Friday, August 22, 2008

Debt Rattle, August 22 2008: Jackson Hole Sale

National Photo Company God and Ford 1924
Metropolitan Methodist Church and Ford building, C Street and Pennsylvania Avenue, Washington, D.C.
The church was abandoned and razed after the congregation moved to Nebraska Avenue in the 1930s.
The 1905 Ford Motor Co. building on Pennsylvania Avenue was torn down in 1980.

Ilargi: There is a reason why there is no Nobel Prize for economics. Alfred Nobel didn't want one. Economics is not a science, far from it, and economists are to a man either enormously stupid or lacking any semblance of a conscience. Or both. Alfred Nobel knew all this.

Nobel set up the fund for the awards that carry his name, in 1895, precisely because his conscience was bothering him. He had seen the destructive potential in his invention, dynamite, too late, and he never got over the realization that he brought such misery on the world.

His will stipulated Nobel Prizes be awarded to "those who ... shall have conferred the greatest benefit on mankind." It’s obvious that no western economist fits that profile, and none ever has or will.

When the Swedish central bank, in 1968, came with The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, Alfred Nobel turned in his grave, and has stayed face down ever since. He saw that economics is far more harmful for mankind than dynamite ever could be.

At the same time, the pathological criminal Milton Friedman wet his dirty panties and pissed on Nobel’s grave. The Riksbank prize, modeled to look just like a Nobel Prize, gave economics the aura of a science, even benefitting mankind, and to Friedman and his Chicago school of made henchmen that was worth all the milllions of dollars it cost. Vanity has few limits. And they knew if they could make people believe all this, their riches would be limitless.

Economists dabble in models that would be discarded in a second in any serious field. The most flagrant idiocy rests in the notion of perpetual growth. Whereas in any other field the very idea is recognized as damaging and ultimately lethal, re: cancer, in economics it is presented as good and healthy.

We are about to pay the price for the perpetually stupid theory of perpetual growth. We are set to find out that it does not exist.

Our money is issued as debt, all of it, and that means interest is due on all of it, which inevitably leads to the conclusion that it can never be paid back in full (hence the need for perpetual growth), and that all money flows in one direction only and must end up in the hands of those that charge the interest.

Our society is a dying corpse. In Jackson Hole this weekend, the next batch of stakes will be driven into its heart.

Buffett Says Fannie Mae, Freddie Mac 'Game Is Over'
Fannie Mae and Freddie Mac, the two largest mortgage finance companies, "don't have any net worth," billionaire investor Warren Buffett said.

"The game is over" as independent companies said Buffett, the 77-year-old chairman of Berkshire Hathaway Inc., in an interview on CNBC today. "They were able to borrow without any of the normal restraints. They had a blank check from the federal government."

Freddie Mac and Fannie Mae touched 20-year lows yesterday on the New York Stock Exchange on speculation a government bailout will leave the stocks worthless. U.S. Treasury Secretary Henry Paulson won approval from Congress last month to pump emergency capital into the companies, which account for more than half of the $12 trillion U.S. mortgage market.

Fannie and Freddie mispriced their products and "kept existing because they had the federal government behind them," Buffett said. Berkshire had been among the largest holders of Freddie until about 2001, when it became apparent the company wasn't being run well, he said.

The two mortgage companies recorded almost $15 billion in combined net losses in the past four quarters as delinquencies rose to record levels, shrinking their capital. The swoon sparked concern they may not be able to weather the worst housing slump since the Great Depression and prompted Paulson to step in with a rescue plan.

Fannie's market value has shrunk to $5.2 billion from almost $40 billion at the beginning of the year. Freddie has declined to $2 billion from $22 billion, making it increasingly difficult for the companies to raise new funds.

Fannie Mae was created as part of Franklin D. Roosevelt's New Deal in the 1930s, a time when the U.S. economy was struggling to emerge from the stock market crash, industrial production had tumbled 50 percent and the unemployment rate rose as high as 30 percent. Freddie started in 1970, when the economy was strained by the Vietnam War.

Both have the implicit guarantee of the U.S. government, so they can borrow at lower rates than banks and make money by purchasing higher-yielding mortgages from home lenders, providing new capital for loans.

Buffett had an 8.5 percent stake in Freddie until he became "uncomfortable" with the risks Freddie was taking on. In 2005, he said "it would not be the end of the world" if Fannie and Freddie stopped buying new mortgages. Former Federal Reserve Chairman Alan Greenspan and Richmond Federal Reserve Bank President Jeffrey Lacker have called for the companies to be nationalized.

William Poole, former head of the St. Louis Fed said last month Freddie is technically insolvent and Fannie's fair value may be negative next quarter. Buffett, ranked the world's richest man by Forbes magazine, said he made a $500 million bid on a Chinese stock "not so long ago" that wasn't accepted. He declined to name the company involved. Berkshire is based in Omaha, Nebraska.

He also said he traveled with Bill Gates, founder of Microsoft Corp., to a Canadian site for extracting oil from tar sands, though an investment isn't imminent. Buffett said oil has "changing dynamics because there's not a buffer for supply like there was" a few years ago.

Buffett has been seeking acquisitions to put some of Berkshire's idle cash to work and toured Europe earlier this year to find candidates. He said today that he's been getting more "distress" calls than real opportunities, and that he's been referring callers to sovereign wealth funds, which he characterized as "innocent money."

Freddie, Fannie Failure Could Be 'World Catastrophe'
A failure of U.S. mortgage finance companies Fannie Mae and Freddie Mac could be a catastrophe for the global financial system, said Yu Yongding, a former adviser to China's central bank.

"If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic," Yu said in e-mailed answers to questions yesterday. "If it is not the end of the world, it is the end of the current international financial system."

Freddie and Fannie shares touched 20-year lows yesterday on speculation that a government bailout will leave the stocks worthless. Treasury Secretary Henry Paulson won approval from the U.S. Congress last month to pump unlimited amounts of capital into the companies in an emergency.

China's $376 billion of long-term U.S. agency debt is mostly in Fannie and Freddie assets, according to James McCormack, head of Asian sovereign ratings at Fitch Ratings Ltd. in Hong Kong. The Chinese government probably holds the bulk of that amount, according to McCormack.

Industrial & Commercial Bank of China yesterday reported a $2.7 billion holding. Bank of China Ltd. may have $20 billion, according to CLSA Ltd., the Hong Kong-based investment banking arm of France's Credit Agricole SA. CLSA puts the exposure of the six biggest Chinese banks at $30 billion.

"The seriousness of such failures could be beyond the stretch of people's imagination," said Yu, a professor at the Institute of World Economics & Politics at the Chinese Academy of Social Sciences in Beijing. He didn't explain why he held that view.
China's government hasn't commented on Fannie and Freddie.

Yu is "influential" among government officials and investors and has discussed economic issues with Premier Wen Jiabao this year, said Shen Minggao, a former Citigroup Inc. economist in Beijing, now an economist at business magazine Caijing.

Investor confidence in Fannie and Freddie has dwindled on speculation that government intervention is inevitable. Washington-based Fannie has fallen 88 percent this year, while Freddie of McLean, Virginia, has slumped 91 percent.

Paulson got the power to make purchases of the two companies' debt or equity in legislation enacted July 30 that was aimed at shoring up confidence in the businesses. He has said the Treasury doesn't expect to use that authority.
The two companies combined account for more than half of the $12 trillion U.S. mortgage market.

Lehman Rises After Korea Bank Says It's 'Open to' Acquisition
Lehman Brothers Holdings Inc., the fourth-largest U.S. securities firm, rose 15 percent in New York trading after a report that Korea Development Bank is "open to" an acquisition.

Lehman climbed $2.03 to $15.75 at 8:30 a.m. before the official open of the New York Stock Exchange. Shares of the New York-based company dropped almost 80 percent this year before today, the worst-performer on the 11-company Amex Securities Broker/Dealer Index. "We are studying a number of options and are open to all possibilities, which could include (buying) Lehman," a Korea Development Bank spokesman said, according to a Reuters report.

Lehman, the largest underwriter of mortgage bonds before the subprime market collapsed, lost the confidence of investors in the past year as it struggled to pare debt holdings. The bank has reported writedowns and credit losses of $8.2 billion in the past 12 months, according to data compiled by Bloomberg.

"The Koreans are signaling a desire to buy Lehman," Ladenburg Thalmann & Co. analyst Richard Bove said today in an interview. "Lehman is massively undervalued and this is a cheap stock." Bove said yesterday that Lehman was a candidate for a hostile takeover because the company, led by Chief Executive Officer Richard Fuld, is unwilling to sell at a depressed price.

The Financial Times reported yesterday that Lehman failed to sell a 50 percent stake to Korea Development Bank and China's Citic Securities Co. The buyers walked away after deciding Lehman demanded too high a price, the FT said, citing people familiar with the Asian lenders.

"For long term investors, opportunities like this do not come very often," said Mamoun Tazi, an analyst at MF Global Ltd. in London. "This deal, if it happens, could be rewarding for KDB from a financial as well as a public relations point of view."
Credit-default swaps protecting against a default on Lehman's bonds dropped 74 basis points today to 315, the biggest one-day decline since April 8, according to CMA Datavision prices.

A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

UK economic growth hits a brick wall
The British economy shuddered to halt between April and June, ending its longest stretch of economic growth for more than a century.
Gross domestic product did not grow at all in the second quarter, the Office for National Statistics revealed. It ends a run of 63 consecutive quarters of growth in the UK and is the weakest data since 1992. The news is a blow to Gordon Brown whose popularity is plunging as the economy heads toward its first recession since the early 1990s.

Economists believe a technical recession - where the economy contracts for two successive quarters - is now likely. Jonathan Loynes, chief economist at Capital Economics, said: "The economy now looks set to grow by just 1.2pc or so this year, with a very strong chance of a technical recession in the second half. And things will be considerably worse in 2009."

The ONS revised down second-quarter growth to zero from initial estimates of 0.2pc after the economic slowdown hit the construction and manufacturing harder than thought. Economists had expected growth of 0.1pc. Construction work has slowed dramatically in the UK, particularly housebuilding, and output fell by 1.1pc in the second quarter, more sharply than the initial estimate of 0.7pc.

Manufacturing output fell by 0.8pc, revised down from a 0.5pc fall, and initial estimates for growth in the services industry were halved to 0.2pc from 0.4pc. The track record of continuous economic growth under the Labour government was until now one of its proudest achievements.

But the Bank of England has already slashed its growth forecasts, saying that the next year will be "painful" with zero growth and "the possibility of a quarter or two of negative growth". The Bank's downward revisions will be embarrassing for Chancellor Alistair Darling, who is still forecasting that the flagging economy will muster growth of 2pc this year and 2.5pc in 2009.

The figures sent sterling plunging against the dollar and the euro as traders digested the news that the UK's economic downturn is deepening. Today's news will intensify the debate on interest rates and increase the pressure on the Bank to start making cuts sooner rather than later to reduce the impact of the sharp slowdown.
Before the GDP numbers were released economists were forecasting that the first rate cut could come as early as November as inflation begins to peak. Peter Newland, economist at Lehman Brothers, said: "We continue to expect a technical recession in the second half of the year and the MPC to respond with the first in a series of rate cuts in November. We judge that the risks of an earlier move have risen."

