Tuesday, August 5, 2008

Debt Rattle, August 5 2008: Shipwrecked Among Cannibals

National Photo Company Shipwrecked Among Cannibals January 1921
Washington - Now playing at the Leader: "Shipwrecked Among Cannibals."
Just loitering outside for a few minutes is practically a graduate course in cannibal lore

Ilargi: With commodities markets going down at their fastest pace in decades, and oil down 20%, perhaps we may cherish some hope that all the inflation talk calms down. The media hype that surrounds inflation starts to feel like a false flag operation. We need to focus on the actual problem at hand: deflation.

At the same time, it’s imperative to point out that availability of energy is not the main problem we have these days. Peak oil (and peak gas, coal etc.) is a very real issue. But, by a very wide margin, it’s not the most pressing, or the worst, issue the world will face in the short term, say the next 5 years.

This is because long before the availability of energy becomes a real problem, the availability of money to pay for the energy will be. And if the number of people who can afford to pay for gas, and heating oil, and electricity, declines, and does so at an increasing pace, energy availabilty turns into an afterthought, and even a moot point, for the time being.

Global finance is in the preliminary phases of a process that will take away most of the money and credit that have made the world go round in the past 50 years. Especially in the past two decades, huge amounts of credit have been lent out, based on a "foundation" of real goods and resources that has grown much less, if at all.

The vast majority of the credit that was handed out has not yet been repaid, and is still held as debt by governments, companies and individuals. But the easy-money credit machine has reached a whole slew of limits, exemplified for instance by the prices paid for homes across the US, which rose 200% in a decade, even though the homes were still the same, and are now crashing back to earth..

Such a process of ever increasing prices has to stop sometime. We are at that "sometime" point. Available credit is already fast disappearing, and it’s just getting started. Nothing central banks can do could halt that process, other than very temporarily.

But the debt remains, both as principal and as interest. Therefore, as the money available in our societies decreases, a substantial part of it still has to go into paying off debts incurred in times of plenty. That in turn means that an growing percentage of what is left in available money will need to be reserved for loan payments, which will worsen the situation hugely.

A 50% drop in US home prices will take $10,5 trillion in equity out of the economy, $100.000 per home. Still, a large portion of the homes have an average $200.000 mortgage attached to them, and these loans will have to be paid back. Don’t count on leniency from banks and lenders, they themselves have a hard enough time. Banks and funds have trillions of dollars worth of bad paper hidden away. These losses will put enormous pressure on the $62 trillion in swaps, as well as the $700-800 trillion in derivatives outstanding.

All of it will lead to drastically lower consumption rates, which will lead to bankruptcies, and tens of millions of jobs falling by the wayside. All levels of government will see their tax revenues fall precipitously, which inevitably leads to more job losses, as well as a steep drop in the level and number of services provided. Pension funds are awash in investments that are losing value on a daily basis, and many will go under, as will 100’s of banks and thrifts.

This is a process that is well underway, and can no longer be halted or avoided. Stop worrying about energy availabilty, or gas prices, there will be plenty of oil. The chances that you will be able to afford it are slim, which is a much more important issue in the near future. That and the food you will be able to buy.

Debt Deflation: How much worse can “It” get?
Last month closed with some far from comforting news about the state of the US housing market (sales and prices still falling), US financial institutions (Fannie Mae and Freddie Mac in need of rescue), Australian banks (NAB’s 90% write-down of its US CDO portfolio).

Then ABS figures showed that retail sales had fallen “unexpectedly” by one percent in June. The recent rally in stock markets came to a sudden end, and after a brief period of renewed confidence, the question “how much worse can “It” get?” is once again doing the rounds.

My answer is: a lot worse. The empirical grounds for this assessment are:
  • The ratio of asset prices to consumer prices–or the inflation-adjusted asset price index;
  • The ratio of private debt to GDP; and
  • Japan

In short, global asset markets have a lot further to fall, and a serious recession–the worst we have experienced since the Great Depression–is inevitable. Let’s first look at what the recent drop in retail sales implies for the economy.

The USA: Double Bubble
While the Dow has fallen substantially in the last year, its inflation-adjusted value is still three times its long-term average, and more than 4 times its average prior to the start of this bubble. Even if the index falls merely to its long term average, it still has another 62% to go (in real terms) from its current level. If it reverts to its pre-bubble average, it has another 73% to go.

Figure 1

If those figures seem ludicrously pessimistic and unrealistic to you, take a look below at the CPI-adjusted Nikkei–which fell 82% from its peak at the end of 1989 to its low in 2003. At the time, most commentators blamed Japan’s Bubble Economy and subsequent financial crisis on the opaque and anti-competitive nature of its financial system.

We were assured that nothing so ridiculous could happen in the transparent, competitive and well-regulated US financial system. Yeah, right.

