sale, Merrill has a UK operating loss of about $29bn that it can carry forward indefinitely for tax purposes.

At the current corporation tax rate of 28 per cent, that means the bank will be able to offset losses against future profits, lowering its UK tax bill by as much as $8bn. Merrill declined to comment. Other banks have suffered heavy losses as a result of the crisis, but these appear to be mainly at the expense of US taxpayers. UBS, the Swiss bank, this week said most of the $42bn the bank had lost as a result of the subprime meltdown was booked in the US.

The majority of Citigroup’s writedowns were also in the US, according to regulatory filings, although its investment banking division in Europe, which is run from London, has suffered losses. Robert Willens, a tax expert, said Merrill’s structure was unusual. “Merrill have to be able to say that the UK subsidiary was the owner of those securities.

It does not matter where the derivatives unit is based or where the trades were executed. The only thing that matters is who was the owner of the securities,” he said. In New York, the heavy writedowns have intensified concerns that some Wall Street investment banks, traditionally large contributors to tax receipts in the city and the state, may not pay taxes for several years as they offset accumulated losses against future profits.

The UK’s corporate tax rate has historically been lower than in other developed countries such as France, Germany and the US, where companies pay taxes to their local city and state, as well as to the federal government. This different tax system has helped to make the City of London a magnet for the global financial services industry.

Based on past levels of activity, it could take Merrill’s UK operations decades to make full use of the tax benefit. In 2006, Merrill Lynch International paid $130m in corporation tax, according to accounts filed at Companies House. If Merrill’s UK subsidiary were to continue to generate profits at 2006 levels, a record year for the investment banking business, it would pay no UK corporation tax for 60 years.

Merrill leaves hole in London’s finances
Two years ago, when Merrill Lynch reorganised its European operations by shifting its main subsidiary to Dublin, the decision sparked concerns that the investment bank was moving business away from London to take advantage of lower tax rates in Ireland.

But following the credit crunch it is likely to be many years before Merrill needs to worry about paying British corporate taxes again. As a result of a quirk of the investment bank’s internal structure, the majority of huge losses it has suffered as a result of the global credit crisis have been booked through its London-based subsidiary.

The result is that Merrill Lynch International, the bank’s UK subsidiary, has accumulated a $29bn operating loss, which it can offset against future profits. “They’re permitted to carry that forward to set against profits of the same trade,” says one London-based tax expert.

Merrill’s figures, revealed in a regulatory filing, illustrate how the US subprime meltdown is directly affecting the UK government’s tax receipts, which are already under pressure from the slowing housing market and economic slowdown. However, the City of London is not the only financial centre feeling the pinch. In New York, politicians are becoming increasingly concerned about the impact on the city’s tax base of the hefty losses suffered on Wall Street.

“It will be a number of years before Wall Street starts paying taxes again,” Michael Bloomberg, the mayor of New York, said at a press conference this week in Manhattan. “They will carry forward all of those losses.” Many financial groups have already recorded sizeable income tax benefits. In the first half of the year, Citigroup recorded a $2.3bn income tax benefit after recording a $4.5bn pre-tax loss from continuing operations. Merrill had a $4.2bn tax credit in 2007.

Merrill is not the only bank to suffer heavy losses. However, rival bankers expressed surprise that the bank’s writedowns had been channelled through its UK subsidiary. UBS, another victim of the subprime meltdown, said this week that the majority of its losses had been booked in the US. Most of Citigroup’s losses have also been reported in the US, where they occurred.

Merrill’s losses arose from its holdings of collateralised debt obligations backed by US subprime mortgages. Even though many of the CDOs were created by bankers based in New York, the bank booked the majority of the business through Merrill Lynch International, its London-based subsidiary, which handles most of its trading and derivatives operations.

According to people familiar with the bank’s structure, Merrill has historically booked most of its global trading and derivatives activity through London. This was partly because British regulators have traditionally been quicker to adapt the tax code and banks’ capital requirements for new financial structures. The UK’s low corporate tax rates were also attractive.

Nevertheless, the losses highlight the ways in which the credit crisis has dented the industry that in recent years has been responsible for a significant chunk of corporate taxes. Large banks accounted for about 30 per cent of the UK’s corporation tax receipts last year, according to a study by PwC, the accounting firm. But this figure is likely to be lower this year as a result of writedowns across the banking sector.

Meanwhile, Wall Street banks are estimated to account for about 20 per cent of New York state’s revenues and 9 per cent of the city’s tax receipts. Traditionally, financial groups have paid taxes on the earnings in advance – a measure that protects them from being fined for underpayments.

As a result, the huge tax losses they are accumulating could prompt the banks to ask the government for refunds as well as sharp reductions in future tax liabilities. That, in turn, would worsen the fiscal plight faced by both New York city and state.
New York state is projected to record a $26bn deficit during the next three years and a $630m shortfall in the current year.

David Paterson, New York’s governor, said recently that tax receipts from banks had fallen sharply during the past few months.
However, bankers point out that financial institutions also contribute to the tax base by employing large workforces who pay income tax and sales taxes.

Indeed, from the City of London’s perspective, Merrill’s heavy tax losses may provide a welcome boost at a time when employment is under pressure: “With this kind of a tax loss to work with, Merrill might decide it makes sense to shift business to the UK from other parts of the world,” a tax expert says.

UK home repossessions rise 24%
The number of homeowners in England and Wales threatened with repossession rose by a quarter in the year to the end of June, official figures showed today.

The Ministry of Justice said lenders made 28,658 possession orders against borrowers in the second quarter of the year, 24% more than in the same period of 2007. The figures were up 4% on the previous quarter, suggesting a slight increase in the number of homeowners struggling with their debts as rising bills squeezed their finances.

Meanwhile the number of possession claims – which is the step before the case is heard in court – reached 39,078.
Although the ministry said claims were running at the same rate as in the first three months of this year, this is 17% up on the figure for the second quarter of last year. Last year, the number of repossession claims reached a 15-year high, at 137,591, and the signs are that it will be even higher this year.

Today's data does not reflect the number of homes actually repossessed by lenders but shows how many court actions have been started against homeowners. Some homeowners may be threatened with action by more than one lender, if for example they have a loan secured on their property as well as a mortgage, and some cases will result in a payment plan being reached.

The figures show 48% of the possession orders granted by courts in the quarter were suspended to give the borrower time to pay off outstanding installments and arrears. Last week the Council of Mortgage Lenders published figures showing the number of properties that had been taken into possession in the first half of the year.