The Bank believes that as the economy contracts, inflation will start to fall, coming back to the Bank's 2pc target before actually falling below target within the next two years.

Recession fear for half the globe, says Goldman Sachs
Half the world economy, including the UK, is in recession or on the brink, according to research from Goldman Sachs.

The investment bank has warned that the world's major economies, including the US, Japan, the eurozone and the UK, are "either in recession or face significant recession in the months ahead". It also raised fears that the slump could have a profound knock-on effect for China, whose thirst for raw materials and consumer products has been propping up many economies.

The bank's international economist Binit Patel warned: "Given its importance to world growth in recent years, a world recession would in all likelihood involve a hard landing in China." America, the world's largest economy, has so far avoided recession - news that has helped the dollar's recent recovery.

However, Goldman warned that the country is now facing a major downturn as the effect of the credit crisis takes its toll, having been delayed for some months by a series of tax cuts and interest rate reductions.

France and Germany's economies have shrunk in the second quarter of the year along with Japan's. Meanwhile, many fear that the UK's official statistics will soon show the economy shrinking.

Martin Feldstein, the Harvard University economist and former head of the National Bureau for Economic Research - which determines whether a recession is in place - said he was "much more pessimistic than a year ago".

David Page, economist at Investec, said: "We are pessimistic about the outlook for the economy, particularly as households continue to be squeezed by high inflation and the credit crisis. We now forecast the first UK recession since 1990-91, starting in the fourth quarter this year.

However, with inflation likely to peak in excess of 5pc over the coming months, we think the MPC will not feel able to provide [interest rate cuts] until February next year."

Paulson to Decide Whom to Hurt in Any Rescue of Fannie, Freddie
-- Treasury Secretary Henry Paulson's response to the sinking fortunes of Fannie Mae and Freddie Mac might boil down to picking which investors get hurt and by how much.

At stake if Paulson does intervene: the fate of worldwide bondholders of $5.2 trillion of agency and mortgage-backed debt and scores of large banks, insurers and pension funds that own the firms' common and preferred shares. Paulson's choices probably include buying Fannie's and Freddie's bonds, a special class of preferred shares or preferred shares convertible into common stock, analysts and investors said.

The terms and conditions of any purchases would put the government ahead of other creditors and stockholders, while ensuring that bondholders are protected, they said. "He's had zero clarity on this whole issue, and until the market knows where Hank's going to be in the capitalization structure, then it gets worse not better," said Paul McCulley, a fund manager at Pacific Investment Management Co., which has the world's largest bond fund.

"The presumption" is that holders of the government- chartered companies' subordinated bonds "will be covered," McCulley said in an interview on Bloomberg Television from Jackson Hole, Wyoming. Common shareholders would be wiped out, he predicted.

Paulson got the power to make purchases of the two companies' debt or equity in legislation enacted July 30 that was aimed at shoring up confidence in the beleaguered mortgage- finance companies. The Treasury chief could also forego using that authority, and wait until Fannie Mae's and Freddie Mac's capital is so eroded that regulators can put them into receivership.

"I don't think they'll do half-measures if it means using taxpayer funds," said Andrew Laperriere, managing director at International Strategy & Investment Group, a money management and research firm in Washington. "That requires steps including complete control," said Laperriere, who used to work as chief economic adviser to former Republican House Majority Leader Richard Armey.

Paulson telephoned Senate Banking Committee members this week to tell them the Treasury is closely monitoring the situation and, for now, doesn't plan to inject taxpayer funds, according to a Senate aide who spoke on condition of anonymity.

"We are staying on top of the situation and communicating with the companies and their regulators," Treasury spokeswoman Jennifer Zuccarelli said. Meanwhile, "top executives" at Freddie Mac "have been talking with many potential investors this week," said Sharon McHale, a spokeswoman for the McLean, Virginia-based company.

Shares in Washington-based Fannie have dropped 60 percent and those of Freddie have lost 64 percent since July 30.
"Private shareholders should be concerned," said Edwin Truman, a senior fellow at the Peterson Institute for International Economics in Washington and a former official at the Treasury and the Federal Reserve. Traders "will drive the price of the stocks down to nickels and dimes," at which point Paulson will step in, he predicted.

Truman forecast the Treasury would end Fannie and Freddie dividend payments, with officials taking over management.
Fannie, the largest mortgage-finance provider, was created in the 1930s and became a publicly owned company in 1968. Freddie was started in 1970. Designed to boost homeownership, the companies issued debt to finance purchases of mortgages and package home loans into bonds sold on to investors.

Their debt is held by companies including MetLife Inc., the largest U.S. life insurer, American Equity Investment Life Holding Co., and GE Asset Management Inc. Preferred shares are held by banks from Philadelphia-based Sovereign Bancorp to Frontier Financial Corp. of Everett, Washington.

As mortgage defaults climbed, concern mounted Fannie and Freddie lacked sufficient capital. Paulson asked Congress for emergency powers to shore up support for the firms. If either company has trouble selling bonds to finance maturing debt, Paulson's hand may be pressed. They have about $20 billion of unsecured debt due on average every week, with more than $220 billion maturing by the end of next month.

A takeover could also be triggered if either company fails to meet its regulatory capital standards, to be released by the Federal Housing Finance Agency next month. "Treasury might be forced to act soon to fight a market- psychology problem instead of being able to act on its own time," said Joshua Rosner, an analyst with independent research firm Graham Fisher & Co. in New York.

There's no consensus about how widespread the losses would be in an intervention. Pete Davis, president of Davis Capital Investment, an independent advisory firm in Washington, argued that both equity and subordinated bondholders wouldn't be protected, with owners of mortgage-backed securities and senior debt kept secure.

Davis wrote in a note yesterday that Paulson will probably aim to put off using taxpayer funds as long as Fannie and Freddie are still able to fund the U.S. mortgage market. "Paulson does not want his legacy to be that he committed $50 billion or more of taxpayer money to bailing out the" firms, Davis wrote.

Central Bankers at Retreat May See Few Options to Fix Economy
The world's top central bankers gather at their annual U.S. mountainside symposium today with a sense there's not much more they can do to repair credit markets and rescue the global economy.

Reports in the last week showing a surge in inflation reinforce expectations that Federal Reserve Chairman Ben S. Bernanke will have to keep U.S. interest rates on hold. Similar conditions in Europe are paralyzing his counterparts at the Bank of England and the European Central Bank.

"All the central banks can provide now is time for the banking system to heal," Myron Scholes, chairman of Rye Brook, New York-based Platinum Grove Asset Management LP and a Nobel laureate in economics, said in an interview. "What more they have to offer is now very limited."

Bernanke may discuss his strategy when he opens the conference in Jackson Hole, Wyoming, with a speech on financial stability at 10 a.m. New York time. His audience comprises a who's who of central banking, including ECB President Jean- Claude Trichet, Bank of Japan Deputy Governor Kiyohiko Nishimura and central bank officials from about 40 other countries.

The event, ending tomorrow, has been hosted by the Kansas City Fed in Grand Teton National Park since 1982. In the U.S., borrowing premiums for banks and corporations are at their highest in months, prolonging the drag on growth. That's after Fed policy makers cut the main interest rate this year at the fastest pace in two decades, introduced three emergency-lending programs and helped Bear Stearns Cos. avert bankruptcy.

"There isn't a lot they can do" now, said former Fed Governor Lyle Gramley, senior economic adviser at Stanford Group Co. in Washington. "The Fed really has to hope and pray that credit markets begin to heal by themselves." Europe's biggest central banks have refused to jeopardize their price stability mandates by lowering rates and have warned about the danger of bailing out investors.

Trichet's ECB raised its benchmark rate in July by a quarter point to 4.25 percent and the Bank of England is refusing to ease credit even with the U.K. near a recession. "Many central banks around the world have been in a position where they have been focused on inflation, and they didn't have the same intensity of the slowdown that we saw in the U.S.," said former Fed governor Laurence Meyer, vice chairman at Macroeconomic Advisers LLC in Washington, in an interview at Jackson Hole.

The Fed, while leaving the benchmark interest rate unchanged for its last two meetings, says financial markets "remain under considerable stress." One gauge watched by the Fed, the premium for banks to borrow for three months over a measure of the future overnight lending rate, averaged 0.77 percentage point last week, the highest since April.

The Fed's rate cuts also have failed to pass through to the housing market. The average rate on a 30-year fixed mortgage was 6.47 percent last week, about where it was a year ago. "Higher mortgage rates and sharply tightening credit standards in mortgages have gummed up a key channel through which monetary easing is supposed to stimulate aggregate demand," said Mickey Levy, New York-based chief economist at Bank of America Corp., who is attending the symposium.

Apart from lowering rates, Bernanke has pushed the limits of the Fed's powers to ease the crisis in credit markets. In December, he started auctioning 28-day loans to commercial banks. He followed that in March with a $200 billion program to auction Treasuries to investment banks in exchange for mortgage-backed securities and other debt. Bernanke also offered cash loans to other bond dealers that trade with the Fed.

With all these programs in place, Fed officials may be reluctant to do more without assurance that it will ease the credit crisis and not do more harm. "They have done a lot, and at some point they simply have to give the markets the time needed to heal," said former Fed researcher Brian Sack, senior economist at Macroeconomic Advisers.

At the same time, investors are looking to the Treasury Department, not the Fed, to bail out mortgage-finance companies Fannie Mae and Freddie Mac using newly granted authority. European policy makers, meantime, have refused to be as activist as their U.S. counterparts, arguing that they can't be seen to bail out investors who made risky bets. Trichet says the ECB's "collateral framework has served us pretty well."

While the Bank of England in April followed the Fed in agreeing to swap damaged mortgage-backed securities for government bonds, Governor Mervyn King has resisted calls from lenders for it to buy securities outright. Some, such as former Bank of England policy maker Willem Buiter, who will address the meeting tomorrow, argue that the Fed's actions to date store up trouble for the future.

"There will have to be a lot of soul searching about whether central banks, in their rush to forestall a financial disaster, have created moral hazard and perverse incentives on an unprecedented scale," Buiter said.

Nobel prize winners warn financial system is still not out of the woods
A top caste of Nobel Prize economists has warned that the world's financial system may not start to recover for at least another year, leaving banks at mounting risk of an insolvency crisis.

"There is a tremendous amount of de-leveraging still necessary in the United States and Europe," said Myron Scholes, the father of complex derivatives."I'm not exactly sure when it's going to end. There are many financial institutions that need to add capital or sell assets, but it's getting more difficult," he said, at the annual gathering of Laureates on Lake Constance hosted by Sweden's Riksbank.

Mr Scholes, co-founder of the hedge fund Long-Term Capital Management, has had a brush with a systemic melt-down. His fund was almost $100bn (£53bn) underwater in the 1998 financial crisis after Russia's default caused bets on Italian and Spanish bonds to turn bad. The US Federal Reserve came to the rescue by slashing interest rates.

Joseph Stiglitz, the former head of the White House Council of Economic Advisers, said the crisis would cost the US $1.5 trillion over the next three years. But this is just the start. The downturn is engulfing most of the global economy. "This has spread to Europe, and will probably spread to China," he said.

He said the European Central Bank was making a serious error trying to squeeze inflation. "There is no theoretical justification for this," he said. "They seem to have recognised that there are other risks beside inflation, so there is a glimmer of hope," he said.

