Saturday, August 23, 2008

Debt Rattle, August 23 2008: What do YOU say America?

Louise Rosskam What do YOU say America? 1942
Shulman's Market at N and Union Street SW, Washington.
Posters of Axis leaders Mussolini, Hitler and Admiral Yamamoto in the window.
Along the bottom of each it says What do YOU say America?

Ilargi: This will turn out to be one of the most expensive weekends in world history. But don’t worry too much about it; your children will pick up most of the tab.

We are witnessing an unprecedented increase of dirty fat and sticky fingers grabbing at the public trough. Since we long ago gave away control over the trough to those same fat fingers, we are now powerless to protect the safety of our children’s futures. So we might as well watch the Olympics. Bread and games work miracles, always have.

100 bank failures in the next year? Easily, and that’s the bare minimum. $850 billion at risk, for which the FDIC has less than $50 billlion in protection funds. If 10% is lost, the alleged deposit insurance is a laughing stock.

In the far more likely case that the loss is 20 or 25%, there will be no laughing. If more than 100 banks fail, which is also the far more likely case, there’s no telling what will happen. The one sure thing is that it will be very ugly.

GM and Ford want $50 billion "to develop fuel-efficient cars". We recognize this as a nonsensical driveling lie, since we know that the $25 billion already allocated to the two will barely be enough to cover their losses in just one, the last, quarter.

The Jackson Black Hole conference is being used, as we speak, to hand out taxpayers’ money from all over the rich world. You pay my patsy, I’ll pay yours. It's madness to claim that Fannie and Freddie, or GM and Ford, or Merrill and Citigroup, could still be saved. But then, that's not the goal here, is it?

We all see this happen, we watch the headlines getting darker, fast, we notice the mood changing from cheerleading to last rites. But how many of us have our eyes still on the ball? How many, when letting all this darkness sink in, truly understand what really goes on?

Have you given any thought lately to how profitable a crisis can be? If it’s your big fat digits that hold the trough, there’s much more money to be made in a crisis than in a stable situation. So you create one.

Lehman's clock is ticking
Lehman Brothers' latest march toward the once-unthinkable price of $10 a share was interrupted when a Korean bank expressed interest Friday in the struggling brokerage firm. The question now is whether CEO Dick Fuld is willing to reciprocate.

A spokesman at the Korea Development Bank in Seoul said Friday that the state-run firm "is considering all kinds of options [with respect to] Lehman Brothers," including an outright purchase. The news sent Lehman's stock, which has lost three-quarters of its value this year as investors worry about potential losses on the firm's big mortgage portfolio, up more than $2, to $15.93 a share in heavy trading. The shares closed up 69 cents at $14.41.

A Lehman spokesman declined comment on the story. But the market was upbeat because Fuld - after weeks scouring the globe for a strategic investor and getting rebuffed at every turn - now has a chance to do a deal that will put the firm on stronger footing. One high-profile analyst says the clock is ticking. Richard Bove, of Ladenburg Thalmann, told Bloomberg TV on Friday, that Lehman risks a hostile takeover if it doesn't act soon.

For now, it matters not that Korea Development Bank wasn't Lehman's first choice. Korean newspapers report that the New York-based brokerage firm first approached sovereign wealth fund Korean Investment Corp. But KDB apparently wasn't upset by the snub, perhaps because of some personal ties to Lehman: Its chief executive, Min Euoo-Sung, was the head of Lehman's Korean operations for three years before taking over at KDB last year.

Of particular note is whether the KDB would buy Lehman outright or simply take a big stake. The past year has been busy for sovereign wealth funds and financial companies hit hard by the collapse of the credit bubble. Singapore's Temasek has made two multibillion-dollar investments in Merrill Lynch, the state-run China Investment Corp. has put $5 billion into Morgan Stanley and Abu Dhabi has forked over $7.5 billion for a big hunk of Citi.

For Lehman shareholders, the distinction between a buyout and an equity infusion is the difference between taking pain all at once or continuing to suffer for an undetermined time. If Lehman were purchased outright, the firm would no longer need to peddle a piece of its crown jewel, the investment management arm led by the former Neuberger Berman.

Nor, presumably, would Lehman need to imminently offload nearly $40 billion in various commercial real estate loans and securities, which are sinking in value on a daily basis. On the other hand, if KDB is looking at a mere equity investment, then Lehman may have to keep reducing the size of its balance sheet. So the firm would get some new cash and a deep-pocketed partner, but it would still be facing big losses selling into an unfriendly market.

The Neuberger stake has been valued at anywhere from $8 billion (by Bernstein Research) to well north of $10 billion (various published reports), though it is unclear if Lehman seeks a direct sale or only wants to off-load a percentage of the unit. The issues with the commercial real estate paper are clearer: That portfolio is almost certainly a large slice of the rumored $2 billion to $4 billion hit the firm is said to be looking at for next quarter.

Either way, a KDB accord would be a breakthrough because, despite actively seeking bidders and interested parties for the investment management arm and the commercial real estate paper for more than two weeks, Lehman has not come close to striking a deal.

Up to this point, Lehman management has taken a very different approach to this crisis from its rivals at Citi and especially Merrill Lynch. Citi and Merrill's leaders have relentlessly struck deals to sell troubled portfolios and reduce their balance sheet issues, even financing transactions at favorable terms to get risky assets off their books.

Ultimately, should it fail to do a deal, Lehman is telling the market that CEO Fuld hasn't made a clean break with a failed strategy and wants only another investor to help it through a proverbial rough-spot. That's not a message investors are likely to welcome.

Wall Street should soon know where it stands vis a vis Lehman. Richard Bove, the Ladenburg Thalmann analyst, said Friday on Bloomberg TV that Lehman and Fuld have through the weekend to structure some sort of transaction that would give investors the reassurance they seek about the state of the firm's balance sheet.

According to Bove, if a deal doesn't materialize by Monday, then "Lehman is in play." He suggested a stock price of around $20 might get a deal done. Given Lehman's recent lows, and the memory of what happened to Bear Stearns earlier this year, that might not sound like a bad price.

Despite the ominous warning, it's unlikely that Lehman would become the target of a hostile bid. For one thing, Lehman employees own about 30% of the firm's shares. Still, Fuld has been trying to draw an investor willing to pay a 20% premium to book value, Bove said - or in the low $40 range.

While Lehman shareholders, would surely prefer $40 to $20 a share, Bove scoffed that the firm "doesn't have a prayer" of getting the higher price. For Fuld, time may be running out. 

Uncertainty Over Fannie and Freddie
Anxiously awaiting a move by the Treasury Department and spurned by large investment firms, Freddie Mac and Fannie Mae find themselves unable to raise capital and with little ability to maneuver.

Treasury officials have reviewed multiple plans for intervention, according to people who have spoken to top Treasury officials. But they have not identified a set of triggers that will compel a government bailout. Nor have they indicated to Freddie Mac or Fannie Mae executives when a bailout may occur or what form it may take.

As a result, investors are telling Freddie Mac and Fannie Mae that they remain unwilling to purchase new shares in the firms. “We’re in a Catch 22,” said an executive with one of the mortgage firms who was not authorized to speak to the media. “As long as there is uncertainty over Treasury’s plan, we can’t raise money, and as long as we can’t raise money, there’s going to be more and more speculation about Treasury’s plan.”

In recent days, Freddie Mac has met with potential investors at the law offices of Davis, Polk & Wardwell. But the company has been told by several private equity giants — the Texas Pacific Group, Kohlberg Kravis Roberts & Company, the Carlyle Group and the Blackstone Group — that those investors are unwilling to purchase any type of new stock in the company until it is clear what steps the Treasury Department may take to assist the ailing firm.

“You would have to be insane to invest in these companies right now, and we’ve basically told them that,” said an investment professional with one firm that was approached by Freddie Mac, but who is not authorized to speak to the media. “When Treasury comes in, they are guaranteed to get a better deal than us, which would push down the value of our investment. So why would we ever invest before we know what Treasury is going to do?”

Treasury has been asking for management changes at Freddie Mac, according to people briefed on the discussions. Richard F. Syron, the chief executive, has collected more than $38 million in compensation since 2003. Freddie Mac is looking for new investors to fulfill a pledge made to federal regulators earlier this year to raise $5.5 billion.

That goal has become increasingly difficult as the stock prices of Freddie Mac and Fannie Mae have declined by more than 87 percent in the last year. Shares of Freddie Mac fell 35 cents, or 11 percent, to $2.81. Shares of Fannie Mae rose 15 cents, or 3 percent, to $5.

In theory, declining stock prices should not pose a problem for the day-to-day operations of either company. People familiar with the finances of both firms say they have enough capital to cushion against losses through this year, as long as they can continue to borrow billions of dollars each month.

As the companies’ stock prices decline, however, some buyers of debt are beginning to back away, including Asian central banks. Though the companies have some debt offerings every week, the next big one — and big test of market confidence — is probably several weeks away.

On Friday afternoon, preferred shares of the companies were trading at 40 cents on the dollar, down about 20 percent over the last week. Those shares were trading at 80 to 85 cents just one month earlier. Moody’s Investors Service, the ratings firm, cut its ratings on Fannie Mae’s and Freddie Mac’s preferred shares to Baa3, from A1 on Friday, a downgrade of five notches leaving the shares just above junk status.

And the billionaire investor Warren E. Buffett, the chairman of Berkshire Hathaway, said in an interview on CNBC that “the game is over” for the firms to continue operating as independent companies. Thomas C. Priore, chief executive of Institutional Credit Partners, a fixed-income management firm, said, “Any investor stepping in will need certainty around the financing and leverage of their equity.” “Right now, those are the things that are uncertain.”

As speculation mounts about if and when the government will intervene, Treasury Secretary Henry M. Paulson Jr. has declined to discuss with the companies or other outsiders how a bailout might look. People close to Mr. Paulson and other Treasury officials say those policy makers are constantly taking the temperature of market participants, and will act when they think that confidence has eroded to the point that it damages the firms’ capacities to buy and sell mortgages.

Mr. Paulson is remaining quiet, say those close to him, because he thinks any indication of a preference for a particular plan or a trigger will be self-fulfilling, with the market immediately creating the need for that plan. People knowledgeable about the proposals, however, say the options being studied include guaranteeing a debt or equity offering of either company, or a direct investment in either firm.

Many analysts on Wall Street speculate that Treasury will invest in the companies through preferred shares to protect taxpayers from losses.

Moody's ratings cut latest blow to Fannie, Freddie
A major credit rating agency cut the preferred share rating on Fannie Mae and Freddie Mac amid mounting concern about the ability of the two largest U.S. home funding providers to access capital, in the latest blow before a widely expected government bailout.

Early in the day, influential stock market investor Warren Buffett told CNBC there is a "reasonable chance" that Fannie Mae and Freddie Mac stock will get wiped out in a government rescue, reflecting market sentiment that has slammed the companies' shares toward 20-year lows this week. The shares closed mixed on Friday.

In the ratings cut, Moody's Investors Service cited concern that market turmoil has hurt the mortgage finance giants' ability to get fresh capital. Moody's made a ratings adjustment that suggests a greater likelihood the government sponsored enterprises, called GSEs, will need "extraordinary financial assistance" from the government or shareholders.

"Given recent market movement, Moody's believes these firms currently have limited access to common and preferred equity capital at economically attractive terms," Moody's analysts said. Many analysts expect the government will have to exercise new abilities to recapitalize the companies, effectively nationalizing them. Those worries yanked their stock closer to zero this week from more than $65 a year ago.

Fannie Mae shares rose 2 percent to $4.98 while Freddie Mac stock dropped 4 percent to $3.03. Freddie's shares had fallen about 20 percent at one point on Friday. A source familiar with Treasury's thinking said on Friday that any backstop would aim to keep the shareholder-owned status of these GSEs, erasing sharper earlier losses.

The debt these companies issue to fund their mortgage purchases benefited, in contrast, from the view that a federal rescue assures repayment for bonds even if not for shareholders. Fannie and Freddie own or back nearly half of all outstanding U.S. mortgages.