Figure 2

The story for the US housing market is little better. The index has already fallen 23% from its peak in 2006. A reversion to the long term mean implies a further 38% fall in the average house price in America; while reversion to the pre-Bubble mean implies a further 41% fall.

Write-downs by US financial institutions certainly haven’t yet factored in that degree of possible fall in housing values, and as Wilson Sy, the cheif economist at APRA, pointed out recently in two brilliant research papers (1 2), the banks’ “stress test” modeling greatly under-emphasizes the impact of such asset price falls on their financial viability. House price falls in the USA are far from over, and likewise “unexpected” write-downs by US financial institutions.

Figure 3

Overall, if US markets fall back to their pre-Bubble levels, the stock market will plunge about 80% from its peak (much the same degree of fall as applied in Japan) and the housing market will fall 55% (rather more than happened in Japan, where average house prices fell 44%–but less than Tokyo, where they fell over 70%).

The unique feature of this US asset bubble is that it affects both stocks and houses. There have been three Stock Market Bubbles in the USA in the last century: the “usual suspects” of the 1920s and 1980’s, but also one that doesn’t normally rate a mention: a ’60s Bubble that peaked in 1966, and was followed by a slump that only ended in mid-1982 (see Figure 6).

As Figure 6 indicates, this dual bubble has no precedent. Not only is it a bubble in both asset markets, both bubbles dwarf anything previously experienced. Even the great Roaring Twenties stock market bubble barely pokes its head above the long term average, compared to the 2000s Stock Market bubble–and in the 1920s, as Figure 4 shows, the housing market was relatively undervalued. The over-valuation of today’s housing market far exceeds the now comparatively minor bubble when Keating (Charles, not Paul) was on the loose in the USA.

Figure 4

While the Australian Stock Market is not as severely overvalued as the American, it is still substantially over its long term trend. Even after the recent falls, the inflation-adjusted All Ordinaries Index exceeds its level before Black Tuesday in 1987. It has another 30% to go before it will have reverted to the mean of the last 25 years (see Figure 5).

Figure 5

The prognosis for the Australian housing market is substantially worse. Even on short term data–covering only the last 22 years–the market could fall 40% if it reverted to the mean, and 50% if it reverted to the pre-bubble mean. Nigel Stapledon’s research into long term house prices in Australia–which is not shown here–implies an even greater potential for a fall in house prices.

Figure 6

Of course, such talk can seem nonsensical and alarmist. Especially if you ignore what happened in Japan.

Japan: the world’s most recent debt-deflation
Japan clearly underwent a debt-deflation after its “Bubble Economy” spectacularly burst in 1990. In its aftermath, house prices across Japan fell on average by 42%, and by over 70% in Tokyo (though they have since recovered slightly).

Figure 7

Figure 8

What has happened there can happen in Australia, the USA, and the rest of the OECD–especially since our Bubbles, while smaller than the Tokyo bubble, are larger than that for Japan as a whole (see Figure 9).

Figure 9

The killer behind the Bubble: Debt
The level of over-valuation of asset markets reflects the unprecedented scale of private debt, both here and in America–since the vast bulk of that debt was undertaken to finance “Ponzi” speculation on shares and housing. This is the reason that this recession will be so severe–as will the asset market bust.

Every “recovery” from a debt-induced recession since 1970 has involved resumption in the tendency for debt to grow faster than GDP (see Figure 12, where the once seemingly major debt crisis of the late 80s is now just a pimple on the upward trend of the debt ratio to its current unprecedented level).

Yet today the debt to GDP ratio is more than twice that of the Great Depression. It is simply cannot go any higher. Who else, after all, can banks lend to, now that they have exhausted the “subprime” market?

The only way for the debt to GDP ratio now is down (unless we’re unlucky enough to experience deflation, in which case the ratio will rise further, as in the Great Depression), and as it heads down, so will output and employment. A serious recession is inevitable.

Welcome to “the recession we can’t avoid”.

Fisher's Debt-Deflation Theory of Great Depressions and a possible revision
I have been both a central banker and a market regulator. I now find myself questioning whether my early career, largely devoted to liberalising and deregulating banking and financial markets, was misguided.

In short, I wonder whether I contributed - along with a countless others in regulation, banking, academia and politics - to a great misallocation of capital, distortion of markets and the impairment of the real economy. We permitted the banks to betray capital into “hopelessly unproductive works”, promoting their efforts with monetary laxity, regulatory forbearance and government tax incentives that marginalised investment in “productive works”.

We permitted markets to become so fragmented by off-exchange trading and derivatives that they no longer perform the economically critical functions of capital/resource allocation and price discovery efficiently or transparently. The results have been serial bubbles - debt-financed speculative frenzy in real estate, investments and commodities.

Since August of 2007 we have been seeing a steady constriction of credit markets, starting with subprime mortgage back securities, spreading to commercial paper and then to interbank credit and then to bond markets and then to securities generally. While the problem is usually expressed as one of confidence, a more honest conclusion is that credit extended in the past has been employed unproductively and so will not be repaid according to the original terms. In other words, capital has been betrayed into unproductive works.[..]