Its figures, which covered the whole of the UK, showed 18,900 homes had been repossessed between January and June, the highest figure for 12 years. Homeowners have been squeezed by rising energy and food costs and increased mortgage repayments as the credit crunch has pushed up rates.

More than 1 million borrowers are set to come off fixed-rate deals this year, and many of these have faced, or will face, a jump in monthly mortgage costs which could push some into difficulty. As a result the CML is predicting a 50% rise in repossessions this year, with 45,000 borrowers losing their homes. This is still well below the worst year for repossessions, 1991, when 75,500 homes were seized by lenders.

Concerned about rising claims, the Financial Services Authority has urged lenders to use repossession only as a last resort, saying that in the past some have been too quick to start court action against borrowers. Specialist sub-prime lenders, whose customers already have poor credit records, seem to have been particularly keen to start repossession proceedings.

The housing charity Shelter said lenders were "still using repossession as the first rather than last resort" and that in the last six months it had seen a 55% increase in people contacting it for help with a possession action. "Tens of thousands are living with the fear of having the home they've worked so hard for being repossessed by lenders with little compassion," said its chief executive, Adam Sampson.

"After months of rising repossessions, tumbling house prices, and the fear of negative equity this is further depressing news for homeowners, many of whom must be thinking 'am I next?'. "We would urge people who are finding it difficult to meet their mortgage payments to seek advice early. Don't ignore warning letters from your lender as this only makes matters worse."

In recent months the government has stepped up help for homeowners threatened with repossession, and last week it increased funding for legal advisers at county courts around the UK.

The housing minister, Caroline Flint, said: "As well as expanding free legal representation in county courts for households at risk of repossession, we are providing more free debt advice, and are working closely with lenders to ensure that repossession is only ever a last resort. "These services can make a real difference, with more than 80% of repossessions avoided when they are used."

Some investment banks could join Incy Wincy spider down the drain
Incy Wincy spider climbed up the water spout,
Down came the rain and washed the spider out,
Out came the sun and dried up all the rain,
And Incy Wincy spider climbed up the spout again.

Until recently, I have always assumed that Incy Wincy was not all that bright. Despite compelling evidence that the fun of climbing up the water spout would inevitably be followed by the pain of being half-drowned in an avalanche of water, Incy (we are on first name terms) went right back to his old climbing ways.

As a result of the credit crisis, I have been forced to rethink my assumptions. It now strikes me that investment bankers, who we all know are pretty smart, tend to behave rather like Incy. Every couple of years or so, there is a major reversal in financial markets - Black Monday in 1987, the junk bond market collapse, the bursting of the dotcom bubble.

It is terrifically painful for a short while, and then the sun comes out and bankers go back to making lots of money. I now realise that Incy's behaviour was entirely rational. The water spout, which I had thought of merely as a tubular appliance, was in fact stuffed with delicious flies and grubs, which Incy happily chomped on his way up.

A quick dousing with water every once in a while could therefore be viewed as an unpleasant but necessary corrective, which stopped Incy from gorging himself to death. How would Incy feel, though, if next time he ventured up the spout there were hardly any bugs and the pipe was much trickier to climb?

He would, I am sure, be overcome with nostalgia for the days of plenty and even look back fondly on his regular cold showers. Investment bankers, I suspect, feel much the same way, one year into the credit crisis. All banks have suffered - write-offs and loss provisions so far total around $500bn and counting.

Commercial banks which take deposits and lend to consumers and companies undoubtedly have more pain to come, as mortgage and other default rates rise. But investment banks, which operate in wholesale markets, have big problems to grapple with too.

Not only have they found it harder and more expensive to finance themselves, but they also face regulatory restrictions on their activities. At first sight this seems illogical: surely it is commercial banks, which hold people's hard-earned cash, which should be squeezed? But they are already more strictly regulated.

Because of Basel capital requirements - which are currently being tightened further - commercial banks have tended to be less highly leveraged than investment banks and to make lower returns on equity as a result - generally around 15pc, compared with, in recent years, 25pc to 30pc for the investment banks.

Logically, it seemed acceptable for investment banks to take greater risks, for example through proprietary trading, because they were not playing with retail depositors' money, and therefore could be allowed to fail. The rescue of US investment bank Bear Stearns, which proved unable to finance itself in panicky markets, destroyed that myth overnight.

If investment banks have to be bailed out because of the threat to the broader financial system, that means taxpayers may have to foot the bill. So proprietary traders may not be playing with depositors' money, but they are risking taxpayers' money. The investment banking business model has been thrown up into the air.

This must be rather galling for some. Goldman Sachs, one of few financial institutions to have come through the crisis with its reputation intact, nevertheless has some serious thinking to do about its future shape. One obvious answer would be to buy a deposit base - in other words a commercial bank. Goldman could afford to do this and there are plenty of moderately sized ones on offer.

In the past, most investment banks haven't done so because it would have depressed their return on equity, but higher wholesale funding costs and shortage of capital have shifted the economics of that calculation. The other option for investment banks is simply to dump certain activities and become hedge funds or private equity firms.

They might end up looking like Blackstone, a private equity fund with a growing advisory business, or even an old-fashioned marketmaker. The universal banking model favoured by European banks such as UBS and Deutsche Bank is also under pressure. Like Gordon Brown, UBS once had a reputation for prudence.

In fact, the favourable funding terms enjoyed by UBS - because it was a highly rated, supposedly conservative and well-capitalised bank - were used to finance risky trading activities. In other words, its "safer" structure, relative to investment banks, encouraged it to take bigger risks - hence this week's stricter separation of its business units.

Albeit too late, complacency about the capacity of the financial system to absorb shocks has been blown apart by the credit crisis. Take these lines from a report last week by a group of leading bankers. "In the private sector, greater financial discipline at individual institutions must be reinforced by a renewed commitment to collective discipline?.?.?.?there are circumstances in which individual institutions must be prepared to put aside specific interests in the name of the common interest?.?.?."

The Counterparty Risk Management Policy Group III (clearly, no money wasted on a branding consultancy) has a remit to come up with industry initiatives to reduce systemic risk. A cynic might suggest that this is the investment banking industry scrambling to make some proposals it can live with before politicians and regulators impose even more draconian rules.

There is undoubtedly an element of this, but the diagnosis is candid and the remedies suggested quite radical - among them, strict limitations on who can buy complex instruments, tighter risk management and a reduction in off-balance sheet structures.