"The institutions are too big to fail and the government needs them operating," said Jeff Given, portfolio manager at MFC Global Investment Management in Boston. "It's the only part of the mortgage market that's even remotely working right now. "At the end of the day probably the U.S. government's going to come in," he added. "I wouldn't want to be a preferred share owner or a common stock owner, but if you own the debt or the MBS you're going to be okay."

Moody's lowered the preferred stock ratings on the companies to "Baa3" from "A1," and the bank financial strength rating to "D-plus" from "B-minus," it said in a statement. Investors have pummeled common and preferred shares of Fannie and Freddie during the past two months as speculation grew that losses on their mortgage holdings and guarantees are quickly eating away at their capital.

Moody's added that Fannie and Freddie are restricted in their ability to support the worst U.S. housing market since the Great Depression. This difficulty comes just as the government is depending more heavily on the two companies to buy mortgages and stabilize housing and the economy.

At current share prices, "it's a very cheap call on the notion of these guys surviving, and if they do it'll be a multi-bagger payoff," said Chuck Gabriel, managing director, Capital Alpha Partners, LLC in Washington. Freddie Mac has said it intends to raise $5.5 billion in new capital and awaits more opportune market conditions.

"Our management has been talking with a variety of potential investors this week," Freddie Mac Spokesman Douglas Duvall told Reuters on Friday, although he reiterated earlier statements that "we are capitalized above regulatory requirements." Fannie's and Freddie's ease in funding mortgages through the debt issuance is considered crucial for the housing market and economy.

Plenty of investors surfaced for new note issues sold this month by both companies, although Fannie and Freddie paid higher risk premiums than in prior sales. The two GSEs have reported losses for the past four quarters, and rising mortgage delinquencies erode the value of their capital and assets. However, they meet regulatory capital requirements and are successfully rolling over debt on schedule, limiting the need for any nationalization.

Moody's affirmed the companies' "Aaa" senior debt ratings, and the "Aa2" rating on their subordinated debt. In a sign that investors believe a bailout is on the way, risk premiums on most Fannie and Freddie senior debt sold to finance their mortgage purchases have fallen by as much as 0.25 percentage point versus Treasuries this week, returning to levels seen at the end of July.

"Most parties would look at it as the U.S. government stepping in and guaranteeing the obligations of Fannie and Freddie," said Bob Pickel, chief executive of trade organization the International Swaps and Derivatives Association. Large U.S. banks and thrifts that have disclosed holdings of Fannie and Freddie preferred stock and subordinated debt appear to have "manageable" exposure to potential write-downs, with the exception of Sovereign Bancorp Inc, according to report from CreditSights Inc late Thursday.

"Assuming that these securities are relatively well dispersed among the banking system, our view is that this should be a manageable exposure for most banks," CreditSights analysts led by David Hendler wrote.

Fannie, Freddie Preferred Stock Downgraded Five Steps By Moody's
Fannie Mae and Freddie Mac's $36 billion in preferred stock was downgraded to the lowest investment-grade rating by Moody's Investors Service, which said the increased likelihood of "direct support" from the U.S. Treasury may devalue the securities.

The ratings were lowered five steps to Baa3 from A1, New York-based Moody's said today in a statement. Moody's kept its Aaa senior debt ratings on Fannie and Freddie stable and affirmed the subordinated debt because the Treasury will likely make sure the companies continue to make interest payments in any bailout.

Moody's joins a chorus of analysts and investors who say Fannie and Freddie's limited access to "economically attractive" capital will give Treasury Secretary Henry Paulson little choice but to bail out the beleaguered mortgage-finance companies. The preferred shares had already lost at least half their value since June 30 on concern that intervention would mean a stop in dividend payments or involve an injection of preferred stock that ranks ahead of current holders.

Regional banks including Midwest Bank Holdings Inc., Sovereign Bancorp and Frontier Financial Corp., may have the most to lose. Melrose Park, Illinois-based Midwest has $67.5 million, or as much as 23 percent of its risk-weighted assets, in the preferred stock, while Philadelphia-based Sovereign owns about $623 million and Everett, Washington-based Frontier about $5 million.

The downgrade "puts a little more pressure on banks to record some sort of impairment charge on these securities," Daniel M. Arnold, an analyst at Sandler O'Neill & Partners LP in New York, said in a telephone interview. "The more and more likely it becomes that the value of these isn't going to return back to where it was," the harder it is to avoid writedowns.

Paulson last month was granted the power to make unlimited capital injections into Washington-based Fannie and McLean, Virginia-based Freddie should he and the companies deem it necessary. The Treasury has repeatedly said Paulson doesn't expect to have to exercise that authority.

Moody's so-called bank financial strength ratings on Fannie and Freddie, which reflect the odds of a government bailout, were cut four steps to D+ from B-. "The game is over" for Fannie and Freddie, billionaire investor Warren Buffett, the 77-year-old chairman of Berkshire Hathaway Inc., said in an interview on CNBC today.

Fannie's $7 billion of 8.25 percent perpetual preferred stock rose 2.1 percent to $11.29 today. They are down 26 percent this week, with the yield rising to 19 percent from 13.9 percent. Fannie common shares rose 15 cents, or 3.1 percent, to $5 in New York Stock Exchange composite trading and have lost 93 percent in the past year.

Freddie's $1.1 billion of 5.57 percent preferred stock rose 2.1 percent to $7.40 and is lower by 36 percent this week, pushing the yield to 19.5 percent. Freddie common shares dropped 35 cents, or 11 percent, to $2.81 and are down 96 percent in the past year.

Preferred shares rank one level above common stock in the capital structure, which is used to determine the priority of payment in the event of a bankruptcy. Senior debt holders rank first, then the companies' subordinated bondholders followed by preferreds then equity.

The companies, which own or guarantee about $5 trillion of the $12 trillion of U.S. residential loans, were developed to expand financing to homebuyers by buying mortgages from lenders and packaging others into securities that they then guarantee. They have struggled amid rising loan delinquencies, posting $14.9 billion in combined net losses over the past four quarters.

"As we've been saying, we maintain the highest capital rating from our regulator, a strong liquidity position and continued access to the debt markets at attractive spreads," Freddie spokesman Douglas Duvall said today. "We are also pleased that Moody's has affirmed our long-term, short-term and subordinated debt ratings."

New York-based Standard & Poor's on Aug. 11 cut its ratings on the preferred stock and subordinated debt of Fannie and Freddie to A- from AA. S&P said any U.S. equity injections would probably raise the odds of default on their subordinated debt.

Any deferrals on subordinated debt payments "may also affect senior-debt funding" costs, something that the government wants to avoid, Brian Harris, an analyst at Moody's, said in an interview. At the same time, "it's more difficult for the government to explain the rationale for supporting a form of equity holder, such as preferred stock."

Moody's outlook on its Aa2 ranking of the subordinated debt was reduced to negative because of the "fluid situation," the firm said. S&P rates the securities four levels lower than Moody's, and the preferred shares three levels higher.
The cost to protect the subordinated debt of Fannie and Freddie from default dropped today to the lowest in almost two weeks today after reaching a record on Aug. 19.

Credit-default swaps on Fannie's subordinated debt fell 41 basis points to 258 basis points, according to CMA Datavision. Contracts on Freddie's debt fell 48 basis points to 250. 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. A decline signals improvement in investor confidence.

Freddie Hunts for Cash
Freddie Mac executives are sounding out private-equity firms and other investors about the possibility of buying new common or preferred shares in the mortgage company.

But that effort is running up against what may be an insurmountable hurdle: Many investors fear any money they invest now in Freddie or its main rival, Fannie Mae, will be lost later if the U.S. Treasury bails out the companies through a purchase of equity in them. Investors believe such a purchase would likely involve terms that would wipe out the value of previously issued shares.

"Senior management has been talking with a wide array of possible investors this week," said David Palombi, Freddie Mac's chief spokesman. He noted that the company remains above its current regulatory capital requirements but has pledged to raise $5.5 billion of capital "given appropriate market conditions."

Fannie Mae raised $7.4 billion in May but has said it may need to tap the market again, depending on how large losses turn out to be in coming quarters. In July, Congress gave the Treasury authority to lend money to or acquire equity in the companies if needed to prop them up. That helped reassure buyers of Fannie and Freddie debt that the government would stand behind them in a crisis.

But the Treasury's authority may make it harder for them to sell equity because of uncertainty over how the Treasury would treat private shareholders if a bailout is needed. Some people involved in the discussions hope the Treasury might be persuaded to clarify how shareholders would be affected by a bailout. Treasury officials declined to comment.

Another huge uncertainty is how the companies' new regulator, the Federal Housing Finance Agency, will apply its authority to set higher capital requirements for Fannie and Freddie. The agency has said it will need time to work out those requirements, a process that will involve writing regulations and seeking public comment. Meanwhile, investors find it hard to assess the companies' profit prospects without knowing how much capital they will have to hold.

Fannie and Freddie also fear their prospects are being undermined by negative comments from unidentified government officials in various media reports. On Aug. 1, Rep. Henry Waxman (D., Calif.), chairman of the House Oversight and Government Reform Committee, sent letters to Fannie and Freddie asking for any documents that would suggest government leaks in July about their financial conditions. The companies have already turned over materials, according to a committee staff member.

Freddie shares slipped 2.8% to $3.16 in 4 p.m. composite trading Thursday on the New York Stock Exchange. Fannie was up 10% to $4.85. Both stocks have plunged more than 90% over the past 12 months. Freddie's stock-market value of about $2 billion is now less than a quarter that of Hudson City Bancorp Inc., a savings-bank operator in Paramus, N.J. Hudson City has about $49 billion of assets, compared with $879 billion at Freddie.

Paulson's Fannie-Freddie fix
The market is betting Henry Paulson is about to put on his black hat again. But the Treasury secretary may not be so easily typecast in the saga of the government-sponsored mortgage finance companies.

Shares in Fannie Mae and Freddie Mac hit new lows this week on speculation that the government will be forced to support the companies. With the shares down more than 90% over the past year, analysts such as Paul Miller at Friedman Billings Ramsey say the only way the companies can raise enough money to soothe the markets is to lean on the government.

"They're going to need some help here," says Miller, who has written that Fannie and Freddie need to raise $15 billion each to see them through the housing bust. Fannie and Freddie are shareholder-owned, though they have been able to borrow at below-market rates thanks to an implicit government backing for their debt.

Paulson said last month he wants to keep the companies, which buy and guarantee around half of all U.S. home mortgages, in their current form to help ease the pain of the housing bust.

But with investors fretting over possible changes in the companies' capital structure - while Paulson has essentially stood behind the companies' senior debt, he hasn't said what would happen in any restructuring to other securities - the companies' low-cost funding advantage has eroded, pushing mortgage rates up and adding to the pressure on house prices.

So Paulson may soon have to act. The big question is whether he'll reprise his villainous role in the Bear Stearns rescue. For now, there are reasons to think he might not. When the brokerage firm collapsed in March, Bear and would-be buyer JPMorganChase were discussing a deal at $8 to $12 a share.

But Paulson wanted Bear Stearns shareholders to get just $2 a share, to avoid the perception that taxpayer dollars were being used to bail out fat-cat Wall Street types. Bear shareholders eventually got $10 a share, after the deal was renegotiated to calm Bear investors who were threatening to block the deal.

Even so, the markets have taken Paulson's stance in the Bear bailout to mean any government support for Fannie and Freddie might render existing shares worthless. "It seems a foregone conclusion that shareholders are going to be wiped out," says Paul Hickey at investment adviser Bespoke Investment Group in Harrison, N.Y. "But the stocks haven't gone to zero yet."

Indeed, while the outlook for shareholders is uncertain, to say the least, the problems at Fannie and Freddie aren't as dire as the ones that led to the collapse of Bear. That fact may allow Paulson to put away his cudgel. The contrasts between Bear and the GSEs are easy to see. Bear essentially ran out of cash after its customers pulled their funds in a run on the bank. By contrast, even skeptics of Fannie and Freddie acknowledge they aren't about to go broke.

Fannie and Freddie were above their regulatory minimum capital requirements at the end of the second quarter - substantially so in Fannie's case - and both are able to borrow from the Fed in an emergency funding crisis, of which there has been no evidence in any case.