Hyman Minsky and James Tobin credited Fisher’s Debt-Deflation Theory as a crucial precursor of their theories of macroeconomic financial instability.

Fisher explicitly ties loose money to over-indebtedness, fuelling speculation and asset bubbles:

Easy money is the great cause of over-borrowing. When an investor thinks he can make over 100 per cent per annum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with the borrowed money. This was a prime cause leading to the over-indebtedness of 1929. Inventions and technological improvements created wonderful investment opportunities, and so caused big debts.

The public psychology of going into debt for gain passes through several more or less distinct phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of selling at a profit, and realising a capital gain in the immediate future; (c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible.

Fisher then sums up his theory of debt, deflation and instability in one paragraph:

"In summary, we find that:
  1. economic changes include steady trends and unsteady occasional disturbances which act as starters for cyclical oscillations of innumerable kinds;
  2. among the many occasional disturbances, are new opportunities to invest, especially because of new inventions;
  3. these, with other causes, sometimes conspire to lead to a great volume of over-indebtedness;
  4. this in turn, leads to attempts to liquidate;
  5. these, in turn, lead (unless counteracted by reflation) to falling prices or a swelling dollar;
  6. the dollar may swell faster than the number of dollars owed shrinks;
  7. in that case, liquidation does not really liquidate but actually aggravates the debts, and the depression grows worse instead of better, as indicated by all nine factors;
  8. the ways out are either laissez faire (bankruptcy) or scientific medication (reflation), and reflation might just as well have been applied in the first place."

The lender of last resort function of central banks and government support of the financial system through GSEs and fiscal measures are the modern mechanisms of reflation. Like Keynes, I suspect that Fisher saw reflation as a limited and temporary intervention rather than a long term sustained policy of credit expansion a la Greenspan/Bernanke.

I’m seriously worried that reflationary practice by Washington and the Fed in response to every market hiccup in recent decades was storing up a bigger debt deflation problem for the future. This very scary chart (click through to view) gives a measure of the threat in comparing Depression era total debt to GDP to today’s much higher debt to GDP.

Certainly Washington and the Fed have been very enthusiastic and innovative in “reflating” the debt-sensitive financial, real estate, automotive and consumer sectors for the past many years. I’m tempted to coin a new noun for reflation enthusiasm: refllatio? Had Fisher observed the Greenspan/Bernanke Fed in action, he might have updated his theory with a revision.

At some point, capital betrayed into unproductive works has to either be repaid or written off. If either is inhibited by reflation or regulatory forbearance, then a cost is imposed on productive works, whether through inflation, higher interest, diversion of consumption, or taxation to socialise losses. Over time that cost ultimately hollows out the real productive economy leaving only bubble assets standing.

Without a productive foundation, as reflation and forbearance reach their limits, those bubble assets must deflate. Fisher’s debt deflation theory was little recognised in his lifetime, probably because he was right in drawing attention to the systemic failures that precipitated the crash. Speaking truth to power isn’t a ticket to popularity today either.

Moody’s & Fitch Join S&P in Massive Alt-A RMBS Downgrade Avalanche
Just one week after S&P placed over 1600 Alt-A RMBS on downgrade review (final downgrades likely within a few days), Moody’s and Fitch get into the act by actually downgrading hundreds of Alt-A RMBS, most issued by the nations largest banks. 

One of my favorite sites, Mortgage Daily, tracked all the deals. One thing Moody’s mentioned that is very concerning and worth remembering… “due to low current credit enhancement levels relative to current pool projected losses”.  This brings forward a variety of questions.

Remember folks, this is how the real pain of the ’Subprime Implosion’ began; with the downgrades of thousands of subprime RMBS last year. Only now are they finally acknowledging the losses. Although the raters have been pecking on Alt-A and Jumbo Prime for months, this is the first we are seeing of large scale higher-grade RMBS downgrades across the raters.  

This is so large-scale and across so many different paper types and banks, I think all three leading raters coming out in the same week is a fairly significant development. Especially given that the Alt-A universe alone dwarfs subprime. When you throw in Jumbo Prime and lower grade conventional prime all previous loss estimates can be thrown out the window. 

Everyone seems to think Merrill’s subprime CDO sale marks the bottom of the write-down crisis.  I don’t think so but even if it does mark the bottom of the ’subprime’ CDO crisis.  Say ‘hello’ to Alt-a and Prime.

Keep in mind, most of the new downgrades you are seeing do not include Home Equity loans (HELOC) or RMBS, which are widely thought to be ‘unratable’. As a matter of fact, on May 2nd S&P announced they have STOPPED rating them  all together citing “anomalous and unprecedented borrower behavior”. 

There are $1.1 to $1.3 trillion in second mortgages on bank’s balance sheets mostly still owned by the originating banks.  But we will leave this crisis for another story.