"A lot has changed since the wage-price spiral of the 1970s. Labour unions are weaker, and globalisation acts as discipline on wage demands," he added. Mr Stiglitz said the watchdogs had failed to prevent the credit bubble because they were themselves captives of ideology. "There was a party going on and the regulator didn't want to be a party pooper. They encouraged people to take out floating-rate mortgages at 1pc."

"Banks didn't just fail to manage their credit risk, they created credit risk. We have to bear the consequences," he said. He cautioned against a punishment policy that would further damage the banking system, saying it was Japan's refusal to bail out the banking system in the 1990s over fears of moral hazard that led to the protracted slump.

Mr Scholes, an unrepentant free-marketeer, said governments had been a key cause of the debacle. "It is necessary to remind people of risk. I hope there is not a rush to regulation, because the costs might be higher than the benefits," he said.

Moves to restrict lending by the mortgage giants Fannie Mae and Freddie Mac six years ago are a textbook case of what can go wrong. Other lenders operating outside any normal restraint muscled in on their once stodgy home loan business.

Berkeley Professor Daniel McFadden said the crunch was now moving into the broader economy, threatening a number of companies with bankruptcy. He said the disastrous errors of recent years bring into question the whole assumption of "market efficiency" that lies at the core of modern economics.

He proposed a body like the US Food and Drug Administration to certify new types of securities and derivatives. But at root, the failure is one of moral care. "Amid a rush to profit, what's been lost is the idea that a banker has some responsibility to protect the client's interest," he said.

FDIC Passes Around Collection Plate
Poor, poor FDIC - ever the Treasury Department’s whipping boy.

The latter gets to smack the former around like a badminton birdie because the FDIC’s primary responsibility is to clean up the Treasury’s messes. And these days, there are messes aplenty.

It goes like this: The Treasury oversees a regulatory body called the Office of Thrift Supervision, or OTS, that’s tasked with keeping tabs on federal thrifts (which are just mortgage companies moonlighting as federally chartered banks).

Until recently, the OTS was responsible for monitoring IndyMac Bancorp, which collapsed last month under the weight of misplaced mortgage bets. The FDIC is now sorting out the mess. The OTS also oversees such thriving institutions as Washington Mutual, BankUnited and Downey Savings.

Since the OTS’s idea of regulation is apparently to wake up late, sip a latte and spend the day diligently ignoring the wildly unsafe lending practices of its member banks, the FDIC is up to its ears in barely solvent financial institutions.

The FDIC charges deposit-taking institutions fees about $0.05 per $100 in deposits to display the group’s goofy logo (which dates to its Depression-era roots). This is meant to assure customers their money's safe, even if the bank’s risk management policies aren't.

When banks go belly up, the FDIC steps in and covers depositors up to $100,000. In the case of IndyMac, this could cost up to $8 billion. The FDIC’s insurance fund stood at just $53 billion pre-IndyMac, and is now so low it’s been forced to come up with an action plan to raise more money. The options aren't exactly palatable.

It could jack up the fees it charges member banks, but with so many teetering on the edge of insolvency, they don’t exactly have a lot of cash to spare. The FDIC also has a $30 billion line of credit from the Treasury Department, but it’s loath to tap into it, lest it appear desperate.

Finally, it could borrow from the Federal Reserve, and join other flailing institutions like Lehman Brothers and Merrill Lynch, both of which have submerged themselves the warm bath of cheap Federal money.

As the credit crunch migrates outward from its epicenter on Wall Street and infects Main Street, local banks and thrifts are becoming ensnared in troubles previously reserved for complex securities firms. Small banks are often heavily levered to construction firms, small businesses and individuals in their surrounding communities, and are particularly vulnerable to regionalized economic slowdowns.

Downey Savings (in Orange County) and BankUnited (in South Florida), for example, are at the heart of the housing bust. Their local economies are sagging under the weight of job losses in both the construction and mortgage industries, as well as fallout from plummeting home prices. Both banks bet heavily on ill-fated Option ARMs during the boom, and neither is likely to survive the current crisis.

Now, the FDIC's challenge is to raise sufficient funds to cover the coming wave of bank failures - without putting undue stress on the already shaky banking system or igniting fears that it would need to tap taxpayers' money to protect, well, taxpayers' money.

U.S. Stock Futures Rise on Speculation Lehman May Be Purchased
U.S. stock-index futures advanced, indicating the Standard & Poor's 500 Index may trim its weekly decline, on speculation Lehman Brothers Holdings Inc. may be acquired and as oil's decline buoyed the earnings outlook for airlines and automakers.

Lehman, the brokerage that's lost almost 80 percent of its value this year, surged 14 percent after Reuters reported Korea Development Bank said it's open to purchasing the firm. UAL Corp., the parent company of United Airlines, rose 6.8 percent in New York trading and General Motors Corp., the biggest U.S. automaker, gained 1.9 percent as crude slipped $1.36 a barrel.

"There's a ton of petro and trade dollars sloshing around the world now looking for a parking spot," said Michael Mullaney, a Boston-based portfolio manager at Fiduciary Trust Co., which manages $10 billion. A sale of Lehman to a strategic investor provides "an orderly way to work their way out of positions, as compared to a fire sale."

Lehman jumped $1.96 to $15.68. Lehman spokesman Mark Lane declined to comment when contacted today by Bloomberg. Lehman is the fourth-largest U.S. securities firm, and Korea Development Bank is a state-run lender. "We are studying a number of options and are open to all possibilities, which could include (buying) Lehman," a Korea Development Bank spokesman said, according to the Reuters report.

The S&P 500 has lost 1.6 percent since Aug. 15 as concern grew that shareholder value would be wiped out at Fannie Mae and Freddie Mac if they are nationalized and commodities headed for their biggest weekly gain in 33 years. Kenneth Rogoff, former chief economist at the International Monetary Fund, said this week that the world's largest economy has fallen into a recession that may topple some of the nation's biggest banks.

Billionaire Warren Buffett told CNBC that Fannie Mae and Freddie Mac, the two largest mortgage finance companies, "don't have any net worth." "The game is over," Buffett, the 77-year-old chairman of Berkshire Hathaway Inc., said in an interview. "They were able to borrow without any of the normal restraints. They had a blank check from the federal government."

The S&P 500 has dropped 18 percent from an October record as credit-related losses at banks worldwide topped $500 billion and record oil prices curbed profit growth. "Oil is still off 21 percent or so from its high," said Kully Samra, U.S. equity markets analyst at Charles Schwab U.K. Ltd. in London. "So you are going to expect some relief here."

The Reuters/Jefferies CRB Index of 19 commodities soared 3.7 percent to 405.92 in New York yesterday. A settlement at that level today would mark a 6.2 percent gain for the week, the most since July 1975.

Analysts' accuracy in predicting U.S. profits dropped to the lowest level in at least 16 years last quarter, data compiled by Bloomberg show. Earnings estimates from analysts matched results for 6.7 percent of companies in the S&P 500 that reported second-quarter profit, the fewest since Bloomberg began compiling the data in 1992. Accuracy peaked at 30 percent in the fourth quarter of 2000, the year Regulation Fair Disclosure, known as Reg FD, was adopted, and has fallen for six of the seven years since.

Merrill, Goldman, Deutsche Settle Auction-Rate Probes
Merrill Lynch & Co., Goldman Sachs Group Inc. and Deutsche Bank AG agreed to buy back as much as $15 billion in failed auction-rate securities and pay $160 million in fines, settling probes by state regulators.

The accords bring to eight the number of firms that settled claims in the last two weeks that they misled investors by fraudulently marketing the long-term securities as easy to buy and sell. Merrill, among the biggest underwriters of the debt, will redeem up to $12 billion and pay fines of $125 million, the second-largest penalty to date from the probes.

"It's been a great day of progress," said New York Attorney General Andrew Cuomo, who announced the agreements this afternoon. Merrill Chief Executive Officer John Thain, who took part in talks that led to today's agreement, knew his firm had to "step up to the plate," Cuomo said.

Wall Street banks are settling claims stemming from a nationwide investigation into allegations banks peddled auction- rate securities as investments that were as liquid as cash. The $330 billion market seized up in February, when the credit crisis prompted banks to stop supporting the periodic auctions at which the long-term securities were bought and sold.

Goldman will buy back $1.5 billion of the securities and pay a $22.5 million fine, Cuomo said. Deutsche Bank will redeem $1 billion of debt and was fined $15 million. Merrill, which offered on Aug. 7 to buy back $10 billion of debt starting in January, will now start buying it in October.

"We are pleased our clients have the certainty of a favorable resolution to this unprecedented liquidity crisis," Thain, 53, said in a statement. Merrill said in a statement that it had also settled with the Securities and Exchange Commission. Deutsche Bank is "pleased to resolve this matter," said spokesman Ted Meyer. In a statement today, Goldman Sachs estimated it would buy back about $1 billion in securities. The firm said it is cooperating with an SEC investigation.

North Dakota Securities Commissioner Karen Tyler, who as president of the North American Securities Administrators Association represents all the states, said the agreements were a "global deal" for U.S. investors. Massachusetts Secretary of State William Galvin, who sued Merrill last month, announced a separate settlement with similar terms earlier today.

UBS AG, Citigroup Inc. and three other Wall Street banks already agreed to repurchase almost $35 billion of auction-rate debt from individuals, charities and small businesses, accounting for about 17 percent of the estimated $200 billion left in the market. The agreements today contained similar terms, giving priority to so-called retail investors, with the banks pledging to also help institutional clients find markets for their bonds, Cuomo said.

The first five banks, joined by Morgan Stanley, JPMorgan Chase & Co. and Wachovia Corp., will pay $360 million in fines, with UBS agreeing to a $150 million penalty, the largest to date. Bank of America Corp. is among the last major banks with which regulators haven't yet reached an accord. "We announced three settlements today," Cuomo, 50, said in response to a question about Bank of America.

"You think we can get everything done in a day?" Regional brokerages such as Charles Schwab Corp., Fidelity Investments and E*Trade Financial Corp. are also being targeted by authorities for their role as middlemen in selling debt created by the banks. Cuomo also said he is also investigating individuals at the banks, without specifying the banks or number of people.

U.S. regulators will start on-site inspections next week of about 40 brokerages involved in sales of auction-rate debt, stepping up a nationwide inquiry into whether the firms failed to warn clients the market was collapsing, a person familiar with the matter said yesterday.

The Financial Industry Regulatory Authority wrote to the firms this month seeking spreadsheets on bids submitted for the products, copies of training and marketing materials and risk analyses and the results of internal investigations, the person said. It would also like to know whether phone lines on auction- rate trading desks were recorded.

"That they are showing up in offices shows the seriousness of their purpose here," said Brian Rubin, a partner at Sutherland Asbill & Brennan LLP in Washington who represents brokerages. "Normally, they just expect the firms to produce the documents or information by mail, which can take a while. Here they seem to be in a hurry."

Bank of America cuts Goldman, Morgan Stanley earnings outlook
Banc of America Securities analyst Michael Hecht cut his earnings outlook on U.S. investment banks Goldman Sachs Group Inc and Morgan Stanley to reflect a tough fixed-income sales and trading environment, and a downward trend in equity markets.

"...We still believe Goldman and Morgan Stanley stand to benefit from stronger customer flow activity as other firms face more substantial de-leveraging pressures, but still not enough to offset recent cyclical and seasonal pressures across most capital markets businesses the last three months," the analyst said.