"Sober analysis shows they have enough capital," Fox Pitt Kelton analyst Howard Shapiro writes in an e-mail. Shapiro, who rates the stocks overweight, wrote in a report Tuesday that the companies' credit exposure looks "scary" at first glance but actually is likely to be quite manageable, given the quality of their loans and their substantial capital resources.

What's more, the Fannie-Freddie situation lacks the urgency of the Bear meltdown. The government pushed through the sale of Bear because officials feared the markets could unravel if the firm, with its massive derivatives book, failed. With the health of the capital markets at stake, Paulson and New York Fed President Timothy Geithner had to put a deal together, and fast.

In contrast, Fannie and Freddie don't look like a ticking time bomb. The uncertainty about the companies' fate is clearly weighing on the markets right now - Hickey notes that the spread between risk-free Treasury securities and the Merrill Lynch High-Yield Bond Index recently spiked to their widest levels since Bear collapsed.

But since Paulson has the luxury of a bit of time to weigh his options, it's far from clear that Treasury's solution has to involve a shareholder wipeout. None of this is to say that Paulson, who last month received authority from Congress to invest in Fannie and Freddie in case of a market emergency, won't have to take any action - or that the companies' shares are a clear bargain even at these reduced levels.

"Why would you buy these?" asks FBR's Miller, who rates the stocks underperform thanks to the uncertainty surrounding coming credit losses and the associated capital situation.

Moreover, the Asian central banks that have long been big buyers of agency paper have slowed their purchases. If bond buyers show further reluctance, the companies' costs could rise more - a significant consideration with more than $200 billion in agency debt in need of refinancing in coming months.

That said, any solution that clarifies how investors in Fannie and Freddie's common and preferred stock and subordinated debt stand - without looking like a complete massacre - could be met with relief in the market. Miller says resolution of the uncertainty around Fannie and Freddie could send shares in other financial companies sharply higher, as people using the uncertainty to bet against bank and brokerage stocks might then cover their shorts, feeding "a massive short squeeze across the financials." 

Big Three Auto Makers Seek More Help From Washington
Battered by high gasoline prices and weakened earnings, the Big Three auto makers and their suppliers are now seeking significantly more help from Washington in the form of government-backed loans than the $25 billion they had previously been authorized to receive.

The $25 billion in loans were approved as part of an energy bill last year, but now General Motors Corp., Ford Motor Co. and Chrysler LLC will need "well north" of that, a GM spokesman said. The loans have yet to be funded. Following an extreme run up in gas prices that has crushed U.S. vehicle demand, auto executives are now making the case that Detroit could need far more money in order to fund critical initiatives.

"There's a real urgency in that all of the progress we have made on these new vehicles could come to a standstill if we can't get capital at reasonable rates," the GM spokesman, Greg Martin, said, without giving a specific figure. People familiar with the discussions said there is no consensus dollar amount that auto executives are demanding at this point.

Various reports have suggested the domestic auto industry now seeks between $40 billion and $50 billion. The auto maker's would like to have a funded plan in place by the end of 2008.

Unlike the federal Chrylser bailout of 1979, under which the government backed $1.5 billion in loan guarantees so the auto maker would avoid skidding into bankruptcy, the current initiative is positioned as a way to make the Big Three more competitive in a global technology race in which they could otherwise be unable to effectively participate in.

The companies are struggling financially and hope to use the loans to accelerate the development of new technologies and vehicles. "This is not really a bailout," David Cole, president of the Center of Automotive Research in Ann Arbor, Mich. said. "This is actually more like the government acting like a banker as it begins to look at the major consequences of a major failure in the auto industry," he said.

Sen. John McCain, the presumptive Republican nominee for president, said on Friday he backs a plan for the federal government to provide low-interest loans to struggling U.S. auto makers. Sen. Barack Obama, his likely Democratic opponent, said he backs "providing additional assistance to the companies in future years to ensure that advanced fuel-efficient vehicles will be made here in the U.S."

"Our auto companies are rising to the challenge of building the next generation of American cars, but are doing so in times when credit conditions cripple the funding for the facilities and technologies to take the steps to the future," Sen. McCain said in a statement, noting that Congress passed a bill authorizing the loan program.

Sen. Obama said his energy plan would send $4 billion to the industry to retool plants to make fuel-efficient cars and trucks.
This year has brought a deep downturn in auto sales, along with a sudden consumer shift to small cars and away from the trucks and sports-utility vehicles that Detroit depends on for much of its revenue, increasing the interest in help from Washington.

Last year, Congress created the "Advanced Technology Vehicles Manufacturing Incentive Program," aimed at helping auto makers meet higher fuel economy standards. However, Congress didn't fund the program, and the McCain campaign has opposed funding it. McCain has since changed his stance on further assistance to struggling auto makers, but hasn't specified what form it would take.

In Sen. McCain's statement Friday, he noted Congress failed to fund the technology-vehicles program. "I believe we should fund it and take action that will assist Detroit and its suppliers in making it through this difficult time of transition," Sen. McCain's statement said.

Government backing of the loans would enable the auto makers to get significantly better interest terms than they could on their own, reducing the cost of borrowing the money. People familiar with the matter said the rate could be half that which would be available from capital markets.

"Congress created this program and we're quite hopeful they will fund the program now so they can assist us in our transformation of company to producing more advanced technology vehicles," Ford spokesman Mike Moran said. Detroit is reaching out for Washington's help during one of the biggest downturns the U.S. auto industry has ever faced.

Auto sales, tracking at their lowest rate in 15 years, have been hammered by a weak economy and the housing market's meltdown, and demand for the most profitable models – trucks and SUVs – has collapsed due to high gasoline prices.

Together GM and Ford lost nearly $25 billion in the second quarter alone, and continual restructuring charges and persistent operational losses are draining billions from the auto giants' cash reserves on a quarterly basis. Typically, the auto makers could tap the credit markets for additional funding, but Wall Street is exercising caution as it relates to the car industry given the abrupt slowdown in sales and the lack of clarity on when the market will recover.

In GM's case, executives have said they have enough cash on hand to last until the end of 2008, and a liquidity plan capable of keeping the company afloat through 2009. At Ford, options are limited due to the fact it leveraged all its assets in 2006 in order to raise tens of billions of needed financing.

GM, Ford Seek $50 Billion From U.S.
General Motors Corp., Ford Motor Co., Chrysler LLC and U.S. auto-parts makers are seeking $50 billion in government-backed loans, double their initial request, to develop and build more fuel-efficient vehicles.

The U.S. automakers and the suppliers want Congress to appropriate $3.75 billion needed to back $25 billion in U.S. loans approved in last year's energy bill and add $25 billion in new loans over subsequent years, according to people familiar with the strategy. The industry is also seeking fewer restrictions on how the funding is used, the people said today.

GM and Ford lost $24.1 billion in the second quarter as consumers, battered by record gasoline prices, abandoned the trucks that provide most of U.S. companies' profit and embraced cars that benefit overseas competitors such as Honda Motor Co. U.S. auto sales may drop to a 15-year low this year and fall even more in 2009, analysts have said.

"Next year is going to be a make-or-break year in terms of survival," said Mirko Mikelic, senior portfolio manager at Fifth Third Asset Management in Grand Rapids, Michigan, which oversees $22 billion in assets, including GM and Ford bonds. "Any help like these government loans would be a huge boost."

Standard & Poor's said Aug. 19 that U.S. light-vehicle sales will fall to 14.2 million units this year from 16.1 million in 2007 and drop again to 14.1 million next year. The ratings company said there is a 20 percent chance that this year's sales will be as low as 13.6 million and 11.7 million next, presenting an "overwhelming challenge" for U.S.-based companies.

"Our plans, which require significant investments, are at risk because of limited access to capital," said Greg Martin, a spokesman for Detroit-based GM. He declined to comment on whether GM is seeking more than the original $25 billion. "This program will open capital that is necessary to make sure our transformational plans continue at full speed and give us the best chance to succeed."

Mike Moran, a spokesman for Deaborn, Michigan-based Ford, said the automaker had no comment on any funding beyond the $25 billion already approved. "The priority is to get the appropriation that has already been approved," said Linda Becker, a spokeswoman for privately held Chrysler, based in Auburn Hills, Michigan. "Conversations as to why or how we should expand that amount are ongoing."

Congress needs to appropriate about $3.75 billion to cover the upfront cost of the government loans, according to a July 25 estimate in a letter to House and Senate leaders. The letter was sent by 71 members of Congress urging support on the issue.

Presidential candidate and presumptive Republican nominee Sen. John McCain today gave his support to the proposal.
"Our auto companies are rising to the challenge building the next generation of American cars, but are doing so in times when credit conditions cripple the funding for the facilities and technologies to take the steps to the future," he said in an e- mailed statement.

"We should fund it and take action that will assist Detroit and its suppliers in making it through this difficult time of transition," he said in the statement. Others disagreed with the proposal to put taxpayer funds at stake.

"This is a horrible idea, another transfer of funds to failed ventures," said David Littmann, senior economist for the Mackinac Center for Public Policy in Midland, Michigan, which describes itself as a supporter of free-market ideals. "If this were a good idea, the market would price the debt accordingly and give them the money."

Auto-industry lobbyists want Congress to set rules that will allow the initial $25 billion to pay the full cost of upgrading assembly plants, parts production or engineering to improve fuel efficiency, said the people, who didn't want to be identified because the plans are still being developed. The current rules limit loans to 30 percent of the cost.

The industry is also seeking a broader interpretation of what projects are eligible. That might allow the funds to cover the conversion of truck plants into car plants, for example, in addition to paying for vehicles with the highest mileage, such as hybrid-electric cars or fuel-cell models, the people said.

The loans were authorized in last year's Energy Independence and Security Act. Rules to free up the funding are supposed to be written within a year of its December passage, Representative John Dingell said in an Aug. 4 letter to U.S. Department of Energy Secretary Samuel Bodman.

The auto industry wants funding for the loans approved before the current legislative session ends next month. Dingell and other lawmakers have said Congress needs to consider the impact the companies have on the U.S. economy.

GM, Ford and Chrysler employ 240,000 people in the U.S. and account for 7 out 10 U.S. auto workers, according to a report released this year by the Automotive Trade Policy Council in Washington, which represents trade interests of U.S. automakers. The companies support another 5 million jobs at auto dealerships, suppliers and service providers.

The automakers purchased $156 billion in auto parts last year and have invested $225 billion in U.S. plants and equipment since 1980, including $10 billion last year, according to the report. GM has fallen 58 percent this year, and Ford has tumbled 34 percent. GM rose 52 cents to $10.44 at 4:15 p.m. in New York Stock Exchange composite trading, while Ford was up 5 cents to $4.47.

"We've seen these kinds of bailouts for the financial companies, why not the automakers?" said Aaron Bragman, a Troy, Michigan-based auto analyst for Global Insight Inc. "The big problem is that a lot of people in Washington don't see a value in the U.S. auto industry because they have a foreign plant in their district that is doing just fine."

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.

Earlier this month, the Detroit Free Press reported that the top dogs at Ford, GM and Chrysler had a meeting of the minds and decided that the way out of their current losing streak would be to ask the feds for a lifeline. They figure they'll need $40 billion or so to ride out their current troubles until they reach the promised land of hybrids, the Chevy Volt, and, who knows, maybe even profits.

We've since heard that lobbyists for the car makers are taking their pitch for direct federal loans around Washington, with a goal of unveiling the plan after Labor Day -- conveniently in the frenzy of the fall election campaign. They've briefed Congressman John Dingell, the dean of Michigan Democrats, as well as officials in the Bush White House.

The plan is for the government to lend some $25 billion to auto makers in the first year at an interest rate of 4.5%, or about one-third what they're currently paying to borrow. What's more, the government would have the option of deferring any payment at all for up to five years.

Meanwhile, Barack Obama recently signaled that he's open to federal money to help the auto makers invest in "renewable" technology, and Michigan Senator Debbie Stabenow and Mr. Dingell are supporting the $25 billion in loans to the not-so-Big Three as part of a second-round economic "stimulus."