These would all be costly measures, but, as the report points out, less costly than the billions of dollars of writedowns and economic slowdown caused by the credit crisis. Investment banks are, historically, skilled at adapting rapidly to changing conditions. This time, they really have their work cut out. And it seems likely that some may be washed down the drain before the sun comes out again.

How Wall Street's watchdog may be muzzled
For Bear Stearns, the end came with a sonic boom. With Fannie Mae and Freddie Mac, there has been a "dead man walking" hush since the Treasury stepped in to prevent their collapse. But for another of the major institutional victims of the credit crisis, we may be only at the start of a slow death.

That victim is the Securities and Exchange Commission, Wall Street's regulator for the past 74 years. For months, the agency has seemed superfluous to the battle to protect global finance. After the Federal Reserve came to the rescue as a lender of last resort to beleaguered Wall Street banks, the SEC could only watch as the US central bank rode roughshod over its traditional territory.

Worse, when the SEC finally did pipe up, its actions against short-sellers were widely damned as a hysterical over-reaction. Now the SEC's chairman, Christopher Cox, a mild-mannered former Republican congressman, stands accused by some of his own staff for failing to stand up for the agency, as the Bush administration manoeuvres to replace it with something more amenable to Wall Street.

That fraught weekend in March, when the collapse of Bear Stearns threatened to engulf the rest of the financial system, it was the Federal Reserve, under its activist chairman, Ben Bernanke, which stepped in with the billions of dollars in credit needed to keep the investment bank on life support.

And it was the Fed which underwrote the cut-price takeover of Bear by extending $30bn in lending to its acquirer, JPMorgan Chase. Since then, it has agreed to extend credit wherever necessary to investment banks, something it previously only did to the deposit-taking commercial banks directly under its supervision.

Since then, the Fed has been arguing that, now everybody knows that it will prop up the investment banks, it needs also to have the power to regulate them – power that currently resides with the SEC. An uneasy "memorandum of understanding" between the Fed and the SEC, which allows for the sharing of information, is hardly going to be the last word.

Whichever party controls Congress and the White House after November, an overhaul of financial regulation in the US is going to be on the agenda. In this climate, revelations that Mr Cox was not on crucial conference calls between the Fed and the US Treasury during the effort to prop up Bear Stearns are particularly damaging.

He was at a birthday party on the Saturday night in question, and went on holiday a week later, with global finance still on life support – and his protestations of having been constantly in touch have done little to improve the perception of irrelevance.

The SEC is vulnerable to losing its powers of oversight over the investment banks, says the former SEC commissioner Roel Campos, now a partner at the law firm Cooley Godward Kronish – and he doesn't reckon that would be a good development.

"I don't think a lot of the criticism is fair, but the SEC has not done as good a job in describing its role and what it was doing immediately prior to the collapse of Bear Stearns. It is not widely understood that the SEC was there with the Fed, looking at the risk management of Bear Stearns on a day-to-day basis for a long period before its demise.

The SEC has huge amounts of knowledge about how broker-dealer functions work and about the intricate relationships between counterparties – expertise that is not at the banking agencies and not at the Fed. By pointing that out, the SEC could recover some of its credibility.

"The SEC has not had a champion with the Treasury, and the chairman has chosen not to make his case for the agency loudly. Mr Cox is a team player and doesn't want to be seen as at odds with the Treasury, but the people thinking up policy are naturally favourable to the Fed."

The creation of the SEC in 1934 was part of the effort to rebuild American finance after the horrors of the Great Depression. It was the organisation charged with ensuring that companies and brokers who offered securities for sale to the public actually told the truth about these investments and their risks. To reflect its importance, President Franklin D Roosevelt appointed Joseph Kennedy, President John F Kennedy's father, to serve as the first chairman of the commission.

That easy division, with the SEC looking after the investment banks and the Fed guaranteeing and controlling the commercial banking system, has looked a bit anachronistic since the repeal of the Glass-Steagall Act by the Clinton administration, which allowed investment banks to create their own lending operations and helped to puff up the entire edifice of leveraged lending and complex derivatives that has come crashing about our ears.

This has been monitored by the SEC under an informal agreement with the investment banks. The battle over who gets the ultimate power to regulate it, when it gets slowly rebuilt after the current crisis, is a battle the SEC appears to be losing.

"There is growing bifurcation between investor and consumer protection on the one hand, and the safety and stability of markets on the other, and we are at a watershed," says James Cox, a securities law professor at Duke University who is no relation of the SEC chairman. "The debate now is about whether the market stability function will go with the Fed or with a new executive arm.

"One place it is not going to go is the SEC. Frankly, there has never been evidence that the SEC has the tools or the culture to deal with market stability issues. It has an enforcement culture, with strengths in fraud, company filings and disclosure rules.

"As the credit crunch has unfolded, the SEC has looked superfluous. Partly that is because of its remit, but partly it is because of the natural hesitancy and reticence of Christopher Cox and his senior advisers about what is the proper role of governments in markets.

They believe in letting institutions shake out. Hank Paulson, US Treasury Secretary, and Mr Bernanke have proven themselves 'survivalists', who have been able to overcome their predilection towards market forces."

It won't have helped the SEC's cause that when it came to the issue of auction-rate securities – the first and most obvious mis-selling scandal of the credit crisis, where hundreds of thousands of ordinary investors were stuffed with impossible-to-sell bonds they thought were the equivalent of cash – it has been Andrew Cuomo, the combative attorney-general of New York state, who has wrung restitution out of brokers thanks to his legal threats, rather than the SEC.

And Mr Cox did not appear to cover himself in glory with regard to short-selling. He surprised the market with an emergency rule that made it much more difficult for hedge funds to bet on declines in the share prices of 19 major financial companies, announced to coincide with an appearance before politicians on Capitol Hill, but the details of which did not emerge for hours, had to be tweaked several times before they could be introduced, have not been proven to have influenced the trading in any of the stocks, and ultimately were left to expire this week, undermining Mr Cox's insistence that they were vital to preventing financial panics.

Christopher Cox has begun pressing his case for regulation of the investment banks to stay with a beefed-up SEC. But he starts an important battle for the soul of US financial regulation several laps behind the Federal Reserve and opponents on Wall Street who see this as the perfect time to take a few teeth out of the SEC.

A blueprint for regulatory reform by Mr Paulson, which envisages the Fed as a super-regulator with only a narrow role for the SEC, was forged out of Wall Street's frustration with SEC red tape and what investment banks complained was their diminishing competitive advantage over London.