He cut his third-quarter earnings estimate on Goldman to $2.50 a share from $3.98, and on Morgan Stanley to 85 cents a share from $1.02.

Hecht, however, said he expects Morgan Stanley to deliver the best earnings-per-share growth and return-on-equity traction in the group, given continued momentum in its core institutional securities franchise.
He cut his price target on the shares of Morgan Stanley to $52 from $55 and maintained his "buy" rating on the stock.

Hecht cut Goldman's price target to $186 from $192, maintaining his "neutral" rating. Since the start of this month, analysts at Merrill Lynch, Fox-Pitt, Bernstein, Citigroup and Lehman have cut their estimates for Goldman and Morgan Stanley.

'Large Number' of Banks Mis-Marked Assets, U.K. Regulator Says
Incorrect securities pricing found at Credit Suisse Group AG, Morgan Stanley and Lehman Brothers Holdings Inc. is more widespread and will be investigated, the U.K.'s financial regulator said today.

The Financial Services Authority said it will begin the probe next year after finding that securities valuations at a "large number" of London banks were "materially flawed or inadequate," the agency said. The problems may worsen if banks fire compliance and risk officers, the FSA said.

"We recommend that you consider carefully any headcount reduction exercises that will affect valuation-control functions at this sensitive time," FSA Chief Executive Officer Hector Sants wrote in a letter to CEOs last week and made public today.

Incorrect pricing on London trading desks has contributed to $2.8 billion of writedowns. The FSA letter comes a week after the U.K. operations of Credit Suisse, Switzerland's second- largest bank, was fined 5.6 million pounds ($10.6 million) for failing to properly oversee pricing of asset-backed securities.

Spokeswoman Teresa La Thangue declined to say how many mis- marking incidents the FSA has uncovered or name companies targeted. "The fact that we've sent a `Dear CEO' letter isn't unprecedented, but it's rare," La Thangue said. "It means that it's an issue we're taking very seriously."

The FSA will be visiting firms and "wielding a big stick," said Patrick Buckingham, a regulatory lawyer at Herbert Smith and a former Lehman Brothers in-house lawyer. "The FSA has been chomping at the bit to bring an enforcement case based on a lack of systems and controls."

Credit Suisse joined at least three of its competitors in identifying incorrect pricing this year. The Zurich-based bank had to write down holdings by $2.65 billion when it discovered the mis-pricings. Morgan Stanley suspended a credit trader and disclosed $120 million of "negative adjustment" in June relating to erroneous valuations of his positions.

The New York-based firm said it was cooperating with authorities in London and conducting an internal review. The internal review is continuing, London-based spokesman Wesley McDade said today, declining to comment further. Merrill Lynch & Co., the third- largest U.S. securities firm, said in May it was probing a trading desks in London and suspended a trader after discovering he may have overstated the value of some of the bank's equity derivatives.

The trader, who Merrill declined to identify, traded derivatives based on individual stocks for the firm's own account, according to a person with direct knowledge of the matter. Merrill initially determined that he may have overstated the value of some holdings by less than 10 million pounds in April, when his marks were detected, the person said.

In March, Lehman Brothers, the fourth-largest U.S. securities firm, suspended two London-based equity traders after internal controls identified "issues" on share valuations. The sums involved were "not material," an official for the company said at the time.

The regulator hasn't yet investigated the banks. The fine levied on Credit Suisse was based the bank's own review.
The marking incidents reflect common traits, including poor oversight of traders and a lack of seniority for product-control staff, the FSA's letter said.

Securities firms in London and New York have slashed more than 100,000 jobs in the past year as investment-banking revenue fell. Job openings in London's financial-services industry declined for the seventh straight month in July, a survey released today by recruitment firm Morgan McKinley showed.

The FSA is particularly concerned that fair-value accounting, a process companies use to put a price on difficult- to value assets, doesn't properly reflect the fluctuating value of complex and illiquid products such as collateralized-debt obligations, securities derived from a bundle of debt.

Fair value is the price at which an asset could be bought or sold in the current market. Assets have to be given a fair value on balance sheets, even if companies intend to hold them to maturity. Policy makers globally are grappling with how assets can be given a fair value in illiquid markets.

Treasuries Drop as Bernanke Says Slow Growth to Cut Inflation
Treasuries declined after Federal Reserve Chairman Ben S. Bernanke suggested that the central bank is relying on slowing growth and a strengthening dollar to contain inflation.

The decline pushed yields on two-year notes up the most in a month. Government debt had slumped earlier after the Korea Development Bank said it's "considering" an investment in Lehman Brothers Holdings Inc., easing concern about the fallout from credit market losses.

"Bernanke remains highly concerned about inflation but has little willingness to do anything about it," said Mark MacQueen, a money manager in Austin, Texas, at Sage Advisory Services, which oversees $6.5 billion. "If he is only going to jawbone his inflation worries, then we're going to have an inflation problem for a longer time than he's willing to admit."

The yield on the 10-year note rose 6 basis points to 3.89 percent as of 10:36 a.m. in New York, according to BGCantor Market Data. The price of the 4 percent security maturing in August 2018 declined 16/32, or $5 per $1,000 face amount, to 100 28/32. Two-year yields rose 11 basis points to 2.42 percent.

Bernanke called dollar stability and price declines in oil and other commodities "encouraging." Still, the inflation outlook remains "highly uncertain" and the Fed "is committed to achieving medium-term price stability and will act as necessary to obtain that objective," he said at the Fed Bank of Kansas City's annual symposium in Jackson Hole, Wyoming.

"It's status quo as far as the Fed's concerned," said Kevin Flanagan, a Purchase, New York-based fixed-income strategist for Morgan Stanley's individual-investor clients. "He's still trying to walk that tightrope between economic and market risk."

Ten-year yields will climb to 4.03 percent by year-end, according to a Bloomberg News survey of economists, with the most recent forecasts given the heaviest weightings. They are little changed from seven days ago.

Korea Development Bank's Chief Executive Officer Min Euoo Sung declined to comment on a Reuters report that the state-run lender is "open to" a potential acquisition of Lehman Brothers Holdings Inc. Reuters, citing an unidentified Korea Development Bank spokesman, said Korea Development is studying a number of options, including buying Lehman.

Lehman, the largest underwriter of mortgage bonds before the subprime market collapsed, had slumped 77 percent over the past year as it struggled to pare its debt holdings. The bank has reported writedowns and credit losses of $8.2 billion in the past 12 months, according to data compiled by Bloomberg.

Treasury notes also declined as gains in European and U.S. stocks tempered demand for the safest of assets. The Standard & Poor's 500 Index rose 0.9 percent, while the Dow Jones Stoxx 600 Index rose 1.6 percent.

"There's some possibility that there will be an unwinding of the flight to quality," said Yasutoshi Nagai, chief economist in Tokyo at Daiwa Securities SMBC Co., part of Japan's second-largest brokerage. "This level of yields is too low to buy."

The difference between yields on 10-year Treasury Inflation Protected Securities, or TIPS, and conventional notes widened to 2.23 percentage points from 2.16 percentage points on Aug. 18. The figure reflects the inflation rate that traders expect for the next decade. Crude oil rallied 6.8 percent this week, the most since the period ended June 6.

Yields on two-year notes had dropped near the lowest since May as speculation rose that the government will take over mortgage-finance providers Fannie Mae and Freddie Mac.

"Two-year yields can break below 2 percent again," said Padhraic Garvey, head of investment-grade strategy at ING Bank NV in Amsterdam. "We don't think this banking crisis is over. There are still skeletons in the closet that are liable to come out as the economy gets weaker. Inflation will also come off its highs."

Futures contracts on the Chicago Board of Trade show odds of 56 percent the Fed will raise its 2 percent target for overnight bank lending in January. A month ago, traders predicted a rate increase in December. Banks and securities companies have reported more than $500 billion of writedowns and credit-related losses linked to the collapse of the subprime mortgage market since the start of 2007.

The difference in yield between U.S. two- and 10-year notes widened this week to 1.52 percentage points as investors favored shorter maturities, those more sensitive to Fed interest-rate policy. The spread increased from 1.17 percentage points in June.

U.S. consumer prices rose 5.6 percent in July from a year before, the fastest pace in 17 years. The increase means that 10-year Treasury notes yield about 1.77 percentage points less than the pace of inflation. The notes have yielded about 2 percentage points more than the inflation rate on average over the past decade, according to data compiled by Bloomberg.

Despite Fuss, Mortgage-Backed Bonds Have Fans
Despite the woes rocking mortgage companies Fannie Mae and Freddie Mac, bond-fund company Pacific Investment Management Co. continues to favor agency mortgage-backed securities over government debt.

Steve Rodosky, head of Treasury and derivatives trading at Newport Beach, Calif.-based Pimco, said the unit of Allianz SE prefers agency mortgage-backed securities, or MBS, the so-called pass-throughs sold by federally chartered firms, over debentures of the two companies as well as Treasurys as they provide more attractive yields.

"The best opportunities in the markets are in high-quality agency MBS," Mr. Rodosky said in an interview Thursday. "You are getting a collateralized piece of paper at a significantly wider spread." Thursday, Freddie's mortgage bonds were trading at a risk premium of around 2.64 percentage points over the 10-year Treasury note's yield, which was quoted late Thursday at 3.837%.

Pimco's flagship $129.56 billion Total Return Fund increased its mortgage-bond holdings last month to 65% from 61% in June, according to the data from the company's Web site. In contrast, the fund continued to shed government-debt holdings, including Treasurys and agency debt last month for the seventh straight month. The fund is the world's largest bond fund and is run by Bill Gross, the company's chief investment officer.

Agency MBS and unsecured debt have seen their prices fluctuate during the past few weeks amid concerns about the viability of the two government-sponsored enterprises, or GSEs. With their stock prices getting crushed and the housing market apparently far from bottom, the firms capital base is under pressure. At the same time, raising fresh capital is becoming difficult.

Even though Congress passed legislation last month allowing the Treasury Department to provide liquidity to Fannie and Freddie, the Treasury has stopped short of announcing any immediate bailout plans. The uncertainty about the government's plans have fueled sharp price swings in the companies' stocks, bonds and mortgage bonds.

Mr. Rodosky said jawboning by officials alone only provides temporary respite. "Sooner or later you have to follow words with actions," he said. "We are positioned in a conservative way in that there will be a successful resolution to this. They [the Treasury] will go from jawboning to actually acting somewhere within the mortgage markets, probably via the GSEs in order to increase confidence."

Government action presumably would help financial markets as it would restore investor confidence generally, said Mr. Rodosky, adding that it would, more specifically, "allow the GSEs to begin [building] their books once again instead of defending their books."

Fannie and Freddie guarantee or own nearly half of the total $12 trillion U.S. mortgages outstanding. They have long been the mortgage-bond market's backstop, stepping in to buy when other investors have failed to materialize. With their finances under pressure, however -- both companies have reported losses as the housing market has weakened sharply -- they have been curtailing their mortgage purchases.

Mr. Rodosky isn't betting on agency mortgage bonds alone. Other attractive assets to hold are the more established banks and financials, the ones that have multiple lines of business and don't depend solely on any one particular corner of the financial sector, he said.