Of the stand outs, Goldman Sachs, Bank of America, Chase, Lehman, Deutsche, Merrill, WaMu and CITI were mentioned often.  And in looking at the deals, many consist of Pay Option ARMs, which in my opinion were the most toxic loan every created. 

Judging by my data and research, I believe that ‘Pay Option ARM Implosion’ is upon us.  It is the next phase in the overall ’mortgage implosion’ and could make the ‘Subprime Implosion’ look like a walk in the park. On July 17th, I posted some good info on the upcoming ‘Pay Option Implosion’ if you need a review on the topic. Also, directly below is a current accelerated Pay Option ARM reset schedule.  As you can see resets have just started to spike and there is a year and a half to go until the peak.

Ilargi: Greenspan’s original article can be found near the end of this Debt Rattle.

Greenspan warns of more bank bail-outs
More banks and financial institutions could end up being bailed out by governments before the credit crisis is over, Alan Greenspan, the former chairman of the Federal Reserve, warns in an article in Tuesday’s Financial Times.

However, Mr Greenspan cautions that a heavy-handed regulatory response to the crisis would do more harm than good because it would depress global share prices. He worries that governments, already troubled by inflation, might try to reassert their grip on economic affairs.

“If that becomes widespread, globalisation could reverse, at awesome cost,” he says. The former Fed chairman says this financial crisis is a “once or twice a century event deeply rooted in fears of insolvency of major financial institutions”.
Highlighting the examples of Northern Rock in the UK and Bear Stearns in the US, he says: “There may be numbers of banks and other financial institutions that, at the edge of defaulting, will end up being bailed out by governments.”

Mr Greenspan says this “insolvency crisis” will end only when home prices in the US begin to stabilise. He says that “later this year” suppressed housing starts will feed through into a significant decline in home completions, allowing for a “rapid rate of liquidation of the inventory glut”. But this “assumes that current levels of demand for housing hold up”.

Mr Greenspan says the performance of world stock markets will be crucial in determining how well the financial system holds up in the interim, and to banks’ ability to recapitalise themselves. He says a key determinent of global equity prices is the rate at which investors discount future cash flows, and this in turn is influenced by the degree of market capitalism and globalisation.

Citigroup Posts Loss on Credit-Card Securitizations
Citigroup Inc. reported its first loss since at least 2005 on credit-card securitizations, signaling that risks may be growing in a business that generated $3.5 billion of revenue in the past three years.

The biggest U.S. credit-card lender lost $176 million in the second quarter packaging card loans into securities, the company said in an Aug. 1 regulatory filing. The New York-based bank completed fewer deals and was forced to mark down its own $9 billion stockpile of the debt instruments and other stakes the company amassed while selling them to investors.

Led by Chief Executive Officer Vikram Pandit, 51, Citigroup manages about $202 billion of credit-card loans worldwide, about $111 billion of which have been turned into securities and sold, according to the filing. Delinquencies on the securitized portion have jumped by 16 percent since the end of last year to $2.16 billion as of June 30, Citigroup said. The firm's results may portend similar losses for rivals.

Banks and other card issuers "are predicting higher net charge-off rates across the credit-card industry," said Meghan Crowe, a Fitch Ratings analyst who tracks credit-card issuers including American Express Co., Capital One Financial Corp. and Advanta Corp. "Things have been worse than anticipated."

Citigroup spokeswoman Shannon Bell declined to comment. The company's shares fell 4 cents to $18.83 in New York Stock Exchange composite trading today. Job losses and higher food and gasoline prices have squeezed consumers, causing more of them to fall behind on bills and damping a market for credit-card debt that has so far withstood the collapse of the mortgage-backed securities industry.

Wachovia Corp. analyst Glenn Schultz predicted in a July 18 report that loan charge-offs by credit-card securitization trusts industrywide may climb to 7 percent in coming months from 5.6 percent currently.

Charlotte, North Carolina-based Bank of America Corp., the second-biggest card lender, had about $2.9 billion of interests in securitized card loans as of March 31, according to a regulatory filing. No. 3 JPMorgan Chase & Co., based in New York, had about $2.9 billion of so-called subordinated interests, according to a filing.

On July 18, Citigroup posted an overall $2.5 billion net loss, mostly stemming from writedowns on mortgage-related securities including so-called collateralized debt obligations, which are bonds backed by other debt. The bank also reported higher costs to set aside money to cover bad consumer loans.

In its Aug. 1 filing, Citigroup said that "higher funding costs and higher credit costs flowing through the securitization trusts" were the primary reasons for an 11 percent revenue decline to $2.93 billion in its North American credit-card business.

In the year-earlier period, credit securitizations produced a $243 million gain. Net gains from securitization of credit- card loans totaled $1.27 billion last year, $1.08 billion in 2006 and $1.17 billion in 2005, according to the firm's most- recent annual report, filed in February.