Britain, they argued, had a risk-based approach to regulation that was light-touch in day-to-day matters and only descended on institutions regarded as risking damage to the financial system. The SEC, with its raft of rules, would be wrapped into a much-diminished third-tier regulator responsible for protecting investors and market participants from fraud and market manipulation.

Supporters of the SEC, such as Mr Campos, argue that the stage is set for a battle between those who favour the current SEC approach, an "enforcement" approach to regulation, and those who prefer a "prudential" approach which, he argues, would "blunt regulators' teeth". It is a battle that can be won in a Democrat-controlled Congress or with a Democrat administration, he says – but only if the SEC starts fighting for its life.

"Where's The Kaboom?"
Take your pick last night.  Right after the market closed, the dollar started strengthening again.  A lot.
Then, suddenly, the floor dropped out of Gold, and the S&P 500 Futures spiked HARD, with over 2,000 contracts bought at the market. A few hours later, it happened again.  And at 4:30, once more!

What in the Sam Hell is going on? Simple, really.  See, there are what - 8,000 hedge funds?  Well, for 7,999 of them (up until the last few days anyway) they have all been in one trade, more or less - short dollar, long energy, short financials. Nice, if and when it works.

But now that trade has been unraveling at a frightening rate.  As the dollar has gotten stronger it has squeezed people.  Hard.  See, these guys are not just investing the money they get from rich folks all over the world - they are taking that money and borrowing, then investing that.

So when these bets go bad - oil falls, the dollar goes higher, or any of the "parameters" they've been working get the rug pulled out from under them, they have a huge problem, all at once, and they have a very bad hair day. That's happening.  In spades.

This is where the "recovery" has come from in the stock market the last month or so - you kick the shorts in the nuts and they cover, then the lemmings rushing in, once again listening to the idiotic calls of "the bottom is in" from media outlets like CNBC that will shove a microphone under the snout of anyone who toes that line.

This trade started unwinding slowly, but in the last week or two it has gotten very disorderly and so have the markets.  As credit has continued to deteriorate the weaker hands get flushed and forced out.  This causes them to have to buy back their short dollar trade, which spikes the DX. 

THAT in turn spooks someone else, who then covers a big futures short, which in turn freaks out someone in the gold market, and they dump a big long. Rinse, repeat, and continue until the dead bodies are all piled on the floor and only the cockroaches are left scurrying around.

Oh, and those very same Hedgies are some of the guys "guaranteeing" the credit in these default swaps, which means as they go down, credit continues to blow wide, never mind the actual deterioration which is far worse than claimed because these so-called "guarantors" can't actually pay.

What you need to understand is that there is nothing that can be done to stop this.  Not by the government, not Bernanke, not The Fed, nobody.  The overly-geared will die, one by one, until there is nobody left who has too much gearing on for the trade and credit risk they took.

What's worse is that some of our "big institutions", sensing this - that credit quality is deteriorating very, very rapidly, are looking for someone, anyone, to offload the bag to.  Over the last few months they've found a few people they can try to throw the bag at - maybe those with poor risk controls, with automated trading systems that aren't actually verifying anything, and perhaps there's a bit of a pollyanna view at a few of them too?

If you can't find those folks because there aren't any of that sort buying the debt you're desperate to unload (since you know its going to go "boom!") then the next move is to "sell" that debt to some private equity guy but carry back the financing (in some cases on a non-recourse basis!), as several folks have done recently, which makes it look like you got 20 cents on the dollar when in fact you only got 5. 

For the Hedgie or P/E guy who makes the bet, its not a bad deal - they have a defined risk trade, like a CALL option.  For you, the writeoff is real but its 75% less than it should have been, with the rest sitting out in limbo pending the truth being discovered in the fullness of time (when the deal blows up and your "non-recourse" deal comes back at you like a boomerang.)

How many of those folks will die, and what impact will it have on the credit markets in general?  I can't quantify it accurately - I don't think anyone can.  But what is obvious from the magnitude of these "little tremors", and the rapidly increasing rate at which they are coming, is that:
  1. Its very bad.
  2. Its getting worse, at an increasing rate.
  3. A number of supposed "liquidity providers" have either been gamed (and this has not been recognized and reported to the public) or they're "buying" this debt with carried-back loans, making their actual risk of loss tiny compared to the nominal "value" transferred.  In other words and to put it in terms "Joe Q Public" can understand, everyone is still lying!
  4. There is a "supercritical" point where all asset values will get hit at once, unless the process runs to exhaustion first, and I don't think there is a snowball's chance in Hell that it will.

I may be wrong about the impending supercriticality, but if I'm not, well, it would be a good idea to be sure you are in safe places with your money.  Equities and debt other than treasuries would be in the "not" column on the list of safe instruments, and note carefully the very specific constraint on exactly what sort of debt is safe - all other, and I do mean all, is not.

German, French Economies Shrink as Spending, Investment Falter
Germany and France, the euro area's two largest economies, contracted in the second quarter as faltering sales undermined investment by companies and soaring costs eroded consumer spending power.

German gross domestic product fell a seasonally adjusted 0.5 percent from the first quarter, when it rose a revised 1.3 percent, the Federal Statistics Office in Wiesbaden said today. In France, GDP declined 0.3 percent, reversing a 0.4 percent gain in the previous three-month period.

The stronger euro and slower global growth have damped demand for euro-area exports just as faster inflation erodes domestic purchasing power. Confidence in Europe's economy has fallen to the lowest in almost 15 years and European Central Bank President Jean-Claude Trichet last week said growth will be "particularly weak" through the third quarter.

"There are two factors here: a correction from the strong first quarter and an underlying slowdown," said Aline Schuiling, an economist at Fortis in Amsterdam. "The first-half picture is of moderate growth and it is going to remain weak in the euro zone for the remainder of the year."

The euro-area economy probably shrank by 0.2 percent in the second quarter from the first, when it expanded 0.7 percent, according to the median estimate of 40 economists in a Bloomberg News survey. The data will be published at 11 a.m. today.

Even with the weaker growth, the ECB last month raised its key rate to 4.25 percent, a seven-year high, to curb inflation. German consumer prices rose 3.5 percent in July from a year earlier, the statistics office said today, revising up its initial 3.4 percent estimate. European inflation quickened to 4.1 percent last month, more than twice the ECB's 2 percent limit, according to a first estimate on July 31.