A government bailout of Fannie and Freddie will benefit agency mortgage-bond investors. Those holding senior Fannie and Freddie debt are also expected to be protected. However, shareholders, preferred stockholders, and subordinated debt holders may suffer. Mr. Rodosky said it all depends on the details of the government's plan.

"I would venture to say that they want to protect as many current investors as they possibly could on all levels of the capital structure. I just don't know what path they would choose," he said. Treasurys have seen their values lifted by flight-to-quality flows this quarter following a selloff in the second quarter.

Mr. Rodosky remains unshaken because unlike short-term investors, Pimco bases its investment strategy on a longer-term horizon, usually on a 12-month basis. Mr. Rodosky said a government bailout could increase supply of Treasurys, which will push up yields in the long run.

In the near term though, Treasurys' performance will hinge on whether or not policy makers move to help the GSEs, he said. "If they continue to address the issue by jawboning, you have to deal with the fact that the real economy, both domestic and outside the U.S., is slowing, and continues to be pressed on the consumer base globally. That will keep general levels of rates depressed [for] longer," he said.

High-yield, high-risk corporate debt, or junk debt, will continue to be in a weak state as the economy is under pressure, he said.

Average debt for British family hits $120,000
Britons are facing a growing threat of bankruptcy, as latest figures show the average household is almost £60,000 in debt.
Experts warned that despite the credit crisis and stricter conditions on lending, cash-strapped Britons are suffering from years of indulging on relatively cheap borrowing.

Figures show the total outstanding UK consumer debt - including credit cards, loans and mortgages - has increased by 7.3 per cent to £1,444 billion over the past year, up from £1,346 billion in June 2007. There are almost 25 million households in the UK, therefore carrying an average debt of £58,461.

Stephen Gifford, Grant Thornton's chief economist, said: "The figures clearly illustrate the continuing problems of growing personal debt levels in the UK. If the property market and economy continue to weaken, the current levels of personal debt will be unsustainable and there will be a marked increase in personal insolvencies."

He added: "UK economic growth has chugged along quite nicely thanks to rising consumer spending which has largely been on credit. While most of the debt is perfectly serviceable and secured on dwellings, the rising number of insolvencies and repossessions is testament to this process having a negative outcome for an increasing number of individuals."

A total of 24,553 people went insolvent during the three months to June this year, according to figures from the Insolvency Service. Grant Thornton said that the number will climb in the next six to 12 months as the fallout from the credit crisis shows its true colours.

British Families Drowning in Debt
It's 4:30 p.m., and the television in a government-subsidized apartment in Gravesend, south of London in Kent, is showing an advertisement for hair dye. Nearby, a baby is sleeping in a stroller. The TV and the stroller are among the few things that still belong to Maxine King, aside from a mountain of debt.

Her doctor prescribed antidepressants, but King's mood hasn't particularly improved. This morning an abscessed molar had her screaming in pain, after a dentist pulled out a nerve. But the tooth is hardly the problem, says King. What's worrying her is something else: her three small children, whose feet continue to grow. "I don't know where I'm going to get the money for new shoes," King murmurs.

She turns her swollen face away. Twenty-four years old, King has been fighting the undertow of poverty for a year. Poverty has won. Her mistake lay in believing what banks and politicians in Great Britain have been advising for years. Conventional wisdom was to get a "foot on the property ladder" as quickly as possible.

In other words, buy property, and do it early in life. And it was okay, they said, to take out a large amount of credit, because property values would continue to rise, just as they had nearly tripled in the preceding decade.

In the past year, however, the trend has reversed. The decrease in property values began in the United States, and in the past few months the phenomenon has reached Spain, Ireland and Great Britain—countries where a building boom produced a housing bubble that is now bursting.

After that bubble bursts, the next sound is often a quiet whimper at the kitchen table. With interest rates rising and the value of houses declining, the first to go bankrupt are those who had little capital to begin with and could only receive dubious credit. In the United States it's called "subprime": credit that's risky, second-rate and expensive.

For years, banks bundled these credits together and then resold them, making first-rate profits. That bubble, too, has burst. Between March and June alone, 37,740 British homeowners had to turn their property back over to the banks. By the end of the year it's likely to be 75,000.

More than a million people in Britain will have difficulties paying off their debt. After 15 years of economic boom, a word is on their lips again that the country thought it had struck from its vocabulary entirely: recession. The television in the Kings' apartment is now showing the Simpsons, perhaps the world's most famous dysfunctional family.

Maxine points to a framed picture just above the TV that shows a small boy and girl, her older two children, wearing the jerseys of the English national team. "We wanted a nest for the family," she says, "and to stop throwing away money on rent."

The Kings wanted to join the 70 percent of British citizens who own their own homes. Maxine's partner Dave, a bus driver, promised he would work 90 hours a week so they could afford their house. His mother also gave the couple £10,000 ($19,600).

The Kings didn't have to look for long before they found a mortgage lender that told them a house for £168,000 ($329,400) would be no problem as long as they could pay £870 ($1,700) in interest each month. The company sent the young couple all the necessary papers—including ones that should actually have gone to Dave's boss, to show proof of his earnings. Just fill that out yourself and initial at the bottom, the nice banker told them.

The family had hardly moved into the house when Dave began to complain. Nothing but work, no time for his friends at the pub, and he hadn't wanted the house anyway. The daily grind of making payments was smothering the dream. One morning, three weeks before the birth of their third child, Dave came home from the pub and said, "I'm leaving you. I can't take it anymore."

When Maxine wanted to sell the house and pay back the mortgage, the banker suddenly wasn't so nice anymore. He wanted £9000 ($17,600) as penalty interest. When Maxine explained her unfortunate situation he said, "I'll see you in court," and hung up. The legal proceedings have dragged on for months. Each day the house depreciates in value, and when it's finally sold, Maxine guesses she will be left with £30,000 ($58,800) worth of debt. And her credit rating will be ruined, preventing her from ever borrowing money again.

U.K. Economic Growth Stagnated in Second Quarter
The U.K. economy stagnated unexpectedly in the second quarter, ending the nation's longest stretch of economic growth in more than a century.

Gross domestic product was unchanged from the previous quarter, the Office for National Statistics said, compared with a previous estimate for growth of 0.2 percent. Economists had expected a 0.1 percent expansion, according to the median estimate of 34 economists. Growth was 1.4 percent from a year earlier, the weakest since 1992.

The report adds pressure on the Bank of England to set aside inflation concerns and cut interest rates. It also worsens Prime Minister Gordon Brown's struggle to salvage his reputation for economic competence. The pound fell more than 1 percent against the dollar and weakened against the euro.

"There is still worse to come," Ross Walker, an economist at Royal Bank of Scotland Group Plc in London, said in a Bloomberg Television interview. "We may have to wait until early 2009 before we get the first rate cut because the inflation situation still looks pretty forbidding." Business investment fell 5.3 percent, the most in 23 years. Household spending declined for the first time since 2005, falling 0.1 percent.

Industrial production, which includes manufacturing as well as utilities and oil and gas extraction, has now contracted for two consecutive quarters. Construction also shrank. Service industries, which range from banks to airlines, grew at the slowest rate since 1995.

The U.K. currency declined as much as 1.1 percent to $1.8550 against its U.S. counterpart. It has already posted its longest run of declines in at least 37 years against the dollar this month. Against the euro, the pound weakened as much as 0.7 percent to 79.86 pence from 79.32 yesterday.

The implied rate on the December futures contract fell 2 basis points to 5.72 percent. The contract settles to the three- month London interbank offered rate for the pound, which was set at 5.76 percent today. Europe's second-largest economy emerged from its last recession in 1991 and then shrank for a single quarter in the three months ending in June 1992.

Britain's pace of expansion from a year ago compares with 1 percent in Japan, 1.8 percent in the U.S., and 1.5 percent in the nations using the euro.

Today's report is a blow to Brown, who is battling to revive his government's popularity with voters and quell talk of challenges to his authority from within the ruling Labour Party. Opposition lawmaker held up the figures as evidence that Brown's ability to manage the economy has collapsed.

"Brown's bubble has burst," George Osborne, a Conservative member of Parliament who speaks on finance. "Millions of people are paying an unfair price for Labour's economic incompetence and the fact the prime minister didn't put money aside during the good times to prepare for a rainy day."

Vince Cable, a Liberal Democrat lawmaker who speaks on economic policy, said the figures show "the full extent of the self-delusion which led ministers to believe that everything was well with the British economy." Brown said on Aug. 20 that the government will announce measures to revive the economy next month. He is attending the Olympic Games in Beijing today.

"The U.K., like other economies, is seeing the consequences of globally high commodity prices, as well as the uncertainty in the credit markets," a Treasury spokesman said in an e-mailed statement. "The government's priority is to guide Britain through these challenging times."

The economy faltered after banks choked off credit following the collapse of the subprime mortgage market in the U.S. Goldman Sachs Group Inc. economists said yesterday tighter credit markets will push half of the world economy into a recession.

Speculation nation
The nearly universal -- but utterly mistaken -- belief that housing prices would keep going up, up and up was the all-important catalyst, argues Robert Shiller in "The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do About It," for the Great American Housing Boom of the early 21st century.

Homebuyers, mortgage lenders, bankers, credit rating agencies, investors and government regulators all bought into the dream. So buyers agreed to mortgages they couldn't afford, lenders lent money that couldn't be paid back, bankers repackaged the bad loans into fancy securities, credit rating agencies gave the securities high ratings, investors gobbled them up, and government looked the other way.

It's a simple story, but then the United States is, in some respects, a very simple nation. We really, really love our bubbles -- especially when they involve get-rich-quick land schemes. Shiller quotes, to great effect, the opening line of historian Aaron Sakolski's 1932 book "The Great American Land Bubble: The Amazing Story of Land-Grabbing, Speculations, and Booms From Colonial Days to the Present Time": "America, from its inception, was a speculation."

We are speculators. That's what we do. Therefore, declares Shiller, "the most important single element to be reckoned with in understanding" the housing debacle "is the social contagion of boom thinking." "The ultimate cause of the global financial crisis is the psychology of the real estate bubble."

Robert Shiller is someone who should be taken seriously when attempting to understand the intersection of economic bubbles and the real estate market. A professor of economics at Yale University, Shiller earned worldwide renown by identifying the stock market boom of the late '90s as a bubble doomed to pop in his book "Irrational Exuberance," originally published in March 2000 at the absolute peak of the market.

He is also the co-creator of the Case-Shiller Home Price Index, currently deemed one of the most authoritative measures of housing price trends. He was one of a handful voices who declared that the housing boom of the early 21st century was utterly out of whack with historical pricing data, and he predicted a devastating bust. Right again!

"The Subprime Solution," however, is nowhere near as satisfying, or compelling, as "Irrational Exuberance." Because the story isn't really that simple. There's more to this mess than just "psychology." In accordance with the first half of the title, "The Subprime Solution" is more concerned with prescribing a sheaf of fixes to America's bubble mentality than exploring exactly how we got here.

The unifying principle behind most of Shiller's suggestions is the aim of helping Americans better understand economic affairs, in order to prevent them from making so many dumb decisions. The best means for combating social contagion, then, is better access to good financial information.

There's some sound stuff here. Shiller believes the federal government should subsidize financial advice for low-income taxpayers, require more financial disclosure, and create a new financial watchdog that would review the quality of financial products in a fashion similar to the Consumer Product Safety Commission.