Like other banks, Citigroup packaged credit-card loans into securities so it could tap into the pool of fixed-income investors looking for bonds not tied to corporate debt, municipal bonds or mortgages. That market has slowed, according to data compiled by Bloomberg. In July, banks and securities firms issued $2.1 billion of credit-card securities, the lowest monthly volume in two and a half years. The industry issued $6.8 billion of them in July 2007.

Banks' interests in securitized credit-card loans are vulnerable partly because of the way the deals are packaged, according to Fitch's Crowe. Security holders typically are granted senior interests, meaning they stand first in line to get repaid if loan losses climb or the instruments default. Banks often retain the junior interests, meaning they're first to absorb the losses.
"These guys hold the lower pieces," Crowe said, declining to comment on Citigroup specifically.

Citigroup has about $6 billion of "trust-issued securities" backed by credit cards, according to the Aug. 1 filing. The bank said it has another $3.1 billion residual interest in credit-card securitization trust cash flows.

Lehman may have to raise capital if it sells assets
Lehman Brothers Holdings Inc is expected to follow in Merrill Lynch & Co Inc's footsteps and sell a lot of risky assets at a loss. But shedding the assets may create another headache for Lehman -- the need to raise large amounts of new capital, including common equity.

Any capital raise would be painful for Lehman and its shareholders, given that the company just raised $6 billion in June and trades at a significant discount to its book value, or the net accounting value of its assets.

But Lehman, the fourth-largest U.S. investment bank, may have little choice as it wrestles with roughly $65 billion in mortgage-related assets, particularly after Merrill Lynch agreed to shed $30.6 billion in toxic assets at a fire-sale price of 22 cents in the dollar, analysts said.

"Lehman's caught between a rock and a hard place. They're getting more and more pressure from regulators and investors to add reserves or mark these things down," said David Hendler, an analyst at independent research firm CreditSights in New York.

"In normal times, they could wait it out, but the market wants it done now," Hendler added. The New York Post reported on Friday that Lehman was talking to potential buyers about selling $30 billion in assets. CNBC television reported Friday that Lehman was in talks with BlackRock Inc to sell mortgage securities and other assets. Both Lehman and BlackRock declined to comment.

Lehman's chief financial officer told Merrill analyst Guy Moszkowski recently that the investment bank was willing to sell assets at a loss if the deal materially reduced risk, the analyst said in a report. Lehman had roughly $65 billion in mortgage and real estate-related assets on its balance sheet as of May 31.

Selling at a loss seems increasingly likely after the Merrill deal last week. Lehman's assets may be of much higher quality, but Merrill's low sale price for mortgage-linked securities implies that many banks' assets connected to mortgages may be marked down further.

Lehman wouldn't have to sell assets at much of a loss before it had to raise capital. Brad Hintz, an analyst at Sanford C. Bernstein, wrote in a note on Monday that any loss much greater than $1.5 billion -- which translates to selling $30 billion at a discount of at least a 5 percent to their current value on Lehman's books -- would likely force Lehman to issue at least some common equity.

Selling assets at enough of a loss would force Lehman to record a quarterly charge -- eating into capital for an investment bank that many investors already believe is undercapitalized. Any big reduction in Lehman's capital could bring pressure from regulators and rating agencies to raise capital.

Depending on the price that the assets are sold for, Lehman might have to raise $4.5 billion to $7 billion in capital to offset losses, CreditSights' Hendler said. Given that Lehman's market capitalization, or value in the stock market, is currently about $13 billion, such a capital raise could leave existing shareholders owning a much smaller portion of the company.

A Lost Decade of Housing Equity: Los Angeles and Orange County will hit a Housing Price Bottom in May 2011
The California housing market is facing a major calamity. In April of 2007 California reached a peak median price of $597,640 only to see those gains erased in the following year. By June of 2008, the median price in California is hovering at $368,250, a drop of 38.38% with no signs of slowing down.

This is data gathered from the California Association of Realtors. Seeing a statewide drop of nearly 40% in one year may be a tempting incentive for people to jump back in the market. I’ve recently gotten many e-mails about people asking about a market bottom and whether they should be buying today.

This bottom psychology has also taken hold on Wall Street. There seems to be a new campaign of getting people to jump back in with both fists with the idea that things are hitting a price bottom. This is a mistake. Just because something has become radically “cheaper” in relation to a peak price does not make it worth the current price.

There has to be some underlying economic valuation that justifies the price. After all, the recent job report saw unemployment spike up to 5.7% and we also saw our 7th month of continued job losses:

Clearly there will be no second half recovery. In fact, here in California the Governor just signed an order to reduce the wages of 200,000 state employees to the minimum wage and laid off thousands of part-time employees. Do you think this is good for the California housing market? Who will be the future buyers of these homes? When we examine the data we realize that prices have further to come down. I’ll give you five reasons why prices will continue to fall in California:
  1. State Budget Crisis means higher taxes and spending cuts (a combination of both).
  2. $300 Billion in Pay Option ARMs set to recast in the state.
  3. Declining price momentum - 3 measures show prices crashing
  4. Market psychology. Why buy today when prices will be cheaper tomorrow?
  5. Real estate prices do not always go up.