Spain's economy grew at the slowest pace since a 1993 recession in the second quarter as the country's once-booming construction industry slumped, according to separate figures today. Italy's economy, the third-biggest in the euro region, unexpectedly shrank in the April-June period, edging closer to a fourth recession in a decade.

An index measuring the economic climate in the euro region dropped to the lowest since 1993, the Munich-based Ifo institute said yesterday. Measures of both current conditions and expectations declined, according to institute's quarterly World Economic Survey.

The economic slowdown isn't confined to the euro area. The Bank of England yesterday cut its forecast for U.K. economic growth as unemployment rose the most in almost 16 years. The central bank's governor, Mervyn King, also said there is the "possibility of a quarter or two of negative growth."

In China, industrial production expanded in July at the slowest pace since February 2007, as cooling global growth curbed orders for goods and higher fuel and raw-material prices deterred some companies from expanding. Trichet, speaking last week after the ECB kept its benchmark rate at 4.25 percent, said the central bank has "no bias" on interest rates and he removed a reference from his introductory statement to "moderate, ongoing growth."

While oil prices have retreated 20 percent from a record $147.27 a barrel reached on July 11, they are still 60 percent higher than a year ago. The euro, which rose to a record $1.6038 on July 15, has gained 10 percent in the past 12 months. Ryanair Holdings Plc, Europe's biggest discount airline, last month said it may post the first full-year loss since going public in 1997 on higher fuel costs.

"The real slowdown is only starting now," said David Kohl, deputy chief economist at Julius Baer Holding AG in Frankfurt. "The worst is still ahead." Cooling growth has prompted investors to start to price in interest-rate reductions. Yields on Eonia forward contracts, a widely used market gauge of interest-rate expectations, have fallen in the past month. The yield on the March contract dropped to 4.14 percent today from 4.38 percent a month ago.

German factory orders have fallen for the past seven months and dropped the most in a year in June, according to figures published last week. An index of European manufacturing and services activity fell to 47.8 last month from 49.3 in June, where below 50 indicates a decline.

Some companies are trying to offset falling western European and U.S. orders by expanding in eastern Europe, oil- exporting countries and emerging Asia. Hochtief AG, Germany's largest builder, today reported a jump in second-quarter profit and increased its full-year forecasts on rising demand for construction and mining work in Australia and Asia.

In Germany, the second-quarter contraction was exacerbated by companies bringing forward investment in construction due to unusually mild weather in the first three months of the year. The decline in GDP, better than the 0.8 percent median forecast of 41 economists surveyed by Bloomberg, was mostly due to a drop in construction, capital investment and consumer spending, the statistics office said. The French contraction was unexpected, as economists had expected 0.1 percent growth.

Spain in crisis, Europe crumbles, ECB slammed
The economies of Germany, France and Italy all contracted in the first quarter and may now be in full recession, shattering assumptions that Europe would prove able to shrug off the effects of the credit crunch.
The picture is darkening so fast in Spain that Prime Minister Jose Luis Zapatero cancelled holidays and called his cabinet back to Madrid yesterday for the first emergency session of its kind since the Franco dictatorship. The crisis meeting agreed to a €20bn (£16bn) blitz on public works, tax cuts, and a mortgage rescue to halt the downward spiral.

Growth has turned negative in Ireland, Denmark, Latvia, and Estonia, while grinding to a halt in Sweden and The Netherlands. Iceland contracted by a staggering 3.7pc. The grim data from Eurostat follows a recession warning in Britain, and shock news that the Japanese economy had shrunk 0.6pc in the second quarter.

Almost the entire bloc of rich Organisation for Economic Co-operation and Development (OECD) countries - still two thirds of the world economy - are now in the grip of a major downturn. The oil shock over the early summer appears to have had a dramatic effect on the heavy industries of Japan and Germany.

The eurozone as a whole shrank by 0.2pc, the first contraction since the launch of the single currency a decade ago. Germany led the slide with a fall of 0.5pc. France and Italy fell 0.3pc. The delayed effects of the strong euro, tight credit, and slowing exports have now kicked in with a vengeance.

"This is an alarm warning for the economy," said the Confederation of German Industry (BDI). The European Central Bank and its president Jean-Claude Trichet appear to have misjudged the severity of the downturn, and may have made a serious error by raising interest rates a quarter point to 4.25pc last month. By then it was already clear that property markets were slumping across much of the region.

“What is shocking is the speed of the collapse in Germany,” said Albert Edwards, global strategist at Société Générale. “I think there has been a lot of hubris at the ECB. They took a derisory attitude towards the US, saying the Federal Reserve was too aggressive in cutting rates. Now they are reaping the bitter reward of their policy,” he said.

The ultra-hawkish Bundesbank’s Axel Weber gave no hint yesterday that the ECB is softening, suggesting that the bank sees a deliberate crunch as the only means to pre-empt a 1970s-style wage-price spiral. “The confidence expressed by some observers that weaker economic growth will lead to a damping of inflation pressures is in my opinion premature,” he said.

This is a highly controversial point. Although fuel and food prices have pushed headline inflation to a post-EMU high of 4.1pc, core inflation has fallen from 1.9pc to 1.8pc over the last year. Real wages have suffered a brutal squeeze. Julian Callow, Europe economist at Barclays Capital, said the ECB erred by pre-announcing a rate rise in June.

“They boxed themselves in, and it became hard to retreat. It is clear from the August Bulletin that they have now really woken up to the downturn,” he said. “Recessions in Europe are very nasty events: they tend to be a lot deeper and more protracted than in the US, which is better able to cope with the ups and downs of the business cycle,” he said.

Mr Callow said the EU’s budget deficit limit of 3pc of GDP makes it impossible for many countries to cushion the hard-landing with a spending boost. France and Italy are already near the ceiling. Indeed, Italy is having to tighten policy into the downturn.

Bernard Connolly, global strategist at Banque AIG, said the eurozone faces possible disintegration unless there is a fiscal bail-out from Germany that matches – in sheer scale – Berlin’s Versailles reparations payments after the First World War.

“The bursting of the EMU credit bubble seems imminent, and will reveal current account imbalances among euro area countries as extremely dangerous. The medium-term feasibility of the euro area in its current form must be open to very considerable doubt,” he said.

Spain needs a devaluation of 30pc and Greece needs 40pc to restore balance to their economies after suffering a major loss of unit labour competitiveness. The current account deficit is 10pc of GDP in Spain, and 14pc in Greece.