The government should also get involved, he suggests, in regulating the boilerplate language of mortgage contracts, so that consumers don't have to take on faith that all that mumbo jumbo isn't just a scam cooked up by mortgage lenders. He even proposes a new system of economic measurement that would embed inflation into the price of goods. If such a system had been in place, Shiller suggests, Americans would realize that the common perception that housing values always rise is generally not supported by the facts.

More provocatively, Shiller also proposes taking advantage of innovations in financial technology to create new derivative markets that would "tame speculative bubbles in real estate." This "liquid market in real estate futures" would allow investors to sell real estate short if they believed that the market was in a bubble.

... then any skeptic anywhere in the world could, through his or her actions in the marketplace, act to reduce a speculative bubble in a city, for such a bubble represents a profit opportunity for short sellers. If the market were widely watched, then home builders would see the projected price declines and scale back their own activities, thus averting huge construction booms such as the one we have recently witnessed in the United States.

Shiller's proposal is a lightning rod precisely because many observers have pinpointed innovative derivative markets as one of the causes of the subprime debacle. Yet Shiller proposes a package of new, state-of-the-art financial products as part of the solution. Shiller, it should be noted, is not an entirely disinterested observer.

As he notes, he has "been campaigning for innovative new markets for real estate for twenty years," and he applauds a big "breakthrough" that occurred in 2007 when the Chicago Mercantile Exchange created single-family home-price futures markets "using the S&P/Case-Shiller Home Price Indices that Karl Case and I initially developed."

Shiller could be right. Maybe the real estate market does need more liquidity. There are, without question, legitimate and valuable uses for futures markets and other derivative products that enable the hedging of risks by both producers and consumers of various commodities.

But a crucial part of the subprime story and the consequent global financial credit crunch is the destructive role of innovative financial products dreamed up by Wall Street financial wizards. Wall Street's miraculous ability to repackage risky loans so that they appeared safe enough for investors all over the world to gobble up like hotcakes ended up creating a clear incentive for bankers and mortgage lenders to peddle even more misbegotten and financially absurd loans to anyone who asked for one.

We aren't talking here about uninformed Americans making bad choices. We're talking about the brightest, best-informed Americans purposely devising incredibly complex financial products that ended up sending the entire American economy hurtling down the wrong track. The most astonishing, and troubling, flaw in "The Subprime Solution" is that Shiller spends virtually no time or energy whatsoever exploring this part of the story. In his introduction, Shiller notes:

Accounts of the crisis often seem instead to place the ultimate blame entirely on such factors as growing dishonesty among mortgage lenders; increasing greed among securitizers, hedge funds, and rating agencies; or the mistakes of former Federal Reserve chairman Alan Greenspan.

And that's it. There's very little follow-up on any of these sub-narratives, and literally zero explanation of how dodgy subprime loans were transformed into top-rated securities. Granted, none of those factors deserve sole credit for the "ultimate" blame -- but surely they bear some portion of it? Any decent account of "How Today's Global Financial Crisis Happened" requires addressing the culpability of Wall Street, if only to convincingly dismiss it.

But Shiller just doesn't appear to be interested, at all, in a close look at how Wall Street helped to fuel the subprime boom.
The unavoidable conclusion is that markets failed to work properly in the case of the real estate boom, and one reason why they failed is that the smartest financial operators in the world, motivated by greed and encouraged by a generation of government permissiveness, did some very, very stupid things.

Shiller may be correct that part of the answer, going forward, is greater integration of futures markets into the bedrock activities of American economic life. But his argument would be stronger if it incorporated a more detailed analysis of Wall Street's infatuation with sliced-and-diced mortgage-backed securities.

It's not as if Shiller didn't have enough room. "The Subprime Solution" is a small and slender book. Not counting the index, it consists of 177 pages that feature wide margins and ample space between lines of print -- two notorious indicators that a publisher is trying to cash in quickly on a hot topic by fattening what should be a pamphlet into a full-fledged volume. Readers deserve better.

Bank of Canada wants derivatives trading addressed
The Bank of Canada urged a federal panel studying securities regulation to include derivatives trading as part of its deliberations.

In a submission to the Expert Panel on Securities Regulation, Bank of Canada Governor Mark Carney said that it is “generally recognized” that regulators have failed to keep pace with rapid mutations in the types of derivatives offered and the ways in which they are bought and sold.

Derivatives, such as currency swaps, are different than securities, such as bonds, in that cash doesn't necessarily change hands at the outset of the transaction. An explosion in the trading of the instruments, which tends to occur outside the spotlight shone on stocks and bonds, is raising concern that derivatives pose a growing threat to the financial system.

“Given that derivatives markets have become a vital component of the financial system, the bank believes that the Expert Panel should consider the regulation of these markets,” Mr. Carney said in the letter, dated July 31 and released Thursday among about 70 submissions posted on the panel's website.

There are two broad types of derivatives: those traded on exchanges, such as the Montreal Exchange, and those traded over the counter between two parties. The over-the-counter trades are relatively difficult to track, making it hard for central banks to pinpoint weak spots in the financial system.

The daily turnover of over-the-counter currency and interest-rate derivatives in Canada surged to $71-billion (U.S.) in 2007, a 34-per-cent increase from 2004, according to the Bank for International Settlements. The daily turnover globally in those derivatives is $4.2-trillion.

Mr. Carney, a former investment banker, said in his letter to panel chairman Tom Hockin that the legislation governing derivatives trading that passed Quebec's legislature earlier this year is a “constructive step” in strengthening the regulatory framework.

In an interview, Mr. Hockin said the growth of derivatives trading validates his review of Canada's regulatory system because it reflects how much the world has changed in the two years since the Ontario government commissioned similar work. “Derivatives are on the table, as are commodities,” Mr. Hockin said. “These are a big part of the current marketplace.”

Mr. Hockin's primary mission as laid out by Finance Minister Jim Flaherty is to propose legislation that would create a national securities regulator, ending Canada's patchwork of 13 provincial and territorial bodies. That's well-worn ground, as panels stretching back decades have advocated a single regulator. The proposal invariably runs into a brick wall of provincial opposition led by Quebec, which remains opposed to Mr. Flaherty's current effort.

The Bank of Canada didn't take a concrete position on a single regulator, arguing simply for “uniform securities laws.”
Mr. Carney also reiterated his support for a principles-based regulatory system rather than one that tries to create a rule for every circumstance. “It is not desirable for regulators to rely on a framework where they need to introduce, or amend, detailed rules every time a new product is created,” Mr. Carney said.

Andrew Cuomo targets Royal Bank of Canada
Royal Bank of Canada is in settlement talks with U.S. regulators over its role in the troubled $330-billion (U.S.) auction-rate securities market, a move that will likely result in the bank repurchasing some of these investments from retail clients.

In an internal memo to brokers, RBC confirmed it has been in discussions with New York Attorney-General Andrew Cuomo, who has single-handedly pursued some of the world's largest investment banks over the way they sold these complex securities to investors before the market froze this spring.

RBC's exposure to the retail market is smaller than that of these players, according to one source, who estimated the bank has approximately $1-billion of auction-rate securities held by individuals and charities. Mr. Cuomo has already wrung settlements out of seven global banks, which collectively have committed to buy back almost $50-billion worth of auction-rate securities from small investors and pay $360-million in fines.

Merrill Lynch & Co., Goldman Sachs and Deutsche Bank were the latest to bow to Mr. Cuomo's pressure, reaching agreements yesterday afternoon. The Attorney-General appears to have taken a page from the playbook of his crusading predecessor, Eliot Spitzer, and is working his way down the list beginning with the largest players in this distressed market.

In its note to brokers, RBC said it has not moved yet to repurchase these securities because the structure of any buyback is dependent upon the approval of regulators. "RBC is committed to addressing the problem of retail clients who hold auction-rate securities," the bank's letter stated.

"We have expressed our willingness to work with regulators to develop and implement a program to provide liquidity to certain individual clients, and small businesses and charities." The timing of a possible settlement is also unclear, given that Mr. Cuomo is said to be focusing on reaching a deal with Bank of America, one of the few large U.S. banks that has been a holdout.

Auction-rate securities are long-term bonds, often backed by municipal debt or student loans, that reset their interest rates every few weeks through an auction. Although the maturities of these bonds can stretch up to 30 years, the frequent auctions provided investors with a convenient way to cash out their holdings — at least until the credit crunch earlier this year, when buyers stopped showing up and the auctions were cancelled.

That left investors stuck with hundreds of billions of dollars worth of investments they couldn't cash out, even though regulators claim that many banks marketed the products as a cash-like investment. UBS AG, Citigroup, Morgan Stanley, JPMorgan Chase & Co. and Wachovia Corp. have also struck settlements with Mr. Cuomo.

The Attorney-General had threatened to take Merrill Lynch to court today, but that was averted after an eleventh-hour deal that will see the firm buy back $12-billion of securities by the end of the year and pay a $125-million fine. Goldman, by contrast, will repurchase just $1.5-billion, and pay a $22.5-million fine.

While the fines themselves aren't huge, the buybacks can be punishing for firms like Merrill, which have already seen their capital position erode amid the collapse of the subprime mortgage market. The bulk of the regulatory focus thus far has been on the major banks that created these products and ran the auctions. Yesterday, however, there were signs the probe is widening.

The Financial Industry Regulatory Authority has reportedly sent letters to almost 40 brokerages, including TD Ameritrade, saying they will begin on-site inspections of sales practices, marketing materials and disclosure. The entrance of FINRA suggests that regulators will now move beyond the big banks to look at whether brokerage firms that sold the paper directly to retail customers properly communicated the risks. Reports said that Charles Schwab, Fidelity Investments and E*Trade also received letters.

Deflation, Not Your Father's Stagflation
The first shot came with Bloomberg headline: "Housing, Prices Raise Stagflation Risk." Soon thereafter, CNNMoney got in on the stagflation action: "Stagflation? Or just stagnation?" Still, others were less convinced. According to the LA Times: "Jump in inflation puts Federal Reserve on the spot." And Forbes: "Inflation Worries The Fed." so which is it? Inflation? Stagflation? Stagnation?

The last perceived bout with Stagflation occurred in the 1970s. Have we now come full circle from ultra-slim slacks back to bell bottoms? Is this our fathers' Stagflation, or something different?  My view is that this bout with "Stagflation" is simply part of an ongoing transition from cyclical inflation to deflation. Let me explain.

The word "stagflation" was first coined by British Tory MP Iain MacLeod in a 1965 speech to Parliament. "We now have the worst of both worlds - not just inflation on the one side or stagnation on the other. We have a sort of 'stagflation' situation," he said. In simplest terms, stagflation is inflation + recession... at the same time! 

"That's impossible," claimed Keynesian theorists who in the 1970s comprised the dominant force in economic theory and practice. According to Keynes, recessions are solved by one thing: inflation. But what, according to Keynes, solves inflation? One thing:  recession.

In a brief period during the 1970s the United States economy experienced simultaneous inflation and high unemployment. The confluence of events leading up to this developed like a perfect storm.  First, the U.S. was at war in Vietnam, and because wars are expensive and require public financing, money supply was increased. As one would expect, the increase in dollars (the supply of money) led to inflation. 

In fact, inflation became so entrenched during the 1970s that people began to anticipate higher prices and therefore did something any rational actor would do: they purchased more goods ahead of time, increasing demand. Toss in the 1973 Oil Embargo, the collapse of Bretton Woods, and the U.S. economy experienced a perfect storm of inflation and slowing growth. 