The combination of these factors is going to stunt any supposed recovery for the California real estate market. Yet for all the negative news on the economy and housing there will be a housing bottom at a certain point in time. When will housing actually hit a bottom? Some think we are already there. For those that are actually putting their money where their mouth is, there is the real estate futures market. And their bet is that housing for Los Angeles and Orange Counties will not hit a bottom until May of 2011.

Here Comes The Next Wave Of Defaults And Failures
If you thought we were almost through the subprime mess and that things are going to start getting better, you might want to consider this news: According to some financial experts, the subprime problems are only the beginning.

Alt-A (low document and stated-income-type loans) and even prime mortgages are starting to see dramatic upticks in their default rates. Alt-A loan defaults have quadrupled to 12 percent from April 2007 to April 2008, and delinquencies on prime loans doubled during that same period, according to the New York Times.

The chairman of JP Morgan Chase, James Dimon, called the outlook for these mortgages “terrible” and said he expected losses on the company’s prime loans to triple in the coming months, according to the New York Times. Economist and New York University Professor Nouriel Roubini went so far as to say in a Reuters article that hundreds of banks were going to fail, and the ultimate price to tax payers would likely be between $1 and $2 trillion.

If these Alt-A and even prime mortgages start to go bad, we are going to be in for financial trouble far worse than we’ve seen so far from the subprime meltdown. Subprime mortgages make up only a small percentage of total mortgage loans, and the government was hardly on the hook for any of them.

If prime loans start going bad in large numbers, though, we had better watch out. Now that Fannie Mae and Freddie Mac have an unlimited line of credit--and official backing of the U.S. government--taxpayers could potentially have to foot the bill on trillions of dollars of mortgage loans.

Worse, though, if either one of these companies--or any of the big banks for that matter--have to seek government assistance it will likely send a tremor through the entire financial industry and economy. How many foreign governments, or anyone, are going to feel good about buying U.S. treasuries when our financial system is falling down around us?

And we have to take into account that the government has been trading U.S. treasuries for mortgage debt in order to prop up these financial institutions, so now our economy and dollar are being supported by these mortgage instruments. Not exactly the pillar of safety and security that we would like be supporting our currency.

Jobs are declining, inflation is rising, and now this. I’m not sure exactly how we are going to get out of this mess, but I’m sure the ol’ government has something up their sleeves. I’m sure it will involve some sort of bailout and printing of money, so basically some variation of the status quo.

The good news for us is that the world is addicted to U.S. debt, the same way we are addicted to being in debt, and as long as we have our foreign friends paying our way, we will be good. Kind of like the former movie star or sports hero who never has to buy their own meals.

We all know what happens to them when they get too old, though, and people stop remembering their greatness. How much longer our run will go on, I don’t know, but I can tell you I certainly am not buying treasuries or financial stocks right now.

Thain Says Merrill May Become Profitable 'Shortly'
Merrill Lynch & Co., the U.S. securities firm that booked almost $19 billion of net losses in the past four quarters, may become profitable soon, Chief Executive Officer John Thain said.

"We will shortly be back to profitability," Thain told CNBC in his first public comments since the firm raised $9.8 billion in a share sale last week. He declined to be specific about when the New York-based firm would end the losses. Merrill was forced to raise money to offset writedowns triggered by the sale of $30.6 billion in collateralized debt obligations, the mortgage-linked securities that caused the bulk of the firm's losses, Thain said.

The share sale was the biggest so-called secondary stock offering in U.S. history. "We had the buyer lined up," said Thain, 53. "We had negotiated a trade. Waiting until January certainly ran the risk to us that these assets continued to deteriorate in value and that they caused further losses."

Lone Star Funds, a Dallas-based investment manager, bought the CDOs for 22 cents on the dollar. Thain said in the interview that the discount reflected the volume of the assets being sold and a dearth of trades in the market. "This is the first big trade in the CDO market," Thain said. "There really has been no liquidity until now. There's no question this price was a bulk-sale price."

The sale "dramatically reduced our risk," Thain said. "It puts us in a much better position to manage our business going forward." Merrill doesn't need to raise additional capital "today," Thain said. That might change if prices for the firm's assets, which include subprime mortgages, drop further. "We are much smaller in terms of risky assets but it's not zero," Thain said. "If asset values continue to fall, particularly mortgage assets, we still have some exposure."

The economy won't rebound anytime soon, Thain said. "The U.S. economy is going to continue to be weak," he said. "If you look at the combination of falling home prices, rising unemployment, high energy prices, both gasoline and however you heat your home, and rising food prices, all of those are going to make difficult for the consumer, all of which I think makes the U.S. economy slow at least until sometime next year."