Mr Connolly said the combination of collapsing demand in southern Europe and a slide in the external value of the euro now means that the EMU bloc may now start to export the effects of its troubles to the rest of the world, making it harder to bring the credit crisis to an end.

Eurostat said Spain managed to eke out growth of 0.1pc in the second quarter but this is a lagging indicator. The switch from boom to bust is now turning violent. There are mounting fears that the country could tip into a severe crisis over the next year.

“A momentous economic slowdown is now under way. We believe the deterioration in Spain is just in the beginning stages,” said a report by Morgan Stanley. It said there was a serious risk of a blow-up comparable to the ERM crisis in the early 1990s. This time there is no easy exit. Spain cannot devalue within EMU, or resort to emergency monetary stimulus.

The Bank of Spain revealed yesterday that Spanish lenders have now borrowed €49.4bn from the ECB, confirming reports that smaller banks with heavy exposure to the property market are now relying on EU taxpayer funding to survive. It is unclear whether long-term support of this kind is strictly legal under EU rules.

Some banks appear to be issuing fresh bonds for the sole purpose of obtaining money from the lending window in Frankfurt. Spain’s finance minister Pedro Solbes says it was clearly “unsustainable” for the country to build 800,000 homes last year in the final crescendo of the boom, but said there was nothing the government could do to stop it.

“The economic situation is worse than we all predicted. We thought it would happen slowly but instead it has hit fast,” he said. Construction reached 18pc of GDP in 2007, much of it funded from foreign capital sources that have now dried up. The sector is in freefall. Unemployment has jumped by 457,000 over the last year. Industrial output plunged 9pc in June.

Hong Kong's Economy Shrinks For First Time in Five Years
Hong Kong's economic growth slowed more quickly than expected in the second quarter, showing its first quarter-to-quarter decline in five years as the effects of financial problems elsewhere spilled into the territory.

Gross domestic product dropped by 1.4% on a seasonally adjusted quarter-to-quarter basis -- the first such decline since the second quarter of 2003, when Hong Kong was hit by an outbreak of severe acute respiratory syndrome, which brought some segments of the economy almost to a halt.

The government said GDP rose by 4.2% from a year earlier in the second quarter, down sharply from a revised figure of 7.3% for the first quarter as the territory started feeling the pinch from slowdowns in major economies and turbulence in financial markets.

The year-to-year growth figure came in well below a median forecast of 5.3% from 12 economists surveyed by Dow Jones Newswires, and marked the slowest year-to-year growth rate for any quarter since the third quarter of 2003.

The government acknowledged the economy likely will keep slowing until next year. "The volatile financial markets will last for a while and the global economic slowdown is not likely to be short-term. I see the slowdown will last until 2009," government economist Kwok Kwok-chuen told a news conference. Despite the slowdown in the quarter just ended, Hong Kong's government said it was maintaining its earlier target of 4% to 5% growth for all of 2008.

Some private economists were more pessimistic. Hang Seng Bank senior economist Irina Fan called the figures "a surprise," which she attributed to lower-than-expected consumption. "The domestic consumption, which was a major pillar of the growth last year, will no longer help as much in sustaining growth," she said.

Domestic consumption rose 3.1% in second quarter from a year earlier, easing from 7.9% rise in first quarter. Total export of goods grew 4.4% from a year earlier, easing from an 8.3% rise in the previous quarter. "I expect there will be tougher times ahead," Ms. Fan said. She cut her full-year GDP growth forecast to 4% from 5% previously. Hong Kong's GDP grew 6.4% in 2007.

The government raised its consumer price index forecast to a 4.2% rise for the full year, from an earlier prediction of 3.4%. Inflation came to 2.0% in 2007.

Western oil demand set for biggest fall in 25 years
Oil demand in Western countries is set for its biggest fall in 25 years as the global economic slowdown intensifies and consumers respond to high prices.

Demand in the economies of the Organisation of Economic Co-operation and Development (OECD) countries is set to average 48.6 million barrels per day this year, a decline of 1.3 per cent or 620,000 barrels from 49.2 million in 2007, the International Energy Agency says.

Gareth Lewis-Davies, director of commodities research at Dresdner Kleinwort, points out that this represents the largest fall since 1983, when OECD demand fell by 684,000 barrels per day in the years after the Iranian revolution. He cited growing evidence that high prices were forcing basic shifts in consumer behaviour in these countries as people used fuel more sparingly and reduced car use.

The US Transportation Department said this week that Americans drove 4.7 per cent, or 12.2 billion, fewer miles in June compared with a year earlier. It was the eighth consecutive monthly fall. Mr Lewis-Davies said that collapsing demand from Western economies had been a key factor driving a rapid fall in oil prices, which have dropped almost 22 per cent since reaching a record high of $147 per barrel on July 11.

Yesterday, the price of a barrel of crude was about $115. He said an exit of speculative money betting on rises in the oil price had amplified the drop. Falling Western demand for crude has been largely offset by strong demand from developing countries such as China, where fuel is still subsidised. Globally, oil consumption is expected to grow slightly this year by 760,000 barrels per day to an average of 86.8 million barrels, the weakest global growth rate since 2002.

In 2004, explosive demand from China triggered a 2.9 million barrel rise in global demand compared with the previous year. All of the growth this year is expected to come from developing countries. Some analysts believe that oil demand in non-OECD countries will fall to its weakest level for years and could brush close to zero.

Iain Armstrong, a Brewin Dolphin analyst, said that China's decision to shut down large tracts of its industrial base during the Olympics to help to cut pollution was likely to reduce significantly non-OECD demand for fuel. Beijing's push to stockpile fuel in the run-up to the Games to ensure there are no shortages is likely to lead to a fall in demand over the next few months as those supplies are used up.

Weaker economic growth driven by falling demand for manufactured goods from developed countries is likely to be another factor dragging on non-OECD oil demand for the remainder of this year. Mr Lewis-Davies said that it was harder to make accurate predictions about non-OECD oil demand because of a lack of reliable, up-to-date data.

Data Raise Questions On Role of Speculators
Data emerging on players in the commodities markets show that speculators are a larger piece of the oil market than previously known, a development enlivening an already tense election-year debate about traders' influence.

Last month, the main U.S. regulator of commodities trading, the Commodity Futures Trading Commission, reclassified a large unidentified oil trader as a "noncommercial" speculator. The move changed many analysts' perceptions of the oil market from a more diversified marketplace to one with a heavier-than-thought concentration of financial players who punt on big bets.