Many people think of Bretton Woods as The Gold Standard. But the difference between the Bretton Woods Agreement and a "real gold standard" with fixed parity, is that under Bretton Woods, while currencies were convertible into gold, countries retained the right to change par values. Keynes actually described Bretton Woods as the opposite of the gold standard.

Anyway, as these factors circulated and combined, the result for the U.S. was very high inflation expectations combined with diminished output, high inflation and very high interest rates.

Enter,The Monetarists. The best known of all Monetarists was Milton Friedman, of course, who was awarded the Nobel Prize in 1976 "for his achievement in the fields of consumption analysis, monetary history and theory and for his demonstration of the complexity of stabilization policy."

In Friedman's book, Monetary History of the United States 1867-1960, he popularized the monetarist mantra that, "inflation is always and everywhere a monetary phenomenon." Therefore, according to Friedman, the "trick" to maintaining an acceptable rate of inflation was simply for the central bank to closely monitor the economy and use central bank policy tools to keep the supply and demand for money at equilibrium.

Monetarists, as you can see, have no problem with fiat currency. Instead, monetarists view an artificial inflation of the money supply as "ok" as long as it does not become excessive.  In other words, pumping up the money supply is fine, as long as you do it slowly... perhaps so slowly that people don't notice. 

Thanks to stagflation, The Monetarist school of thought, and Friedman in particular, developed the "Expectations-Augmented Phillips Curve." Professor A.W. Phillips "discovered" the Phillips Curve, which, ahem, "simply" shows the relationship between unemployment and inflation.

Phillips found that there appeared to be a necessary and fixed trade-off between unemployment and inflation. Any attempt by a government to reduce unemployment would lead to increased inflation. Keynesian's loved this, of course... until stagflation arrived, breaking the unemployment-inflation relationship. Friedman, in order to "save" the Phillips Curve, showed how it could be "adapted" to inflation expectations.

The 80s were known for one thing. No, not that thing, Senor Escobar. That other thing. Supply-side economics. Supply-side economics is grounded in Jean-Baptiste Say's Law of Markets: There can be no demand without supply. Supply-side economics holds that the key to economic growth is a combination of low marginal tax rates with monetary policy directed at maintaining price stability.

But it's central tenet might be better expressed as the gold-price rule.  In order to maintain price stability, the dollar must be anchored to gold. If the price of gold falls below the specified gold price, then there must be a growing demand for money. If it rises above it, then demand for money has decreased.

President Reagan's economic policy (which many attribute to the successful conclusion of the stagflation and/or inflation of the 1970s) is often equated with supply-side economics and a true "free-market" spirit.  However, economic policy under the Reagan administration was clearly only partially grounded in true supply-side theory and Frank Shostak argued several years ago that supply-side economics is not really a free market approach at all: 
"In fact, they are very much like the rest of mainstream economics. While mainstream economists advocate the management of demand, supply-siders advocate the management of supply." he wrote.  "In the free-market economy, neither demand nor supply is managed. Both consumption and production are equally important in the fulfillment of people's ultimate goal, which is the maintenance of life and well-being. In short, consumption is dependent on production, while production is dependent on consumption. The loose monetary policy of the central bank breaks this unity by creating an environment where it appears that it is possible to consume without production. This unity can be restored by bringing back the market-selected money: gold."

So where are we today? Is this the return of stagflation? Are "inflation expectations" creeping higher? [This week’s] release of the Producer Price Index showed a year-over-year increase of 9.8% in the headline number while the core year-over-year rate, which excludes food and energy, edged higher to 3.5%. 

Combined with housing deflation, stagnant wages and increasing concern that employment is doomed to edge higher, the word "stagflation" is increasingly making the rounds.   As the 70s proved, an increase in inflation expectations can produce a cycle of demand that feeds on itself, despite rising unemployment and slower growth. But there are critical differences that exist today. This is most decidedly not our fathers' stagflation. 

In 2006 when I first wrote about Stagflation I asked the following questions: 
  • What if the familiar 1970s cycle of increasing inflation expectations doesn't repeat itself because of where we are in the credit-cycle? 
  • What if there is no longer the same appetite for credit expansion now as there was between 1980 and 2005?
  • What if the consumer no longer has the same appetite for risk? 
    What if the consumer is in cut back mode in response to even the slightest whiff of inflation; i.e. food and energy? 

The answer was that if any of those conditions are present, then what may look like Stagflation now will simply be the transition between excessive risk-seeking behavior, a seemingly endless appetite for credit, and a correction to the Federal Reserve's long-term credit expansion. 

In 2006 the view as that as long as appetites for credit remained healthy, we can continue to happily teeter between inflation and stagflation. Today, there is no question that appetite for credit has diminished in virtual lockstep with debt destruction and less credit availablity overall. 

After more than two decades of credit expansion the limits have been met. The debt in the economy is no longer sustainable without an expansion of credit and we are now seeing reductions in lending, reductions in spending and reductions in production, all of which are conspiring to slow the velocity of money necessary to sustain economic growth. The Federal Reserve's ability to "engineer" the economy out of deflation is entirely dependent on expanding appetites for credit, an increase in the velocity of money. 

A general decline in the ability and, more importantly, the desire to lend and borrow acts is showing up virtually everywhere we look. The Fed's Senior Loan Officer Survey, which has been tracking tightening lending standards for residential mortgages and even commercial lending, found that 60% of domestic banks expected to tighten standards on credit-card loans in the second half of the year. That's really the final straw in the consumer's back.

So, the government should do something, right? Ironically, government intervention and regulation, everything from splitting up the bond insurers, enforcing penalties against banks such as Citigroup, JP Morgan and Wachovia for backing away from the auction-rate securities markets, nationalizing Fannie Mae and Freddie Mac, and by extension the entire U.S. real estate market, will have the perverse effect of further slowing the velocity of money. 

That is bad news for the Federal Reserve because at the end of the day it doesn't matter how much credit is made available; it matters how many people are willing to take it, and how quickly it circulates throughout the economy.

Stagflation is simply the transition from credit expansion to credit contraction, leading inevitably to deflation.


Anonymous said...

Moving from the last thread, since this one was just posted.

I would like to ask for advise from the participants here.

We have a second mortgage on our home. Call it $20,000 USD.

We also happen to have put together around $20,000 USD in cash. This came about as the result of a period of accelerated savings and was pushed over the threshold by this year's bonus.

Our plan all along has been to pay off the second mortgage with this money. I have an inherent distaste towards debt and would very much like to see this debt gone.


I believe that we are about to enter a deflationary period. I believe that during a deflationary depression, one should avoid debt and hoard one's cash.

So how would the readers here recommend I prioritize? I could extinguish one debt, but that would mean the elimination of this large cash nest-egg which will not be easily replaced. Despite having spotless credit, there is no guarantee we could "borrow it back" if we needed this cash again.

So, what should we do? Hoard the cash or extinguish the loan? I'm of very mixed feelings...

Anonymous said...


have a similar problem, my nest egg equals my debt. pay off debt now or hold cash and payoff debt slowly????????

EBrown said...

Kudos on piling up a nice bit of cash! From where I sit it seems that many other factors of your life must be incorporated into your decision whether or not to discharge your debt with your cash stash.

Will you be entirely out of debt after your $20,000?

Do you plan to live in this house for the next decade? Is it realistically possible to do so (heat to a minimal level in winter, access to water and food systems)?

Do you have other family members or close friends who may end up living with you or that you could move in with if (when) things get really rough?

It's hard to advise about a situation I know so little, and I am loathe to do so. Given the information you've laid out I can envision a scenario where it makes sense to pay off the debt now with your hoard and other particulars that would weigh heavily against doing so right now...

Anonymous said...


Years ago my husband and I paid off our debts with our savings. This was very liberating. It's amazing how one can save when there are no debts and one is disciplined to live frugally and simply.

Today we live debt-free. We have one credit card only which we pay off in full at the end of the month (if used) and use in emergencies, such as when renting a car or ordering something needed online.

In your case, given today's financial climate, I'd recommend to hoard your savings (not in a bank), and live very simply to be able to pay off your debt as soon as possible.


Anonymous said...

"The unifying principle behind most of Shiller's suggestions is the aim of helping Americans better understand economic affairs, in order to prevent them from making so many dumb decisions."

To understand something is "to stand in the midst of it." When I understand something I'm responsible for my thoughts and actions about it. For me, learning how money works has meant personal revolution, which includes no debt. No debt is freedom and, as noted above, at the moment makes it remarkably easy to save. If you're going to invest, invest in people you know and projects that make your community better.

Greenpa said...

"Economics is not a science, far from it, and economists are to a man either enormously stupid or lacking any semblance of a conscience. "

Really, Ilargi, there are times I wish you weren't so shy, and would just speak up. :-)

While I totally agree that economics is not, in any fashion, a science- I may (foolish me) have a little more compassion for those calling themselves "economists". It's possible even for pretty intelligent people to be totally sucked in to huge fallacies- when everyone else believes them, and they are taught as dogma, from childhood.

Those of us who are enlightened should pity them, I think, more than despise. We should start a rehabilitation program, to save those that are not too far gone. Don't you think? What fun that website would be! "At last, help; for foundering Economists! A 12-step program..."

I base this of course on my own experience, in my own field, eco/bio. It's so common for an otherwise reasonable and intelligent professor to also have one, or two, utter blind spots; where no logic or evidence can touch them. Classic.

Stoneleigh; I've downloaded the movie; hope to watch it carefully soon, with Beelar and Spice. We're all paying attention.

Just now my major economic problem is- a chipmunk explosion. Somehow, it seems appropriate to the mudslide world at large.

Anonymous said...

Samuel, that 20,000, as long as you hold it in reserve you would still have the option of paying off that mortgage at any time. In a sense by holding that cash you are debt free now. The costs would be in the fee for holding the mortgage and that could be looked on as a sort of payment for a doomster insurance policy.


Anonymous said...

The Next Bailout: Detroit

First came Bear Stearns, then mortgage lenders and borrowers, followed by Fannie Mae and Freddie Mac: They've all looked to Uncle Sam for a bailout, and now the word around Washington is that Detroit will be next on the taxpayer supplicant list.
Link here

Anonymous said...

GM is now a "me too" company; In their ads they claim they are better than Toyota and Honda. No mention of being better than Ford since that counts for nothing. And GM's main sales pitch is "buy GM because someday we'll have an eletric car". So of course they'll need a bailout. After all, what's good for GM is good for America.

Greyzone said...


Homo sapiens is desperately in need of a real science that addresses extraction of natural resources, creation of goods and services, and which includes impacts of these activities instead of just the gains. However, so long as the current social structure remains intact, there will never be a true science in this field. Instead, the pseudo-science of economics will continue to predominate.

All that we can do in the meantime is learn what we can about the current fallacies and attempt to live our lives in spite of these fallacies rather than in direct servitude of them.


If I were in that precise position and assuming I wished to stay in said property even in the event of very serious social disruption, I would pay off the debt immediately. First off, whatever your current payment is on the debt becomes immediately available to future savings. Further, any other savings you are getting can contribute to this as well.

A $20,000 debt is probably costing you something like $400-$500 per month, I'd guess? So being able to save that gives you $4800-$6000 back in savings in just 12 months anyway. Further, if you can double that (savings from another source), you could have $9600-$12000 saved in a year.