Detroit's political calculation is plain: Having seen the way Washington has bowed to rescue the mortgage industry and Wall Street, why shouldn't auto makers give it a try? Michigan is up for grabs in the election, so now is the time to strike with a goal of getting the Bush Administration and both Presidential candidates to agree.

The car makers can also claim with justification to have been hurt as badly as anyone by Washington's policy blunders. The weak dollar has contributed to the spike in oil prices that has socked their most profitable vehicles. And the nonsensical way that fuel-economy standards force Detroit to subsidize cars that consumers won't buy has helped put the Big Three in this hole.

Then again, the car makers saddled themselves with a cost structure in flush times that has proved unsustainable as their market share has eroded. They have made great strides of late in shedding legacy pension and health-care costs, but they took decades to do so. The fact that GM's lending arm, now 51% owned by the owners of Chrysler, dipped its toes in mortgage lending hasn't helped either.

There also happens to be a thriving U.S. auto industry outside of Michigan. These plants are owned by foreign companies, but they employ 92,000 Americans and build and sell cars here. Tens of thousands of their shareholders are Americans. Would these companies and plants get equal consideration under any bailout plan?

And if Toyota and Honda get help, why not Delphi and other auto suppliers? We're told the low-interest loan proposal would give priority to the "oldest" plants -- which is another way of saying those plants organized by the United Auto Workers. Bailing out "national champions" because of their long history or politically connected work forces is something you'd expect from France.

With rare exceptions -- Chrysler in the 1970s -- the U.S. government has managed to remain immune to that European disease. But as the nearby table shows, Washington has begun to make a habit of bailing out any business or industry that can marshal enough political clout. That's a lot of risk to put on the taxpayer dime, and that's not counting such other runaway liabilities as Medicare.

We wish the Treasury and Federal Reserve hadn't started all this with its Wall Street rescues, but at least Bear Stearns was put out of business and its shareholders lost nearly everything. That's also typically what happens when the Federal Deposit Insurance Corp. takes over a failing bank, as in the case of IndyMac in July.

If Fannie and Freddie require a taxpayer infusion, we can't believe Treasury wouldn't wipe out their shareholders and fire their managers as well. And if Detroit's executives really want taxpayers to save them, then at a minimum they should suffer the same fate as these other companies and shareholders. Somehow we doubt this is what the Big Three really have in mind.

Regardless of where and why these federal bailouts started, American taxpayers can't save everyone. The only way to stop this parade of supplicants is to start saying no -- and Detroit is as good a place as any.

Columbian Bank and Trust of Kansas Shut by Regulators
Columbian Bank and Trust Co. of Topeka, Kansas, was closed by federal and state regulators today, the ninth U.S. bank to collapse this year amid bad real- estate loans and writedowns stemming from a drop in home prices.

The bank, with $752 million in assets and $622 million in total deposits, was shuttered by the Kansas state bank commissioner's office and the Federal Deposit Insurance Corp., the FDIC said today in a statement. Citizens Bank and Trust will assume the failed bank's insured deposits. Columbian Bank's nine branches will open Aug. 25 as Citizens Bank and Trust offices, the FDIC said. Customers can access their accounts over the weekend by writing checks or using ATM or debit cards.

"There is no need for customers to change their banking relationship to retain their deposit insurance coverage," the FDIC said. The pace of bank closings is accelerating as financial firms have reported more than $500 billion in writedowns and credit losses since 2007. The FDIC's "problem" bank list grew by 18 percent in the first quarter from the fourth, to 90 banks with combined assets of $26.3 billion.

Prior to today, the FDIC had closed 36 banks since October 2000, according to a list at The U.S. shut 12 banks in 2002, the highest in the period, and 2005 and 2006 had no closures. A call to the Kansas Office of the State Bank Commissioner after regular working hours wasn't immediately returned.

U.S. bank regulators closed Florida's First Priority Bank on Aug. 1; Reno-based First National Bank of Nevada, Newport Beach, California-based First Heritage Bank, and Pasadena-based IndyMac Bancorp Inc. in July; Staples, Minnesota-based First Integrity Bank and ANB Financial in Bentonville, Arkansas, in May; Hume Bank in Hume, Missouri, in March; and Douglass National Bank in Kansas City, Missouri, in January.

Lessons from a lost decade
As falling house prices and tightening credit squeeze America’s economy, some worry that the country may suffer a decade of stagnation, as Japan did after its bubble burst in the early 1990s.

Japan’s property bubble was also fuelled by cheap money and financial liberalisation and—just as in America—most people assumed that property prices could not fall nationally. When they did, borrowers defaulted and banks cut their lending. The result was a decade with average growth of less than 1%.

Most dismiss the idea that America could suffer the same fate as Japan, but some of the differences are overstated. For example, some claim that Japan’s bubble was much bigger than America’s. Yet average house prices nationwide rose by 90% in America between 2000 and 2006, compared with a gain of 51% in Japan between 1985 and early 1991, when Japanese home prices peaked.

Prices in Japan’s biggest cities rose faster, but nationwide figures matter more when gauging the impact on the economy. Japanese home prices have since fallen by just over 40%. American prices are already down by 20%, and many economists reckon they could fall by another 10% or more.

What about commercial property? Again, average prices rose by less in Japan (80%) than in America (90%) over those same periods. Thus Japan’s property boom was, if anything, smaller than America’s. Japan also had a stockmarket bubble, which burst a year earlier than that in property.

This hurt banks, because they counted part of their equity holdings in other firms as capital. But its impact on households was modest, because only 30% of the population held shares, compared with over half of Americans.

Nor were Japanese policymakers any slower than American ones to cut interest rates and loosen fiscal policy after the bubble burst, contrary to popular misconceptions. The Bank of Japan (BoJ) began to lower interest rates in July 1991, soon after property prices began to decline. The discount rate was cut from 6% to 1.75% by the end of 1993.

Two years after American house prices started to slide, the Fed funds rate has fallen from 5.25% to 2%. A study by America’s Federal Reserve concluded that Japanese interest rates fell more sharply in the early 1990s than required by the “Taylor rule”, which establishes the appropriate rate using the amount of spare capacity and inflation.

Japan also gave its economy a big fiscal boost. The cyclically adjusted budget deficit (which excludes the automatic impact of slower growth on tax revenues) increased by an annual average of 1.8% of GDP in 1992 and 1993—similar to America’s budget boost this year. Japan’s monetary and fiscal stimulus did help to lift the economy.

After a recession in 1993-94, GDP was growing at an annual rate of around 2.5% by 1995. But deflation also emerged that year, pushing up real interest rates and increasing the real burden of debt. It was from here on that Japan made its biggest policy mistakes. In 1997 the government raised its consumption tax to try to slim its budget deficit.

And with interest rates close to zero, the BoJ insisted that there was nothing more it could do. Only much later did it start to print lots of money. America’s inflation rate of above 5% is an advantage. Not only are real interest rates negative, but inflation is also helping to bring the housing market back to fair value with a smaller fall in prices than otherwise.

But in another way America is more exposed than Japan was. When its bubble burst in 1991, Japan’s households saved 15% of their income. By 2001 saving had fallen to 5%, which helped to prop up consumer spending. America’s saving rate of close to zero leaves no such cushion.

John Makin, at the American Enterprise Institute, a think-tank, argues that monetary and fiscal relief were necessary but not sufficient to revive Japan’s economy. The missing ingredient was a clean-up of the banking system, on which Japanese firms were more dependent than their American counterparts. Japanese banks hid their bad loans beneath opaque corporate structures, and curtailed new lending to profitable businesses.

A vicious circle developed, whereby banks’ bad loans depressed growth which then created more bad loans.
In another new report Richard Jerram, at Macquarie Securities, concludes that America “will not come close to repeating the experience of Japan”, because its regulatory system, financial markets and political structure will not let it procrastinate for so long.

America has a more transparent regulatory structure which presses banks into recognising losses and repairing their balance-sheets—even if regulators were slow to recognise that the banks were shifting risky securitised assets off their balance-sheets in the first place. But Japan’s regulators for a long while were in cahoots with banks over hiding their bad loans.

Over the past year, American banks have been quicker than those in Japan in the 1990s to disclose and write off losses and raise new capital. In Japan it took a long while before the political will was there to use taxpayers’ money to plug the banking system. A big test for America’s Treasury will be how quickly it recognises the need to nationalise Fannie Mae and Freddie Mac, the teetering mortgage giants.

One advantage over Japan, says Mr Jerram, is that America is spreading the costs of its housing bust across other countries. Foreigners hold a large slice of American mortgage-backed securities. Sovereign-wealth funds have provided new capital for American banks.

And America’s booming exports have helped to support its economy, thanks to the cheap dollar. In contrast, the yen’s sharp appreciation after Japan’s bubble burst hurt exports at the same time as domestic demand was being squeezed.

By learning from Japan’s mistakes, America can avoid a dismal decade. However, it would be arrogant for those in Washington, DC, to assume that Japan’s troubles simply reflected its macroeconomic incompetence. Experience in other countries shows that serious asset-price busts often lead to economic downturns lasting several years. Only a wild optimist would believe that the worst is over in America.

The Final Fate of Fannie and Freddie
The market's pummeling of Freddie Mac and Fannie Mae eased up a bit on Aug. 21, after four days of selling. But with the stocks both down more than 85% year-to-date, investors appear to believe it's a question of when, not if, the Treasury Dept. will be forced to use its newly acquired powers to bail out the mortgage giants.

Of course, the authority Congress granted to Treasury Secretary Henry Paulson to invest in Fannie and Freddie's shares—or make loans to the troubled companies—was supposed to strengthen them. It's had the opposite effect. The stocks are now both trading under 5, a sign that investors believe the companies' common equity will be wiped out in any bailout package.

But the pain goes deeper. Preferred shares of the government-sponsored enterprises (GSEs) have lost roughly 80% of their value, as Wall Street ponders their fate. Even their subordinated debt, which historically traded at a similar yield to the GSE's senior debt, now trades at historically wide spreads of three to four percentage points above the senior debt.

Only senior creditors seem completely assured of getting their money back. But neither Treasury officials nor Fannie and Freddie executives are giving their plans away just yet. "It's kind of [like] radio silence," says one credit trader familiar with the situation.

Of course, some argue that a bailout can wait. As of early August, both Fannie's and Freddie's capital holdings were above their mandatory levels, with Freddie possessing a capital requirement surplus of $2.7 billion and Fannie holding $9.4 billion in additional cash.

Credit research outfit CreditSights estimates that Fannie and Freddie could lose $17.3 billion and $8 billion, respectively, before breaching government-mandated capital levels. Meanwhile, both continue to be able to service their debt at a reasonable, if historically high, interest rate about 30 basis points below the London interbank offered rate.

Paulson is probably just hoping the status quo holds for a while longer. When he argued in favor of Treasury's increased power over Fannie and Freddie in July, Paulson claimed that just having the ability to act would prevent him from needing to. The Bush Administration is hoping to steer clear of another high-profile bailout after the Bear Stearns mess, and if Fannie's and Freddie's capital positions hold up reasonably well,

Treasury could wait for the GSEs to burn through their cash before making any moves. The "key players would likely prefer to delay action until after the November elections if possible," Richard Hofmann, an analyst at CreditSights, wrote in a recent research report.

Treasury, however, may not have the luxury of time. While Fannie was able to raise $7.4 billion during the second quarter, Freddie held off on seeking the $5.5 billion it announced it would raise. With its stock at 3.16 and speculation high that a bailout is inevitable, it may be difficult to coax additional capital into Freddie's coffers, either with common stock or preferred shares. Without the cash, Freddie could breach its mandatory surplus threshold in the third quarter of this year.

And so, the GSE watch has become the financial world's version of the Olympics—no one can take their eyes off it. Part of this is practical, as banks hold enormous amounts of Fannie and Freddie preferred shares and subordinated debt on their balance sheets. If the preferred equity is wiped out, banks will have to take more capital writedowns, adding to their already enormous troubles, says Dory Wiley, CEO of Dallas-based Commerce Street Capital.

Fannie and Freddie make up about half of the U.S. mortgage market, and with them on the ropes, there's little chance for a housing recovery. Without a housing recovery, the credit markets will continue to be jammed up. And things promise to get worse before they get better. Fannie and Freddie have about $250 billion in debt to refinance in September, and everyone will be watching to see if they're successful.