Merrill financed about 75 percent of Lone Star's purchase, the firm said in a statement last week. The financing was structured so that there was "almost no probability" that Merrill suffers more losses on the assets, Thain said. Merrill gets a "disproportionate amount of the cash flow" from the CDOs to pay down the loan to Lone Star, he said.

At Freddie Mac, Chief Discarded Warning Signs
The chief executive of the mortgage giant Freddie Mac rejected internal warnings that could have protected the company from some of the financial crises now engulfing it, according to more than two dozen current and former high-ranking executives and others.

That chief executive, Richard F. Syron, in 2004 received a memo from Freddie Mac’s chief risk officer warning him that the firm was financing questionable loans that threatened its financial health.

Today, Freddie Mac and the nation’s other major mortgage finance company, Fannie Mae, are in such perilous condition that the federal government has readied a taxpayer-financed bailout that could cost billions. Though the current housing crisis would have undoubtedly caused problems at both companies, Freddie Mac insiders say Mr. Syron heightened those perils by ignoring repeated recommendations.

In an interview, Freddie Mac’s former chief risk officer, David A. Andrukonis, recalled telling Mr. Syron in mid-2004 that the company was buying bad loans that “would likely pose an enormous financial and reputational risk to the company and the country.”

Mr. Syron received a memo stating that the firm’s underwriting standards were becoming shoddier and that the company was becoming exposed to losses, according to Mr. Andrukonis and two others familiar with the document.

But as they sat in a conference room, Mr. Syron refused to consider possibilities for reducing Freddie Mac’s risks, said Mr. Andrukonis, who left in 2005 to become a teacher. “He said we couldn’t afford to say no to anyone,” Mr. Andrukonis said. Over the next three years, Freddie Mac continued buying riskier loans.
Mr. Syron contends his options were limited.

“If I had better foresight, maybe I could have improved things a little bit,” he said. “But frankly, if I had perfect foresight, I would never have taken this job in the first place.” Mr. Andrukonis was not the only cautionary voice at Freddie Mac at the time.

According to many executives, Mr. Syron was also warned that the firm needed to expand its capital cushion, but instead that safety net shrank. Mr. Syron was told to slow the firm’s mortgage purchases. Instead, they accelerated. Those and other choices initially paid off for Mr. Syron, who has collected more than $38 million in compensation since 2003.

But when housing prices began declining in 2006, choices at Freddie Mac and Fannie Mae proved disastrous. Stock prices at both companies have fallen by more than 60 percent since February, destroying more than $80 billion of shareholder value.

More than two dozen current and former high-ranking executives at Freddie Mac, analysts, shareholders and regulators said in interviews that Mr. Syron had ignored recommendations that could have helped avoid the current crisis.

Many of those interviewed were given anonymity for fear of damaging their careers by speaking publicly.
Now, some outsiders are saying that Mr. Syron and the top executive at Fannie Mae — some of the highest-profile figures in the business world — should be replaced.

“The top people should be booted out, and replaced by executives who have the confidence of the markets,” said Janet Tavakoli, a finance industry consultant and observer of both firms. Large Freddie Mac shareholders, speaking on the condition of anonymity, echoed those sentiments.

Mr. Syron and the Fannie Mae chief executive, Daniel H. Mudd, defended their choices, saying in interviews that they did not anticipate that the housing market would decline so quickly and that they were buffeted by conflicting pressures.

“This company has to answer to shareholders, to our regulator and to Congress, and those groups often demand completely contradictory things,” Mr. Syron said in an interview. Indeed, executives of both companies maintain that one of the reasons the firms hold so many bad loans is that Congress has leaned on them for years to buy mortgages from low-income borrowers to encourage affordable housing.

In 2004, Freddie Mac warned regulators that affordable housing goals could force the company to buy riskier loans. Others, however, dismiss that explanation. “Sure, it’s hard to deal with the pressures of Congress and shareholders and regulators,” said a former high-ranking Freddie Mac executive. “But that’s why executives get paid so much. It’s not acceptable to blame those pressures for making bad choices.”

In a statement, Freddie Mac said executives were unable to verify that Mr. Andrukonis’s memorandum existed, and that the company’s default and delinquency rates were substantially lower than other firms. “There is little to nothing that Freddie Mac could have done to prevent the losses that it is now incurring,” wrote company spokesman, David R. Palombi.

Mr. Mudd said the companies were victims of circumstance. “You’ve got the worst housing crisis in U.S. recorded history, and we’re the largest housing finance company in the country, so when one goes down, the other goes with it,” he said. A Fannie Mae spokesman, Brian A. Faith, said that beginning in 2005, executives “sounded the alarm” about riskier loans and began limiting their purchases.