I highly recommend paying off any debt you can immediately because this puts cash back into your pocket immediately which can then be available for debt-free usage or further savings.

However, if you are considering leaving the current property, I'd hold onto the cash and attempt to sell ASAP. Prices are only going lower for a long time to come. If you want out, get out now and then you will be free to use the $20,000 for whatever purposes you envision (including just saving it for a rainy day).

In my view, the core of your decision rests on whether you intend to make your stand on your current property or not.

perry said...

In THIS world, there is no worse a situation to be in than having no cash. So, keep the cash. Live simply, and pay off the debt OVER TIME. Consider your cash stash as your ticket to personal FREEDOM!

If you give up that freedom, you do so by catering to the wishes of the bankers!

Cater to your OWN wishes! Be Free! Keep the cash stash; pay off the mortage over time.



Anonymous said...

Samael - Here's another idea. Apply $10,000 to the principal, and keep $10,000 in cash.

Anonymous said...

samuae, Grey figures you are paying as hfollows:

A $20,000 debt is probably costing you something like $400-$500 per month, I'd guess?

If so, I really would pay that off or risk ending up in the East river in cement boots, wow a 25% Am I reading this right? interest rate.


BTW ilargi if this one double posts the problem is not at my end (this would be the third in a row).
Also doesn't seem to be a trash can to dump a double post in now.

EBrown said...

I'm trying to wrap my brain more fully around money creation in the US. I understand how bank credit works as dollars, but I'm not sure I fully get the Fed-Treasury link in dollar creation. The Treasury borrows dollars that the Fed creates? The Fed also lends created dollars to its member banks? Is this correct? Ultimately the act of dollar creation comes back to the Fed? Thanks.

Anonymous said...

Re Sam,

To even hazard a piece of advice, anyone would need a lot more information.

Is it a fixed rate mortgage? For how long? What is the rate? What year are you in? What is your monthly payment? Are you USA or Canadian, and how does the interest deduction effect your taxes? What percentage of your monthly payment now goes to the liquidation of the principal? How secure is your job and income with the coming depression factored in? How rapidly is your area being affected by falling prices in housing? What are the chances that you would need cash for an emergency such as health which ties into your current medical insurance status?

How attached are you emotionally to the house? Could you sell it quickly, at a profit, and find an equivalent place to rent at the same cost, assuming that you still have positive equity in it? All things being equal (and they never are) , one is better off renting than owning until the housing market bottoms. Ilargi projects trough figures to be 10-20% the price of the peak. Renting gives you more mobility if your area really goes to hell in terms of danger, violence, and general unlivability. And rents will roughly follow the housing prices downward while mortgages do not. When the trough hits, you can buy your house back and still have most of the proceeds from the current sale to get you through hard times.

And the question already brought up – do you plan to make “your stand” during the coming time of trouble in this house? And, of course, this decision is based upon complicated factors often discussed here and laid out by James Kunstler and others.

If life were simple we wouldn’t be on this planet.

Ilargi said...


The Fed buys treasuries from the Treasury. It pays for them with newly minted keystrokes.

The treasuries they then hold are used as collateral (which by now, with financials leveraged 60:1 or more, has become almost an obscene term) for TAF and other "emergency" windows.

If things linger for 6 or 12 months, re: TAF, they are in the real world not considered emergencies, but then again, we're not talking the real world here.

Keep in mind that many actions in the world of finance take place in 24 hour periods ("windows"). Hundreds of billions are lent, borrowed and paid back every day. Global derivatives trade is perhaps as much as $1 quadrillion per year, or $3 trillion per day.

Note that the Treasury, that is the government and hence YOU, pays a 6% interest rate for all treasuries the Fed buys. Therein lies the perversity: a government can very well issue its own money, but the US conceded that power in 1913.

No wonder, then, that the US dollar has lost 96% of its value since: the one and only way just to pay the interest rate over previously issued treasuries, is to issue ever more treasuries.

I had to write today's intro in a hurry, and I'm not sure everyone will understand it, but that, right there, is the link to perpetual motion and growth.

Just in order for the US government to pay the interest over the money that the central bank has "allowed" it to issue, it needs to ask the same central bank to allow it to issue more. Over which it again pays the 6% interest rate. It really is, left field as it may sound at first, rinse and repeat.

And, insane enough as it is, that's just the start. New financial instruments, securities, derivatives etc., have encouraged the establishment of a system that allows (investment) banks to create money from air everytime some dupe signs a mortgage loan.

Which is then securitized, and sold to other dupes, a process that allows for more leverage, i.e. banks issuing 1000% more in loans to the dupe’s dupey neighbors. Fractional banking is your friend!

Ilargi said...


el pollo has a good list of questions.

perhaps you can do half and half, minimize your debt, which will be hurtful when we hit deflation, and still hold half, $10.000, in cash.

team10tim said...


The standard explanation is: The Treasury sales securities to Primary Dealers to finance the deficit. The Fed print's money to buy securities (notes, t-bills, bonds, etc.) from Primary Dealers. The Fed can hold them or sell them or loan them out through the Open Market Committee. When the Fed buys from the Primaries it exchanges existing debt for newly minted money, increasing the money supply. This new money is considered high powered money the banks now have capital above their reserve requirements and they can multiply this new money through the miracle of fractional reserve lending.

There are two pieces that are not explained, one of which I can address.

1) If the Fed buys securities, what happens when those securities mature? The Fed collects and gives part of the proceeds to it's member banks, pays all of it's expenses, and gives what is left over back to the Treasury. (link)

2) What difference does it make to the bank (Primary Dealer) whether the securities are sold to the Fed or on the bond market? How does this exchange increase a banks ability to lend when its balance stays the same (trading a $100 worth of securities for $100 doesn't change the total in the assets column) I'm clearly missing something here, but hell if I know what it is.


team10tim said...


Your response to EBrown's question about banks charging nations 6% for the right to use its own currency makes me think that you will like this paper Fertile Obfuscations:
Making Money Whilst Eroding Living Capital
Paper presented at the 34th Annual Conference of the Canadian Economics Association
exchange value to the owner.

Its about the difference between “oikonomia”, which refers to study of the well-being and
stewardship of the household, habitat or natural environment which is where we get our word for economics but is not what we have. And “chrematistics” which can be defined as the branch of political
economy relating to the manipulation of property and wealth so as to maximize short-term monetary, which is what we have and what we are referring to when we say the "economy."

Oddly enough it was published by a bunch of economist and bankers who seemed to realize that they themselves were full of crap.


Anonymous said...

No one has commented on the fact that Samael has a 20k SECOND mortgage.

Paying this off doesn't leave him debt free - what about the FIRST mortgage???

Consolidate if you can. Keep an emergency stash of a few months.
cj in vt

Anonymous said...

Thank you all for your comments.

The answers you've posted, and the questions you've asked, track closely to my thinking so far.

Only 4 years ago I was single and debt free. Today I am married, the father of two, and possessor of a first and second mortgage. Via my wife our family is also obligated to a Ph.D's worth of student loans. But as the stay-at-home Mother of two, she brings home no Ph.D. salary to extinguish that loan. We are fortunate that my salary can pay all our bills, provide for saving, and allow her to stay home.

The "good" news is that other than the two mortgages and the student loans there is no debt. We have one credit card that is used for the sake of convenience to pay monthly expenses, but it is paid off religiously every month. We have a small line of credit at the bank to cover any accidental overwithdrawals, but it too is paid off religiously on any month that it is used.

Both mortgages and the student loan are at fixed interest rates; 5.6%, 7.75%, and 3.6%.

We are where we intend to stay for now. Not because it is the ideal place to make our "last stand", but because it is where my career has taken us. We talk of moving elsewhere, but haven't found a career option that would enable that move. But discussing this any further draws the entire "big picture" into question, while I am trying to focus on what to do with this cash and this second mortgage.

You all have helped me to focus on the benefits and more importantly the risks at hand.

What is the risk if I pay the mortgage now?
- If we need this money again, and credit dries up, there is no way to get it back.
- Property values in our community have done relatively well through the crisis to date. However, if our house went significantly underwater I would not hesitate long from "walking away" and seeking a rental. Sending this cash to the second mortgage only increases the amount I could lose in this scenario.

What is the risk if I set the money aside?
- The cost of setting the money aside is the difference in interest I pay on the loan versus interest the money can gain. Depending on your assumptions this is $750 - $1500 per year.
- Depending on how the money is stored, there is the risk of losing some or all of it. Banks can fail; money in the mattress can be stolen.

Given these risks, you've helped me decide to hold the money. It would be hard to recover from credit drying up, some event forcing me to need cash, and not having it on hand. If our community takes a turn for the worse, and property values do plummet such that we are underwater, money paid against the second mortgage would just have been flushed away.

These risks seem to overwhelm the risks of keeping it. We can afford the interest differential for the sake of staying flexible. We can manage the principal risk by paying attention to how the cash is saved.

Thank you for being my sounding board. I think the best decision for our family for now is to hold the funds while things continue to unwind.

Anonymous said...

From yesterday's post - "Why buy today when tomorrow will probably be cheaper?" This is classic deflationary psychology at work. Confidence in the housing market is so low and financing can only get more expensive when Freddie and Fannie stop buying (they will) that we may be looking to a price fall of up to 60%-80% now.

Bigelow said...

“Now, who do you think is responsible for all the ups and downs in our economy for the last 85 years? Think about the depression of the late ‘20s and all through the ‘30s. The FED could have pumped lots of debt/money into the market to stimulate the economy and get the country back on track, but did they? No; in fact, they restricted the money supply quite severely. We all know the results that occurred from that action, don’t we?

Why would the FED do this? During that period asset values and stocks were at rock bottom prices. Who do you think was buying everything at 10 cents on the dollar? I believe it is referred to as consolidating wealth. How many times have they already done this in the past 85 years?

Do you think they will do it again?”
John F. Kennedy vs, The Federal Reserve

The Lizard said...

How unlikely the creation of a true science of money and resources!

Not to be critical of any who have offered help to Samuel, but just look at how different - and contradictory - it all is. And from exactly the same starting data.

Real science can land an artillery shell in a designated bucket, or land sensitive instruments on distant planets.

Given that standard, what would a real science of money and resources look like? I suspect it is not a possible thing at all. Everyone wants to be well-off, but every economic structure is founded on the principle that only the few will see the advantages, and they must be rewarded for their cleverness.

And while all that is happily going on, we mewl about 'freedom' and 'rights' and 'equality', all the while making sure our own fortunes are secure before the sharing begins among those you leave behind.

The West has history wrong: it isn't an ascending line. It plods a spiral, with the same sorts of events happening again and again, with the participants all believing they have got it right this time.

Apart from having good shoes and dry matches, all the preparation in the world will not change that we will all do what we must when the time comes.

perry said...


Excellent choice!

It's obvious you are smart enough to now devise ways to 'store' and 'secure' your savings in ways that will be of little or no risk of being lost. And there are many! Use the process as a game - to outwit the thugs and bureucrats.

Wal-mart has briefcase-style fireproof safes that will easily hold $20,000 in cash or PM's for as little as $39.00. They also fit nicely into a standard file cabinet drawer...or elsewhere.


David Gerard said...

The solution to the UK economy: complete apathy.