As long as their futures are uncertain, much of the credit market will remain in the doldrums. "They're the pivot point of the whole credit market," says Samson Capital Advisors' Benjamin Thompson. Of course, there's one simple solution to the GSE problem: nationalize them, says analyst Chris Whalen of Institutional Risk Analytics.

He says the Treasury should go ahead and wipe out the common equity, which the market has pretty much done on its own anyway, and promise to make holders of preferred stocks and subordinated debt whole. And financing? If the two mortgage financiers are taken over by the government, notes Whalen, "you don't have to worry about financing."

The credit default swap barometer
In the weeks before Bear Stearns, a Wall Street bank, collapsed in March, nervous investors scanned not just its share price for a measure of its health, but the price of its credit-default swaps (CDSs), too.

These once-obscure instruments, now widely enough followed that they have even earned a mention on an American TV crime series, clearly indicated that the firm’s days were numbered. The five-year CDS spread had more than doubled to 740 basis points (bps), meaning it cost $740,000 to insure $10m of its debt. The higher the spread, the greater the expectation of default.

Once again, CDS spreads on Wall Street banks are pushing higher, having fallen in March after the Federal Reserve extended emergency lending facilities to them. Reportedly one firm, Morgan Stanley, is monitoring its own CDS spreads to assess the market’s perception of its corporate health; if they rise too high, it intends to cut back its lending.

Whether the CDS market is accurately assessing the creditworthiness of Lehman Brothers, trading on August 20th at 376 bps, double the level in early May, will be the next test of its worth. There are some who doubt whether the CDS market is a reliable barometer of financial health. Though its gross value has ballooned in size from $4 trillion in 2003 to over $62 trillion, many of the contracts written on individual companies are thinly traded, lack transparency, and are prone to wild swings.

Recent spikes in CDS spreads on the three largest Icelandic banks are a case in point. In July spreads on Kaupthing and Glitnir rose to levels 35% higher than those observed for Bear Stearns in the days before it was bought out, according to Fitch Solutions, part of the Fitch rating and risk group. But the panic subsided after they released second-quarter earnings.

Insiders say CDSs are increasingly used for speculation as well as hedging, which creates distracting “noise” particularly when the markets are as fearful as they have been recently. On the other hand, although CDS spreads may overshoot, they do not generally stay wrong for long. Moody’s, another rating agency, says that market-implied ratings, such as those provided by CDS spreads, tally loosely with credit ratings 80% of the time.

What is more, CDS spreads frequently anticipate ratings changes. Fitch Solutions reckons that the CDS market has anticipated over half of all observed ratings activities on CDS-traded entities as much as three months in advance. Though the magnitude of the moves may at times be unrealistic, the direction is usually at least as good a distress signal as the stockmarke

Another bloody month for American finance
With blood stocks in New York City low, health officials this month issued an emergency appeal for donations. The lifeblood of financial institutions—confidence—is in equally short supply.

Five months after the Bear Stearns debacle, and a month after America’s Treasury unveiled unprecedented steps to support the mortgage market, some whose share prices had only recently hinted at recuperation are again looking dangerously anaemic.

At the top of the critical list are Fannie Mae and Freddie Mac. The quasi-private mortgage agencies are in danger of being overwhelmed by losses on their holdings of mortgages and mortgage-backed securities (MBS). Ajay Rajadhyaksha of Barclays Capital estimates that Freddie’s balance-sheet has a negative value of at least $20 billion when marked at market prices;

Fannie is $3 billion in the red. Both saw their share prices fall about 44% between August 18th and 20th as it appeared ever more likely that the government would intervene, wiping out existing shareholders. They are caught in a trap: the greater the risk of nationalisation, the harder it will be for the two institutions to persuade investors to provide an estimated $15 billion of new capital that each one needs if nationalisation is not to happen.

Loss of faith in the firms’ equity is one thing, ebbing confidence in their vast pile of debt is altogether scarier. Spreads on the $1.5 trillion of paper issued on their own behalf have widened. A five-year issue by Freddie on August 19th sold for 1.13 percentage points over treasury bonds, the highest spread for at least a decade. As recently as May, Freddie had found takers at 0.69 points over treasuries.

A sudden pullback by overseas investors is largely to blame. Foreigners, mostly Asian central banks and funds, hold 35-40% of the mortgage agencies’ total debt. They continued to be avid buyers this year, but their appetite waned in the first half of August (see chart), and was lower than normal in this week’s Freddie Mac auction. American money managers have taken up the slack, but they too are becoming twitchy about their exposure, according to a market participant.

The situation in agency-backed MBS is even worse, with foreign buyers all but on strike. China’s central bank, which alone had been lapping up more than $5 billion-worth a month, has barely touched the stuff in recent weeks. The spread on the securities has risen to around 2.2 percentage points over government bonds, even wider than it was during March’s turmoil (after adjusting for today’s lower volatility). This has helped to push up interest rates on the “conforming” mortgages that Fannie and Freddie buy or guarantee, at a time when private finance has slowed to a trickle.

The banks that manage the agencies’ debt issues are pulling out all the stops to ensure their success—even to the point of artificially boosting demand through deals known as “switches”. In such an arrangement, an investor agrees to buy into a new issue in return for being able to sell back to the banks an equal amount of an old one, thus ensuring its net exposure does not rise. If enough of these deals are struck, large amounts of debt can be shifted even when demand is thin.

A recent $3.5 billion issue by Fannie was helped along by “very significant” amounts of switching, says one banker involved in it. With $223 billion, or one-seventh, of the agencies’ debt falling due before the end of September, those peddling it will have their work cut out—especially if the Asian investors continue to be put off by unkind headlines.

This is not what Hank Paulson, America’s treasury secretary, envisaged last month when he announced an emergency plan to rescue the twins. By pledging to invest in them if needed, he had hoped to calm markets and thus reduce the likelihood of a bail-out. That gamble looks ever less likely to pay off, however.

If a government recapitalisation does prove necessary, the treasury is likely to take one of two routes: a preferred-stock investment that allows the agencies to raise more capital of their own, or nationalisation through a common-equity injection that leaves current owners with nothing, and thus offers the taxpayer a better deal.

Jeffrey Lacker, head of the Richmond Federal Reserve, this week threw his weight behind the second option. Nationalisation would probably also lead to the removal of both institutions’ managements, and undermine the cosy ties the agencies have long had with Congress.

This comes against an increasingly bleak backdrop. Lehman Brothers, the smallest of the four remaining full-service investment banks, is still struggling to persuade the stockmarket, and its clients, that it has a future. Faced with another big quarterly loss, it is hawking around both its worst assets (a toxic commercial-mortgage portfolio) and its best (Neuberger Berman, a fund manager). Selling a chunk of Neuberger would raise much-needed funds, but it would also leave Lehman looking far less diversified and less stable.

This week Goldman Sachs, the only investment bank still in decent shape, cut profit forecasts for all of its main capital-market rivals, including Lehman, citing the need for further write-downs and a drought in key business lines. (Some analysts had cut their Goldman forecasts the week before.)

It also released a scathing report on American International Group, putting its losses from mortgage-related swaps at up to $20 billion, and even suggesting the giant insurer could suffer an “impairment of counterparty confidence”. The spreads at which big banks lend to each other, meanwhile, hit a two-month high.

One of them may go bust in coming months, mused Kenneth Rogoff, the IMF’s former chief economist, one of a long list of those who think the worst is yet to come. Given what has already been endured, that is a blood-curdling thought.

Task facing Bernanke, Paulson grows bigger, more urgent
Every August, senior officials of the Federal Reserve System and about 100 invitation-only guests gather like monks on a retreat held at a Wyoming lodge inside the gorgeous Grand Teton National Park near Jackson Hole.

Imagine a mix of high-end discourse on the global financial system and communing with Mother Nature in one of the more scenic spots in the country. Wags used to call it Camp Fed. For those wishing a return invite, it is best to refer to it as a symposium. This year's topic — no surprise here — is "financial stability."

When I first attended long ago, Federal Reserve Board Chairman Paul Volcker presided and spoke about the important issues of the early 1980s: inflation (far worse than we're dealing with now), interest rates (far higher than we face), and a U.S. economy whose unemployment rate was nastier than today's.

Somehow we all survived. Still, I suspect Volcker has no desire to swap places with Ben Bernanke. The current Fed chairman's top task — stabilizing an unruly Wall Street and fixing a financial machine built to let people invest confidently and purchase houses with affordable mortgages — is a tough one.

In Wyoming, Bernanke spoke in the Fed's classic style of obfuscation, endorsing "macroprudential" regulation. It's his way of saying he wants the Fed to have more power to control a broader swath of the U.S. financial system. Bernanke, along with Treasury Secretary Henry Paulson, must feel like little Dutch boys jamming their fingers in an increasingly leaky dike. The holes and drips are growing in number:
  • Fannie Mae and Freddie Mac, the teetering twin towers that connect the local home mortgage to the global investor, are all but assured of receiving a major federal bailout.
  • Wall Street's historic Lehman Brothers is rapidly losing the confidence of the broader market and may end up like investment firm Bear Stearns: rudely shoved into the arms of a bigger bank buoyed with federal backing.
  • Giant U.S. banking firms — Citigroup, Merrill Lynch and Wachovia among them — considered "too big to fail" are struggling from bad lending and investment decisions. Citigroup, especially, has been forced to search globally for investors to help recapitalize. One result has been a sharp uptick in Middle Eastern money and influence in what is the nation's largest banking company.
  • "Complex financial instruments" used to mean things like "derivatives" or "collateralized mortgage obligations." How quaint. An explosion of new financial creations spurred by hedge funds, global traders and other players spawned poorly understood and regulated things like credit swap default markets and auction-rate securities.

The trend line? Increasing involvement by the federal government to bail firms out and provide liquidity (to supply cash when only cash will do). Pushing stronger companies to absorb the weaker. And modernizing a creaky police force of regulators.

It's all long overdue. Anyone and everyone who has a pension, a mortgage, a credit card, a car loan, a bond or a mutual fund wants to depend on a financial system that says what it does and does what it says. In Wyoming, Bernanke called the mission "strengthening the infrastructure." It's also called rebuilding confidence in the system. We're not there quite yet.

A Mission Goes Off Course
Whenever the mortgage finance giants, Fannie Mae and Freddie Mac, find themselves in a tough spot — and boy, are they in a tough spot now! — they always seem to find a way to blame their problems on “the mission.”

“We exist to expand affordable housing,” says Fannie Mae on its Web site, and although it also lists its other mission — providing liquidity for the American housing market — it is the former that has long been the companies’ trump card.

That mission of creating affordable housing is the reason that Alan Greenspan, the former Federal Reserve chairman, could testify, year after year, that Fannie and Freddie had become so large, and took so much risk, that they could one day damage the nation’s financial system — only to be utterly ignored by the same members of Congress who otherwise hung on his every word.

The mission is why Representative Barney Frank, the powerful, and usually clear-eyed, chairman of the House Financial Services Committee, will defend Fannie and Freddie even now, when their misdeeds are so clear. The mission is why the two companies were able to run roughshod over their regulator for years, and why the Bush administration was unable to rein them in, even after an accounting scandal.

The mission is why their two chief executives, Daniel Mudd at Fannie and Richard Syron at Freddie, could take home a combined $30 million last year, while presiding over one of the great financial disasters of all time, posting billions of dollars in losses with no end in sight. Thus it was that a few weeks ago, Mr. Syron gave an interview to The Boston Globe that was at once astonishing and completely predictable.

The day before, my colleague, Charles Duhigg, had written a devastating story in The New York Times, describing how Mr. Syron, shortly after becoming the C.E.O. of Freddie Mac in 2004, had been warned by David A. Andrukonis, then the company’s risk officer, that that Freddie Mac was buying loans that “would likely pose an enormous financial and reputational risk to the company and the country.”