As a result, the number of futures and options contracts held by traders counted as speculators -- those who don't have a commercial need to mitigate the risks of energy prices in their business -- rose to 49% of all crude-oil bets outstanding on the New York Mercantile Exchange, up from 38%.

The scale of the recent revision and questions about the reliability and transparency of data in this market are feeding into efforts by Congress to impose restrictions on energy trading. Four Democratic senators on Thursday called for an internal CFTC inspector-general investigation into the timing of a July 22 release of a report led by the agency.

That report concluded speculators weren't "systematically" driving oil prices. Oil prices soared until mid-July before beginning a decline. A letter by the senators asks why the report was released before full reviews could take place of trader information the agency only asked for this summer.

Also at issue is whether the report played down speculators' influence, notwithstanding the report's finding that "the positions of non-commercial traders in general, and hedge funds in particular, often move in the same direction as prices."

A CFTC spokesman declined to comment on the senators' letter. The CFTC, in response to legislators' demands, this summer has been collecting more data about the trades Wall Street firms handle for clients. It has pledged to report back to Congress by Sept. 15.

Meanwhile, a debate is erupting within the agency, which is charged with overseeing the $4.78 trillion commodity futures and options markets, about what the agency does and does not know about participants in this market. The CFTC has been accused by some in Congress this year of lax oversight.

Bart Chilton, a Democratic CFTC commissioner, says the data reclassification "highlights that we need to ensure that we have our data sets not only complete but exhaustively understood. It also shows again we don't have all the information that we need to make declarative statements about the role of speculators in commodity markets. I'm disappointed that the agency released interim study results about the impact of speculators on oil markets when we don't have all the data."

Commodity-market players have relied on the CFTC's weekly reports about large traders, both commercial and speculative, to read trends in the market as they make investing decisions. But as speculative activity has risen, criticism of the data has, too.

Lehman Brothers analysts say the CFTC data, as they are now reported, fail to distinguish certain categories of financial traders from commercial traders and create "an opportunity for the activity of less-informed, purely financial investors to distort expectations."

In recent months, legislators in Congress have demanded insight about the distinction as they try to answer concerns of constituents, from companies to consumers, about what has contributed to the high price of gasoline and other fuels. In response, the CFTC has been collecting more data. It has pledged to report back to Congress by Sept. 15.

The array of opinions about how speculation is affecting energy prices comes about in part because of the tricky task of determining what, exactly, is pure speculation and what is so-called commercial trading, in which companies hedge risks involved with using, selling, or processing physical commodities in their everyday businesses.

Many Wall Street investment banks, private-equity firms and hedge funds have invested in physical assets such as storage terminals, pipeline and distribution companies, power plants and oil and gas properties. That dual role potentially puts them in the position of being both hedgers and speculators.

This is an issue in last month's bankruptcy filing of energy-distribution-and-storage firm SemGroup LP. Creditors allege that it put more capital at risk through speculation than needed to hedge risks in its commercial operations. A company spokesman declined to comment.

For most of June and early July, oil prices zoomed upward, hitting a record $145.29 a barrel on the New York Mercantile Exchange on July 3. But they have since tumbled 21%. Thursday, oil settled at $115.01 a barrel, down 99 cents, or 0.9%.

The CFTC is a few weeks into sorting a massive amount of data requested in June from Wall Street firms, and it is requesting additional data. The firms providing the data are so-called swaps dealers. They sell clients energy derivatives that allow clients to bet on energy prices away from the futures exchanges, and the banks frequently offset the risk of these client transactions by trading on the futures markets.

Thomas LaSala, a Nymex regulatory official, said that the CFTC's reclassification didn't affect any trading levels Nymex imposed on particular traders and that his exchange had not forced the entity to unwind positions.

Oceanic Dead Zones Continue to Spread
Fertilizer runoff and fossil-fuel use lead to massive areas in the ocean with scant or no oxygen, killing large swaths of sea life and causing hundreds of millions of dollars in damage

More bad news for the world's oceans: Dead zones—areas of bottom waters too oxygen depleted to support most ocean life—are spreading, dotting nearly the entire east and south coasts of the U.S. as well as several west coast river outlets.

According to a new study in Science, the rest of the world fares no better—there are now 405 identified dead zones worldwide, up from 49 in the 1960s—and the world's largest dead zone remains the Baltic Sea, whose bottom waters now lack oxygen year-round.

This is no small economic matter. A single low-oxygen event (aknown scientifically as hypoxia) off the coasts of New York State and New Jersey in 1976 covering a mere 385 square miles (1,000 square kilometers) of seabed ended up costing commercial and recreational fisheries in the region more than $500 million. As it stands, roughly 83,000 tons (75,000 metric tons) of fish and other ocean life are lost to the Chesapeake Bay dead zone each year—enough to feed half the commercial crab catch for a year.

"More than 212,000 metric tons [235,000 tons] of food is lost to hypoxia in the Gulf of Mexico," says marine biologist Robert Diaz of The College of William & Mary in Williamsburg, Va., who surveyed the dead zones along with marine ecologist Rutger Rosenberg of the University of Gothenburg in Sweden.

"That's enough to feed 75 percent of the average brown shrimp harvest from the Louisiana gulf. If there was no hypoxia and there was that much more food, don't you think the shrimp and crabs would be happier? They would certainly be fatter."

Only a few dead zones have ever recovered, such as the Black Sea, which rebounded quickly in the 1990s with the collapse of the Soviet Union and a massive reduction in fertilizer runoff from fields in Russia and Ukraine. Fertilizer contains large amounts of nitrogen, and it runs off of agricultural fields in water and into rivers, and eventually into oceans.

This fertilizer runoff, instead of contributing to more corn or wheat, feeds massive algae blooms in the coastal oceans. This algae, in turn, dies and sinks to the bottom where it is consumed by microbes, which consume oxygen in the process.

More algae means more oxygen-burning, and thereby less oxygen in the water, resulting in a massive flight by those fish, crustaceans and other ocean-dwellers able to relocate as well as the mass death of immobile creatures, such as clams or other bottom-dwellers. And that's when the microbes that thrive in oxygen-free environments take over, forming vast bacterial mats that produce hydrogen sulfide, a toxic gas.

"The primary culprit in marine environments is nitrogen and, nowadays, the biggest contributor of nitrogen to marine systems is agriculture. It's the same scenario all over the world," Diaz says. "Farmers are not doing it on purpose. They'd prefer to have it stick on the land."