The article continued: “Mr. Syron was also warned that the firm needed to expand its capital cushion, but instead its safety net shrank. Mr. Syron was told to slow the firm’s mortgage purchases. Instead, they accelerated.” And what was Mr. Syron’s response the next day in The Globe? You guessed it: “If you’re going to take aid to low-income families seriously, then you’re going to make riskier loans,” he said. “We have goals to meet.”

As for the claims made by Mr. Andrukonis to The Times, Mr. Syron said that Mr. Andrukonis had “disagreed” with the chief executive’s decision to reorient Freddie Mac “towards the housing mission.” The major source of friction between the two men, he strongly implied, was that Mr. Andrukonis just didn’t care enough about affordable housing. And if you believe that one ...

Fannie Mae and Freddie Mac occupy a complicated place in the nation’s financial system, but the more you understand what they did, the angrier it should make you — especially since it’s likely that you, the taxpayer, will wind up having to pay for their sins. As the two companies continue to post mammoth, multibillion-dollar losses, the Treasury Department is drawing up contingency bailout plans, which will surely include the assumption of hundreds of billions of dollars in potential liabilities.

That would be hard enough to swallow if the cause had, in fact, been the companies’ willingness to finance low-interest loans to working-class home buyers. But the real reason was greed. You know that statistic you always hear about how half the nation’s $12 trillion in mortgages is “touched” by Fannie or Freddie?

The implication, of course, is that the two companies are the very heart and soul of the nation’s housing market. But the majority of the mortgages in question are ones that are held by Fannie and Freddie as part of their gigantic portfolio of mortgage-backed securities — the same kind of complex derivatives that brought down Bear Stearns and have caused untold pain to most of the big Wall Street firms.

Holding those securities has nothing to do with “the mission.” What Fannie and Freddie are supposed to do — their real mission, if you will — is to create liquidity in the housing market. (The affordable housing mission was added to their charters much later.) They do this primarily by buying mortgages from banks, insuring them, and creating mortgage-backed securities that they then sell to Wall Street.

With a long-term mortgage, for instance, Wall Street takes on the interest rate risk, but doesn’t have to worry about the risk that homeowners will stop paying their loans. Fannie and Freddie assume that risk. That arrangement gives the banks more capital to make yet more housing loans, and supposedly frees them to continue loaning even when the economy takes a dip.

The problem is that while the two companies are still called government-sponsored entities, they are also publicly traded corporations. And for much of the last two decades, they have been hell-bent on growth, the clear goal being to push up their stock prices. “Wrapping” mortgages for banks — you can make money doing that, but you can’t double your earnings every five years, which was the stated goal of the former Fannie Mae chief executive, Franklin Raines.

Ah, but if you buy up the mortgage-backed securities yourself, taking on the interest rate risk as well as the credit risk — all the while using your government-sponsored pedigree to borrow at lower rates than your Wall Street competitors — well, then you’ve got a spectacular growth business. And if you’re the C.E.O., with lots of stock options and bonuses based on stock price and profits — as Mr. Raines was — you can put tens of millions of dollars in your pocket, too.

The mission? It was little more than a fig leaf that the companies trotted out whenever somebody pointed out the obvious: that its growing portfolio of mortgage-backed securities was dangerous. (Needless to say, Fannie and Freddie insist that affordable housing is their real raison d’être, and object to such characterizations.)

Then, in 2003, came the accounting scandal. Fannie Mae had to restate $9 billion in earnings, and Mr. Raines, who had made $90 million during his six years as chief executive, lost his job, replaced by Mr. Mudd, who had been his No. 2. (Mr. Raines never had to give back any of the money, though.) Freddie Mac, its smaller cousin, had to restate about $5 billion in earnings.

Its chief was also booted in favor of Mr. Syron, the former executive chairman of the Thermo Electron Corporation. The accounting scandal emboldened their formerly tepid regulator, the Office of Federal Housing Enterprise Oversight, to crack down on the interest rate risk they were taking with their ballooning portfolios.

So how did Mr. Mudd and Mr. Syron respond? Did they decide to pull back, take less risk and act as a stabilizing force in the market? Not even close. Like their predecessors, Mr. Mudd and Mr. Syron put their investors — and their bonuses — first, and their mission a distant second.

As we are now learning, in 2005 and 2006, the two men plunged their companies headfirst into subprime mortgages — and continued doing so even as the subprime market began to implode. According to Fannie Mae documents obtained by The Washington Post, Mr. Mudd described getting into subprime mortgages as taking a step “towards optimizing our business.” Mr. Syron did the same — as Mr. Duhigg’s article in The Times made clear.

The two companies also got heavily into underwriting so-called Alt-A mortgages, which, as the Post article put it, are “often made with no verification of the borrower’s income.” These are the loans that Mr. Syron is now claiming were made to comply with “the mission.” But the mission had nothing to do with it. Fannie and Freddie got involved with subprime mortgages for the same reason as everyone else on Wall Street: they offered higher rates of return than ordinary mortgages.

Why? Because they were riskier. As we now all know. You want to know the truth about “the mission?” The country doesn’t even need Fannie and Freddie to help with affordable housing. Several laws mandate that banks reinvest in the communities in which they operate — and that mandate has come to be defined largely as making loans available for affordable housing.

Several executives involved in community-based banking told me that Fannie and Freddie actually refused to buy those mortgages — they weren’t profitable enough. (A spokeswoman for Freddie Mac denies this.) With any luck, once we get through this crisis, the country can figure out a better way to provide both liquidity and stability for the housing market without being so reliant on Fannie and Freddie.

But for now, given the paralysis in every other sector of the market, the country badly needs Fannie and Freddie to do what they are chartered to do: “wrap” loans so that banks will keep writing mortgages. That’s why Congress recently passed a law that allows Fannie and Freddie to insure mortgages up to nearly $625,500, from the previous limit of $417,000.

That’s also why the Treasury is now taking pains to ensure the marketplace that the companies will not go bust, even if it means a government takeover. If Fannie and Freddie were to file for bankruptcy — the fate, frankly, they deserve — the mortgage market (not to mention the entire financial system, just as Mr. Greenspan once predicted) would quite likely freeze up completely. In the midst of the worst housing crisis since the Great Depression, that would be disastrous.

All right, so be it, we’ll keep them alive for the greater good of the country, moral hazard be damned. But let’s at least acknowledge that there is something deeply flawed with an arrangement in which the shareholders and executives reap the profits in good times, while the government and the taxpayers absorb the losses when things go awry. At the very least, the companies should stop using the mission as an excuse, and acknowledge they did the wrong things for the wrong reason.

Their only mission has been to get rich, and it has hurt us all.

Treasury wants GSEs shareholder-owned: source
The U.S. Treasury Department still believes that housing finance giants Fannie Mae and Freddie Mac should remain shareholder-owned, a source familiar with Treasury thinking said on Friday.

Shares of Fannie Mae and Freddie Mac fell further this week after news reports suggested the federal government was poised to nationalize the two companies, which together underwrite or guarantee nearly half of the $12 trillion U.S. mortgage market.
Treasury Secretary Henry Paulson last month outlined a series of backstop measures that could be used to support Fannie Mae and Freddie Mac, including a fresh injection of capital from the government.

Speculation has mounted in financial markets that Treasury eventually would be forced to add capital, causing investors to question how such a move could affect the corporate structures. When Paulson announced the lifeline for Fannie Mae and Freddie Mac in July, he and President George W. Bush both said that government policy aimed to maintain the government-sponsored enterprises as private enterprises.

The U.S. Congress backed the proposal in July and on Friday, the White House said that Paulson has unencumbered power to deal with the current crisis as he sees fit. "Secretary Paulson has the lead on the administration's policies related to Fannie Mae and Freddie Mac, working with their regulator," White House spokesman Tony Fratto said.

As the United States suffers the worst housing market downturn since the Great Depression, the two companies' ability to fund mortgages through the issuance of debt to support the U.S housing market is considered crucial for the economy.

Investors have pummeled common and preferred shares of Fannie Mae and Freddie Mac this year as speculation grew that the pace of losses on their mortgage holdings and guarantees is quickly eroding their capital. Both Fannie Mae and Freddie Mac have both lost about 90 percent of their market capitalization since 2008 began.

The two GSEs have reported losses for the past four quarters, and mortgage delinquency rates are rising, reducing the value of their assets and their capital, but they currently meet regulatory capital requirements and are successfully rolling over their debt on the regular schedule, limiting the need for any nationalization by the government.

Paulson and Federal Reserve Chairman Ben Bernanke have both encouraged the companies to raise capital in recent months so that they will have the ballast to weather the current U.S. housing market downturn. When policy-makers hatched their plan to buttress Fannie Mae and Freddie Mac in July, they hoped that merely outlining the plan would sooth investor concerns.

As the companies have reported bigger losses, however, investor anxiety has risen along with expectations that the government will have to take action. Still, officials have repeated that they do not want the companies to fall completely into government hands. Legislation that codified the Treasury rescue plan states that any government aid to Fannie Mae and Freddie Mac should bear in mind "the need to maintain the corporation's status as a private shareholder-owned company."

FDIC's IndyMac Borrower Aid Is 'Dangerous' for Bonds
The Federal Deposit Insurance Corp.'s plan to have IndyMac Federal Bank FSB rework mortgages for troubled homeowners is "dangerous" for bondholders, according to Barclays Capital.

Investors in mortgage-backed securities may be worse off if enough loans default after they're modified because recoveries may be lower as home prices decline, analyst Sharon Greenberg wrote yesterday in a report. Loan changes also cost bondholders by reducing borrower payments, their collateral or both.

"We think IndyMac, under FDIC's watchful eye, will interpret the MBS agreements more loosely and err on the side of modifications over other solutions, including foreclosure," wrote Greenberg, who is based in New York. "This can be dangerous."

FDIC Chairman Sheila Bair, who has led regulators in pressing mortgage-servicing companies to rework loans amid surging foreclosures, two days ago announced plans to have the failed lender modify more loans to keep "tens of thousands" of borrowers in their homes and avoid the effects of foreclosures on the economy. The FDIC took over Pasadena, California-based IndyMac Bancorp Inc. on July 11, making it the third-largest federally insured bank to be seized by federal regulators.

The FDIC said that IndyMac would only modify loans underlying mortgage-backed securities or owned by other investors if doing so improves their value and meets contract guidelines. About 30 percent of IndyMac modifications last year failed, with a third of those representing borrowers missing their first revised payments, Greenberg wrote.

"The reason it is beneficial for bondholders is we're talking about delinquent loans, loans where the borrower's not paying, and we're creating an obligation that now will continue to pay for the long-term," Michael Krimminger, special adviser for policy to the FDIC chairman, said in a telephone interview. Any analysis on whether to foreclose or allow a sale for less than the homeowner's debt will require assumptions on the directions of the housing market and broader economy, he said.

IndyMac mortgage modifications may harm other banks under the FDIC's watch because they own some of the securities, Julian Mann, a mortgage- and asset-backed bond manager at First Pacific Advisors LLC in Los Angeles, which oversees $11 billion, said earlier this week. "It hurts the bondholders that are off any shelf of any bank that is perceived as weak and potentially seizure bait, because the collateral is now in question," Mann said.

IndyMac Federal has about 740,000 mortgages that it owns or services for other companies, according to the FDIC, which earlier suspended foreclosures on the bank's $15 billion in loans. On March 31, the company was the eighth-largest home-loan servicer, overseeing $200 billion of mortgages, according to newsletter National Mortgage News. The company services loans in mortgage securities other than ones it issued, Barclays said.

Modifications may also hurt investors in "senior," or more highly rated, mortgage bonds by reducing their interest payments, Greenberg wrote. That's partly because trustees may fail to use "common sense" to reduce payouts to junior bonds after principal forgiveness for homeowners, she said, citing the experience of investors when West Palm Beach, Florida-based Ocwen Financial Corp. stepped up balance reductions earlier this year.

"We've talked to MBS investors, we've talked to trustees on deals and they want to monitor how we perform as I would expect them to," Krimminger said. Preventing foreclosures may be bad for some borrowers because they would be better off in more affordable rental housing, according to Joshua Rosner, the managing director at New York-based research firm Graham Fisher & Co.

Delaying inevitable defaults also may hide problem loans at banks and prevent prices from tumbling quickly to levels that would make homes cheap enough to allow for a housing recovery, he has said.

Lending to the poor has rich rewards
As banker to the world's most destitute people, Mohammad Yunus has been watching the moral collapse of western finance over the last year with a mixture of amazement and scientific curiosity.

"Our banking is sub-sub-sub-sub-prime: you can't get any lower than us. We have no collateral, no insurance, no taxpayer guarantees, and no lawyers in our system," he said. "Yet we have a loan repayment rate of over 98pc. Our model has never faltered over the years. "The world's big banks had all the collateral, all the guarantees, all the lawyers, and what did they do? They sent us a $1 trillion bill."

His Grameen Bank -'Village Bank' in Bengali - makes a point of searching out those shunned as the greatest credit risk by orthodox banks. The more (seemingly) hopeless, the better. "We send our people out on bicycles to check if they are poor enough. If a woman lives in a one-room house, she qualifies. If she has a leaky roof, she qualifies. We even give loans to beggars: this is risky," allowed Dr Yunus.

We met on the shores of Lake Constance, where he sat in Bengali dress gazing across shimmering waters at the Alpine peaks of Switzerland. The Muslim village boy from Chittagong, now 68, is at home anywhere these days. The 2006 Nobel Peace Prize lifted him to global sainthood. He is the father of the micro-finance revolution, and the smiling face of an enlightened Feminist Islam.

"The banks gave the impression that they were almost perfect, and then we find there is a fundamental flaw in the structure of the system. The regulators allowed them to bundle the risk so that nobody could see what was inside, and then pass it around the world to people who had nothing to do with it.

"We don't seem to be accusing anybody over this whole debacle. It is as if nobody is responsible. We can all go off and play golf: the taxpayer will take care of the problem. When things go well the bankers take the profit, and when it goes wrong they are compensated. This is not symmetrical," he said.

What worries Professor Yunus - he has a doctorate in economics from Vanderbilt University in the US - is that the global banks have now twigged that there is real money to be made from the world's poor. They are muscling in on micro-loans. JP Morgan estimates that the sector could be worth $300bn. Barclays, Citigroup, Morgan Stanley, and BNP Paribas are launching ventures.

"The next thing we are going to see is a micro-finance bubble. The players are becoming bigger and bigger. We've now got hedge funds and mutual funds going around saying 'this is a wonderful idea: you can make so much money and help people at the same time'. It's intoxicating," he said.

Asked about the latest scheme in Mexico where Comportamos is launching the first micro-loan flotation on the stock exchange for $470m, he exhibits a rare flash of irritation. "We don't like them. This is an abuse of the whole philosophy of micro-finance," he said.

The Microfinance Information Exchange in Washington says the industry has already spread across the world with almost 80m borrowers and a loan portfolio of $24bn. The Chinese and Brazilian governments have launched their versions. The model is at times falling prey to top-down elites and profiteers. The inevitable backlash has begun. Critics say savings are the way out of poverty, not debt.

The Yunus venture began in 1976 with loans worth a total of $27 to 42 women making bamboo furniture in the Bangladeshi village of Jobra. It has grown into a giant network of 7.4m clients. Loans have totalled $7bn. Some $6.3bn has been repaid so far. There are no profits. All borrowers are owners of the bank. Revenue is ploughed back into the venture.

"This is about getting people out of poverty. It is a non-loss, non-dividend company with a social objective. It is totally de-linked from the profit system," he said. Dr Yunus's insouciant style is misleading. His model is based on strict discipline. The villagers form 'Groups of Five', with their own elected chair. Each loan project has to win the backing of the others. They enforce payments by peer pressure.

The Grameen bank has 27,000 staff who trudge and cycle from door to door, collecting the weekly payments. The loans typically start at around $30. This is how the 'telephone ladies' get going. They buy one cheap mobile phone. This then becomes the communications hub for the neighbourhood, rented out one call at a time.

Borrowers agree to the code of '16 Decisions': that they will send their children to school, abolish dowries, grow vegetable gardens, and so on. More than 94pc of clients are women. They are better credit risks. "Women have a feature of self-sacrifice for the family that you see all over the world. Men like to spend," he said.

This role as a promoter of women's liberation has made him enemies. Hard-line Islamic groups warn women that they will go to Hell if they accept credit. "The extreme Right religious groups accused us of destroying the social order. By giving loans to women, we were encouraging them to disobey their husbands. They were using religion for what was really a male issue," said Dr Yunus.

"There is nothing in the Koran against women being in business. The Prophet Mohammad married a businesswoman. "The Left didn't like us either. They said this was an American conspiracy to spread capitalism at the grass-roots level. So we were squeezed from all sides. Let them all scream. The revolutionaries are all talk and do nothing."

Like the Virgin network of his friend Sir Richard Branson, the Grameen brand has spawned a plethora of companies from Grameen Software to Grameen Telecom. A joint venture with France's Danone sells yogurt filled with extra micro-nutrients such as zinc and iodine to plug the most common deficiencies. "We sell in the cheapest possible way with no frills, hoping that enough of it will reach poor children," he said.

But it is the army of 100,000 beggars on his loan register that fill him with most pride. Each member of staff adopts four mendicants for mentoring. The beggars are encouraged to do a little selling on the side. "So far, 11,000 have stopped begging completely, and the other 90,000 are now part-time beggars.

They know when to sell, and which houses are a soft-touch for begging. This is good market segmentation. It takes time to close down a core business," he said. This line brought the house down when he spoke to 300 of the world's rising economic stars at the Riksbanks' annual conclave of Nobel Laureates here in Lindau.

Judging by their rapturous ovation for this extraordinary man, the next generation of economists will be no friends of profit. Dr Yunus is a paradox. The root of his philosophy is a variant of the pure market.
"I believe all people are entrepreneurs. Poverty is not inherent. It is artificially imposed by the denial of opportunities," he said.

"One day we will create poverty museums. We will take the next generation of children to show them what it used to be like, and they won't be able to believe it. There is no need for anybody to be poor."

It's more than Fannie and Freddie
A few weeks ago when I was in Maine, I met Chris Whalen. Chris is the managing director of a service called Institutional Risk Analytics, whose primary business is analyzing the health of banks and financial institutions.

What they have done is come up with various metrics which compare how well-capitalized a bank is, how much risk it is taking, and what kind of losses (or profits) it can expect. It is a one of a kind firm, and the data gives Chris a very special perspective on the US banking system.

And what he sees is not pretty. There is a crisis brewing. He expects 100 banks to fail between now and July of 2009. Most of them will be small, but there will be a few large banks. The total assets of those banks he estimates to be $850 billion (not a typo!). Those are the assets the FDIC is going to have to cover when they take over the banks.

Take Washington Mutual as an example. There are problems there. Their debt now trades at 20%, which is worse than junk. There is no way they could issue preferred stock to recapitalize their business. And they are going to need more capital, as they have writedowns in their future due to the slowing of the economy.

Any common issue would have to seriously dilute existing shareholders almost to the point of nothing. There are circumstances in which they can survive, but it would take a remarkable recovery for the US economy, which is not likely. Maybe management can pull a rabbit out of the hat, but it will need some strong magic to get the capital they need at a cost they can live with.

The FDIC has about $50 billion. These reserves have been built up over the years from deposit insurance paid by banks that are part of the program. They are going to need an estimated $20 billion just to cover the failure of Indy Mac. The FDIC will have to cover only a small percentage of the $850 billion, as some of those assets will surely be good.

But if they have to cover 10%, then the FDIC would need another $50 billion. Does that sound like a lot? Chris thinks a more conservative number for planning purposes would be 20-25% potential losses, and you hope it does not get there.

Sometime in the next few quarters, Congress and the President, either the current group or early in the term of the next President, are going to have to address that potential shortfall, before we see bank runs as people fear that FDIC insurance reserves may not be enough. The very sad fact is that taxpayers are going to be on the hook for some time.

What is likely to happen is that a loan facility will be made to the FDIC so they can borrow as much as they need, and pay it back from future bank insurance payments. You can't make up the shortfall just by raising fees. Chris points out that raising fees right now is not really a winning option, as that just makes the financial books of marginal banks even worse. You can raise rates as the banking system returns to health.

If Congress and the President wait too long, there could be a very serious problem, as depositors could start moving their funds under $100,000 (the insured amount) to what they perceive may be a safer bank than their current bank. Rumors could run rampant. This is something that needs to be addressed now. Frankly, this should be addressed right after the elections AT THE LATEST, in consultation with Congress and the new President.

We have seen some $505 billion in bank write-offs so far in this credit crisis. It is serious naiveté to assume that this will be the extent of it. Most of the write-offs have been mortgage-related. We have not yet seen the write-offs that will come as consumers start defaulting on credit cards, auto loans, and other consumer debt. Neither have we seen the losses that will come from commercial real estate or corporate loan as the recession progresses.

You can't write off something until it goes bad, although you can increase your loan loss provisions. This of course hits earnings and your stock price and thus your ability to raise new equity. It presents a very difficult dilemma for bank managers and investors deciding whether to invest or go away.

Sober-minded analysis from the IMF suggests that the total write-offs by all banks may be $1 trillion. Dr. Nouriel Roubini is much more alarmed and puts the potential losses at closer to $2 trillion. That means that banks over time are going to have to increase their loan loss provisions, hitting both earnings and capital. And that means they will have to raise more investment capital and equity at a time when their stock prices are low.

It is a vicious spiral. Banks have less capital, so they are able to lend less to the very businesses that need the money; and without said money the businesses will be less capable of paying their current loans, which means that banks have less capital. Rinse and repeat.

That only prolongs the recession and Muddle Through Economy, which hurts consumers and corporate profits, which in turn puts more pressure on banks. Ultimately it means that banks are going to have to raise a lot more capital than anyone who is buying financial stocks today imagines. And it is largely going to be expensive capital. Look at this note from Bennet Sedacca of Atlantic Advisors:

"Financial entities like banks, broker/dealers, regional banks, finance companies, and insurance companies need credit at reasonable rates in order to finance themselves. I have been concerned for many years that the door would finally shut on banks, brokers and others to raise new capital in the debt markets.

"For many regional banks like KeyCorp, Zions, Regions, and National City, the door has already shut on them--if they wanted to raise capital in the debt market at levels where their outstanding issues regularly trade, they would have to pay 12-15%, hardly economic levels. GM bonds trade near 27% yields. Washington Mutual trades north of 15%.

"Then there are the 'good banks', like J.P. Morgan and Wells Fargo. J.P. Morgan recently sold $600 million of preferred stock at 8 3/4 % and Wells Fargo sold $1.3 billion at 8 5/8%, plus underwriting fees.

"Below I offer up a few guesses of what other issuers would have to pay to issue preferred stock.

* Lehman Brothers--11-13%.
* Merrill Lynch--11-12%.
* Morgan Stanley--9-10%.
* Citigroup--9 1/2-10 1/2%.
* CIT Group--12-15%.
* Fannie Mae/Freddie Mac---15%
* Keycorp--11-13%.
* National City--13-15%.
* Wachovia--10-12%.
* Zions Bancorp--13-15%.
* GM/GMAC--not possible.
* Washington Mutual--not possible.
* Ford--not possible."

Bennet does note a good point. Banks that conserved capital and managed their risks well will be in good shape to take over weaker brethren. They will have access to the capital markets for the money they need for expansion. My own bank was acquired recently by another small regional bank. Deals are getting done.

In another note, and to illustrate this point, Sedacca points out that it is not just Freddie and Fannie. Besides Washington Mutual, mentioned above, "RF (Regions Financial) needs to raise $2 billion says Sanford Bernstein. Let's see, what are their options? They can sell debt. The problem here is that you couldn't sell debt if you wanted.

The last reported trade in RF paper was 2 weeks ago nearly +700 to the 30 year or close to 12%. Their preferreds trade at 10% and the stock is now a 'single digit midget' near $8 a share. So if you could even get a deal done, shareholders would get a 50% haircut."

Let's turn to Freddie and Fannie. There must be some people who think there is some way that the shareholders of Fannie and Freddie will not lose everything, as their shares actually trade. This just simply goes to show that you can fool some of the people some of the time. And as we will see, some of those people are very serious institutions.