In addition to fertilizers, the other primary culprit is the consumption of fossil fuels. Burning gasoline and diesel results in smog-forming nitrogen oxides, which subsequently clear when rain washes the nitrogen out of the sky and, ultimately, into the ocean. Technological improvements, such as electric or hydrogen cars, could solve that problem but the agricultural question is trickier. "Nitrogen is very slippery; it's very difficult to keep it on land," Diaz notes. "We need to find a technology to keep nitrogen from leaving the soil."

Or farmers can reduce the overall amount of nitrogen required by employing new biotechnologies, such as the nitrogen use efficiency (NUE) improvements offered by Arcadia Biosciences. By engineering crops to overexpress a gene that allows roots to absorb more nitrogen, Arcadia scientists have shown that "it's possible for NUE crops to produce the same yield with half as much fertilizer," president and CEO, Eric Rey, says. "In canola, we saw a two-thirds reduction."

Seeds bearing the technology have already been licensed to agricultural giants Monsanto Company and Dupont's Pioneer Hi-Bred International in the case of canola and corn, respectively—and even grass seed from Scotts Miracle-Gro Company may one day employ it. Although field trials over the last four years have proved the genetic changes effectiveness, further testing and government approval means that such crops will not be grown before 2012.

"It's a big economic benefit for farmers if they use only half as much nitrogen as well a big beneficial impact on nitrogen runoff into waterways," says Rey, who hopes that this product will be adopted as quickly as herbicide-resistant crops, which only took five years from introduction in 1998 to become nearly 70 percent of the corn grown in the U.S., and is now nearly 90 percent. "A reasonable expectation is that there would be a dramatic reduction, maybe by 2018."

But that still might not solve the dead zone problem. So much nitrogen is now reaching these coastal waters that much of it ends up buried in sediment, Diaz says, even when new nitrogen sources are removed those sediments release that nitrogen over time, perpetuating the cycle.

That inability to recover is driven not only by the nitrogen buried in the sediment but also by water layers that don't mix with one another, despite the massive flow of rivers like the Mississippi. Instead, warmer, fresher water on the surface sits on top of cooler, denser, saltier water and it takes the energy of multiple powerful hurricanes to blend the two.

For example, as Hurricane Katrina bore down on the Louisiana coast with its powerful winds blowing faster than 130 miles (210 kilometers) per hour, the monstrous tropical storm delivered a benefit: it mixed the warm, oxygen-rich surface waters with the colder, almost oxygen-free waters beneath, dispelling the largest dead zone in the U.S. for a time. Hurricane Rita followed and finished the work, ending early the seasonal dead zone that forms each year at the mouth of the Mississippi.

That dead zone—which last year stretched over roughly 8,500 square miles (22,000 square kilometers), an area the size of New Jersey, and is predicted to grow even more extensive in 2008, thanks to the early summer floods—forms because of the rich load of nitrogen and phosphorus the Mississippi carries down from the farm fields of the U.S. Midwest.

Hoping for hurricanes is neither popular nor sensible, so scientists in the Baltic Sea nations, desperate for solutions, are considering so-called geoengineering options: large-scale human interventions into natural systems. In this case, air would be bubbled into some of the smaller bays to assess what happens. "If you look at agricultural ponds, you can aerate them to prevent low oxygen," Diaz says. "But that's a pond. We're talking about open systems with tides. The water doesn't just stay there."

Ultimately, it may take revolutions in agriculture and transportation, along with the energy of hurricanes to bring life back to dead zones. "If you can't mix a dead zone with the energy of a hurricane," Diaz adds, "I don't see how geoengineering is going to do it."


Anonymous said...

“Finally, it appears that Wall Street will be customarily let off the hook by not admitting any wrong doing.”

“1. Its very bad.
2. Its getting worse, at an increasing rate.”

Let's party!

Anonymous said...

I'd like to see the Bankster Gangsters heads on sticks for my Halloween Party. Yes, their real heads.

Lining the driveway with candles burning in their noses.

Anonymous said...

"Let's party!"

Who has money?

Anonymous said...

I feel reassured using the MSM to reinforce what is being discussed here is the troof.

NPR's Marketplace was basking in the glow of a stronger dollar and the "consensus" that the US economy has hit a bottom...blah...blah...

And at the end of the show they wanted to mention some grey skies and what was coming ahead - and here is where TAE has consistently come into play - he mentioned the next things to look out for are going to be Credit Card Defaults, Auto Loan Defaults, and Commercial Real Estate Defaults.

Another example of things we have been disussing for months.

Thanks again - Forrest

Anonymous said...

I have a question to throw out if any want to engage in some 'inexpensive' speculation.{There has been way too much of the other kind}

Will it be possible for TPTB to keep this corpse of a economy upright and sitting at the table past the election...perhaps even as far as the first of the year.?Or even later.?

We are seeing war,and rumor of more of the showing deflationary pricing in a odd circumstance...I imagine the Europeans are re-thinking relations with a certain bear with a toothache

And the USA still has some truly scary leaders.Ones who appear to have either a "shortimers attitude"...or they are getting ready for some really bad ideologically-driven decisions to change the political/social makeup of this country,and of the world.

Understand,I don't like Bush,and I have a distaste for those of his class ,and especially class& attitude.I am,however smart enough to realize you don't get where he is w/o a certain amount of sharps.Cheney ,on the other hand,is simply a intelligent,truly

scary, evil S.O.B..

This is crunch time.They feel they have not completed the agenda they set for themselves,and see a lot of what they hoped to accomplish stopped dead,or reversed in short order by a Obama presidency

Although he has wall street thugs with credentials on his leadership team..he is still a unknown..Wealthy folks don't like unknowns of any sort.

With all these givens,I can not see how it can stay BAU too much longer.Any thoughts?


Anonymous said...

Snuffy, the insane neocons are capable of anythinng before elections or inauguration.

Democrats and Republicans are both controlled by the same military-industrial-financial complex.

I have no hope in the elites and the powerful.


Bigelow said...

Dollar Rally
“How much of my gold have I sold throughout this… massacre?
Not one gram. The fact that I’m having to hedge my physical gold position with a bullish dollar vehicle is prima facie evidence that this economic system is capable of fabricating its own absurd reality—a reality that I can’t comprehend in any logical way. At some point, I have no idea when, the grand illusion will unwind. History teaches us that that these Ponzi schemes always do.”