It is almost a forgone conclusion that the US Treasury will have to step in and for all intents and purposes nationalize the two government-sponsored enterprises. The estimated losses in these two firms are far beyond what they could raise in a traditional market. And the longer the government waits, the worse the situation is likely to get.

Moody's downgraded the preferred stock in these firms to almost junk level because of the increased likelihood of "direct support" from the US Treasury, which, depending on the nature of the support, could wipe out both the holders of the common and the preferred. The preferred shares have already lost half their value since June 30 on speculation that an intervention would mean a stop in dividend payments (highly likely) and issuance of new preferred that would take preference over current preferred.

Interestingly, this would put more pressure on the banking system, as many banks hold the GSE preferred shares as assets, choosing to get a little extra return over traditional and more conservative assets. But then of course, Fannie and Freddie preferred were considered safe just a few months ago, with the best ratings from Moody's.

"Regional banks including Midwest Bank Holdings Inc., Sovereign Bancorp and Frontier Financial Corp., may have the most to lose. Melrose Park, Illinois-based Midwest has $67.5 million, or as much as 23 percent of its risk-weighted assets, in the preferred stock, while Philadelphia-based Sovereign owns about $623 million and Everett, Washington-based Frontier about $5 million." (Bloomberg)

It is doubtful that banks which hold these assets have written them down yet, but with a downgrade they will almost certainly be forced to do so in the near future. For the record, Fannie Mae has 17 classes of preferred stock, with more than 600 million shares outstanding. Freddie Mac has 24 classes of preferred stock, with about 460 million shares outstanding. The existing shares are trading worse than junk bonds, paying 17-19%.

And it may be a total write-off. It is hard to imagine how Treasury Secretary Paulson, or a new Treasury Secretary next year, could put US taxpayer money into the companies at risk without wiping out the current common and preferred shareholders. The justified outrage would be huge.

The basic problem is that without Freddie and Fannie the US mortgage market would go from crippled to moribund, if not dead. We have created a system that could not function in the short term without them, and the pain of allowing them to collapse would be another 1930s-style Depression, the era in which these firms were first created.

They were never designed to take on the huge leverage they did, or to use hundreds of millions in lobbyist money and campaign contributions to create a massive payment scheme for management and shareholders. Congressional estimates are that this could cost US taxpayers $25 billion, a significant multiple of their current market caps.

Fannie and Freddie will not be able to raise capital on their own. At this point, why would any rational investor put that much money into a company with such a convoluted preferred share scheme, without government guarantees? That estimated loss assumes that the housing market does not get worse from this point. Losses could be much worse, or things could get better. Who knows? Why invest in something with so much uncertainty?

But there are more problems. You can't just take someone else's property, and that is what stock is, without some serious reasons. You almost are forced to wait for a crisis, otherwise shareholders would sue, saying that they suffered unnecessary losses. You can certainly expect the preferred shareholders to sue.

That is why Paulson hired JP Morgan to figure out how to recapitalize the banks. I don't envy the people who are working on that one. Maybe there is some magic somewhere, but as we saw with Bear Stearns, at the end of the day it is all about adequate capital.

The GSE companies should be adequately capitalized and broken up into much smaller firms that would not be too big too fail in the future, and put under a regulator that would enforce reasonable leverage limits, with the profits going to pay back the US taxpayer before any profits or dividends are paid to any other future owners.

That is, if the government takes the two GSEs and puts capital (probably in the form of loans and guarantees) into them, which puts taxpayers at risk, then allows a public offering of the smaller entities to raise capital to repay the loans, any shortfall should be made up by the issuance of preferred shares, and the common shareowners would wait until the government loan was repaid before they would be eligible for a dividend.

And the people responsible for creating the leveraged systems, the board, et al., should be forced to resign. New top management all around. The ultimate goal should be for taxpayers to get their money back and any guarantee, implicit or explicit, to be removed. No mortgage bank should ever again be allowed to be too big too fail.

Now, taken as a part of the total credit crisis, which will run to over $1 trillion (at least), $25 billion may not seem like a lot. But I hope this is a wake-up call for better regulations and safeguards.


Anonymous said...

Privatized Profits, Socialized Loses...why aren't people in the streets about our tax dollars going to pay for CEO bonuses and corporate salaries, especially when no government assistance/bailout is coming to help ‘Joe Citizen’ pay for gas or food?

I am beside myself with disbelief that the war against the American people is being won with so little is all I hear is ignorant applause.

What to do?

Anonymous said...

All I can do is to post these links to two delightful images by David Parkins from the 'Gods that Failed' gallery.

Larry Elliott and Dan Atkinson's book on banking greed came out here in the UK in June. For some reason Amazon don't seem to be stocking it until next month.


Anonymous said...

I don't think 'Joe Citizen' realizes there is a financial crisis. Sure, some people are aware of jobs going away and houses being foreclosed. But this crisis has not yet directly affected most people. What will happen in the near future, that the average Joe/Jane figures out that there is a financial crisis?
Anonymous Reader

Bigelow said...

“What is happening here, of course, reflects one of the largest of the blind spots of contemporary economics: the assumption that market transactions mediated by money are the only significant form of economic activity. Our household jam-making activities drop off the economic radar screen the moment we finish paying for the raw materials. Value is being produced – the same jam offered for sale at next week’s market would bring substantially more than the cost of the raw materials – but it’s being produced outside the market economy, and therefore has no official existence in an economy measured entirely by market metrics.

What makes this particularly relevant in the twilight of the age of cheap oil is that the world’s industrial nations, and above all the United States, have spent most of the last century transferring as much as possible of the household economy into the market sphere. In making our own jam, among other things, Sara and I belong to a minority of American households. Glance back a hundred years, by contrast, and nearly every family in the country outside the very rich and the very poor had an active household economy that produced a large fraction of the total goods and services they consumed. Many factors contributed to this dramatic shift, but one of the most significant is the availability of cheap abundant energy.”
Reviving the Household Economy Part One

Bigelow said...

“THEY LIVE: A Tightwad Nightmare Movie
What's going on?
Did you ever get the sinking suspicion that ten percent of the world has a secret.. and YOU aren't included. The rich get richer and the poor get poorer. Could this all be a massive consumer conspiracy? They Live is a little known movie that explores the question of new age consumerism. Considered a "cult classic", They Live is probably THE best of the early movies by sci-fi movie director John Carpenter.

We've already been invaded!
Essentially, this forgotten 1988 movie begins it's story with a drifter arriving in Los Angeles to discover that our whole narcissistic yuppie society is secretly dominated by aliens who control everything with human disguises and subliminal advertising. This intriguing screenplay was secretly written by Carpenter as a satirical jab at the decadent 80's.

Remove the aliens... And this movie is dead serious
What strikes me about this movie was the very real message of a borderless totalitarian world domination through consumerism. As an indictment of the ominous trends portrayed in Fahrenheit 451, 1984, Brave New World, or Brazil, this movie will scare you to death. As a venue for alien scapegoating, this sci-fi adventure will let you laugh at current social and political commentary. The minute you remove the aliens and replace them with real people, this movie is dead serious.”

Anonymous said...

The most potent weapon available to a taxpayer is to without their taxes. Don't file; don't pay, adjust withholdings to their max. and starve the government until it is prepared to enact the Constitution.

Anonymous said...

Ilargi wrote “Have you given any thought lately to how profitable a crisis can be? If it’s your big fat digits that hold the trough, there’s much more money to be made in a crisis than in a stable situation. So you create one.”

Future gross national product will be derived from these new growth industries: Bankruptcy Lawyer, Debt Collector and Auctioneer.

I saw Danny Schecter’s 2005 documentary In Debt We Trust yesterday. He interviews Michael Hudson who said “People have difficulty realizing that the new economic conflict in our society is between creditors and debtors.”

Make that Predatory Finance and everybody else.

Anonymous said...

"It is routine to weight the risk of a major bank defaulting by looking at the relevant CDS prices.
But here’s an alternative measure increasingly used by asset managers - the spread between the yield on Tier 1 paper and “lower” Tier 2 securities.
Charting Stressed Banks

Greenpa said...

Anon - "why aren't people in the streets "-

I think the answers are multiple, and none encouraging. A) - "people" right now have only fractional educations compared to the past. B) the video game world has made almost everything a fantasy- and made everyone passive receptors of entertainment. Sit back and watch - is what we learn.
C) leaders are in very tight supply. Leaders can still get people moving- but are very very hard to find.

Greenpa said...

oh- forgot to say- I don't think the gutting of the education system has been accidental. It has been at least partly quite intentional- somebody knows that the ill-educated are much easier to fool, and control. We might want to look at the records- who cuts funds for education? Why, it's the same folks cutting regulations for business. Surprise.

What I like least here is; we have a stellar example of good, beneficial, banking in Mohammed Yunnus- truly admirable- and where, pray tell, are the people copying his model? Why isn't there, right now, a "First Non-Profit Bank Of America"? Or Canada? Or Britain? There SHOULD be- but it doesn't seem to be happening. There are plenty of disaffected wealthy kids out there who have the capital to start this kind of thing.

Anonymous said...

greenpa - What about credit unions?

The World Council of Credit Unions (WOCCU) defines credit unions as "not-for-profit cooperative institutions

Credit unions differ from banks and other financial institutions in that the members who have accounts in the credit union are the owners of the credit union and they elect their board of directors in a democratic one person-one vote system regardless of the amount of money invested in the credit union.


Anonymous Reader

Bigelow said...

“During a phone chat with my assistant Luis last week, we discussed our mutual unease with bank stocks. Yes, financials had rallied off the July lows, but we could not explain why and our conversation deteriorated into pointless babble.
Alas, Luis snapped us out of our groveling by suggesting we examine insider trading histories for several of the big banks involved in this mess. Perhaps this would return our joviality and provide an alibi to justify our short-selling debauchery.”
Bank Insiders Made Out Like Bandits Seeking Alpha

Anonymous said...

Here is a bit from Mish's blog

"China's Olympic Sized Bust

China impressed everyone with its Olympic opening ceremonies, but when it comes to profit, the Olympics disappoint China business owners.

Vancouver, London, Chicago Take Note

Similar disappointments are what Vancouver 2010 and London 2012 have to look forward to. Chicago 2016 (a hopeful) should take heed but it won't. Chicago may be in better shape because the recession is likely to be over by 2016, but I still doubt it would be worth the expense.

Many will suffer, few will benefit. Vancouver in particular is unlikely to be prepared for such an outcome. All that glitters is not gold."

Looks like world sentiment is definitely not of the party mood. I think I will order another load of firewood and start planing next year's kitchen garden early.

Anonymous said...

"I don't know what loan sharking is anymore."
Maxed Out author James Scurlock speaking of the Banking Industry.

Greenpa said...

Anon- "What about credit unions?"

oops. My face is pink. Somehow, credit unions just haven't been on my radar. I DO know they exist- but have never really thought of joining one. I don't know why not, beyond mere convenience- banks are easier to find.

Greenpa said...

Thinking about that- why don't credit unions have a bigger impact? Shouldn't they be able to offer better services- cheaper- all the time if they are truly non-profit? And wouldn't everybody rather get more for less? I don't get it.

Anonymous said...

greenpa - Where I live, SW Ohio, there are lots of credit unions. Some are affiliated with specific jobs, but many are open to anyone within a certain county area. We recently joined a well-known credit union in our area, as an alternative to the banks. As many already are aware, Ohio has 5 or 6 large regional banks at-risk. While we know many banks will fail, no doubt credit unions also will fail if too many people default on their loans. But with a credit union, I would hope that the loans defaulting are less than at a bank. Time will tell.
Anonymous Reader

Anonymous said...

greenpa - Also, Credit unions in our area do have a big impact, tens of thousands of members. They seem to have the same services just like a bank. In some ways, this is frightening...because these same services could also become the downfall of credit unions.

One good thing is that the credit union answers to its members, not to a big-salary CEO and shareholders.
Anonymous Reader

Anonymous said...

An aside: I don't see Peter Schiff mentioned on these pages, but Roubini gets lots of ink. Is there a reason? Given Schiff's accuracy...