The depths of Freddie Mac’s problems are complicated by its long-planned, continuing search for a chief executive to replace Mr. Syron, who is expected to remain chairman. Two people who were approached — Kenneth I. Chenault of American Express and Laurence D. Fink of BlackRock — said they did not want to be considered for the position.

Some outsiders are surprised to learn that among the candidates the company is considering is Alan Schwartz, who headed Bear Stearns as it collapsed.

Ilargi: I still like Karl Denninger, but his xenophobic reaction to this is more than ridiculous: "Foreigners blackmail your government!!"

This nonsense comes a week after he failed to rouse enough interest to halt the Housing Bill from becoming law. Now he comes with another resolution that goes nowhere. I get real jittery whenever foreigners are conveniently blamed for the failures of a society and its leaders. That harks back about 75 years now.

If there’s any blackmail going on here, it’s the US government extorting its own citizens. If investors abroad ask that government to stop the practice of deliberately devaluing their shares, then blaming the investors instead of the government is myopic at best.

Fannie's Mudd Soothed Asian Investors as Bonds Rose
Fannie Mae Chief Executive Officer Daniel Mudd was sitting down to a glass of wine with his wife at their Washington home around 10 p.m. on Saturday July 12 when Treasury Secretary Henry Paulson called.

Concerns about the financial health of the biggest U.S. mortgage finance company had driven Fannie Mae's borrowing costs to the highest since March the previous week and its shares had tumbled 45 percent on the New York Stock Exchange. Investors in Asia, the biggest foreign owners of Fannie Mae's $3 trillion of bonds, were asking the Treasury to bolster the government- sponsored company and its smaller competitor, Freddie Mac, said three people with knowledge of the talks.

Paulson told Mudd he had a plan to restore confidence in Fannie and Freddie, the core of the Bush administration's efforts to revive the U.S. housing market. "At that point, the proposal began to take form," Mudd, 49, said in an interview. "We're trying to solve a crisis of confidence. Would this do it?"

The next afternoon, before financial markets opened Monday in Asia, Paulson announced the rescue plan, saying he would seek authority to buy unlimited equity stakes in the companies and their bonds if needed, while the Federal Reserve would lend directly to Fannie and Freddie. Congress included the proposals in a broader housing bill that President George W. Bush signed into law last week.

Asian investors were among the most important groups to soothe because central banks, financial institutions and funds in the region own $800 billion of Fannie Mae and Freddie Mac's $5.2 trillion in debt, according to data compiled by the Treasury. U.S. officials were concerned that sales from the region would push lending rates higher, said the people, who declined to be named because the discussions were confidential.

The extra yield investors demanded to own five-year notes of Washington-based Fannie rather than Treasuries rose to 101 basis points, or 1.01 percentage point, on July 9, from an average of 39 basis points over the previous five years.

Borrowing costs climbed and the companies' shares collapsed after analysts at New York-based Lehman Brothers Holdings Inc. said in a July 7 report that proposed accounting changes might force Fannie Mae and McLean, Virginia-based Freddie Mac to raise a combined $75 billion in capital.

Fannie tumbled 45 percent to $10.25 in New York Stock Exchange trading that week, while Freddie fell 47 percent to $7.75. A year ago both companies traded above $60.At the height of the panic, Mudd dispatched two lieutenants to Asia to meet with debt investors. He declined to say which countries were visited, or the names of the officials.

Freddie and Fannie rely on foreign institutions. Investors and central banks outside the U.S. own about $1.3 trillion of Fannie and Freddie's corporate and mortgage bonds, according to the Treasury. Chinese institutions are the biggest holders in Asia. European investors own $300 billion of the securities.

"If they stop buying the agency debt, then yields would increase," Ajay Rajadhyaksha, the head of U.S. fixed-income strategy at Barclays Capital in New York, said in reference to Asia investors. "The costs would get passed to the consumers."

The average rate on a 30-year mortgage jumped to 6.59 percent on July 18 from 6.22 percent on July 11 as demand for the companies' debt waned, he said. If Asia started selling Fannie and Freddie holdings, "that would be extremely worrisome," Rajadhyaksha said.

Like when it announced the bailout of Bear Stearns Cos. by JPMorgan Chase & Co. on a Sunday in March, the Treasury rushed to pull together a statement on July 13 before markets opened in Tokyo. Paulson, the 62-year-old former CEO of Goldman Sachs Group Inc., "knows the markets; he's seen parts of this movie before," Mudd said.

The decision to allow Fannie and Freddie to borrow from the Fed's so-called discount window was meant to "send a message to the markets that it wasn't just a someday aspiration, but those confidence building measures are in place right now before Tokyo opens on Sunday night," he said.

Fannie, Freddie seen boosting loss estimates, again
U.S. mortgage market giants, Fannie Mae and Freddie Mac, may report further downgrades to their forecasts for credit losses in their upcoming second-quarter results.

The government-sponsored enterprises have already warned investors that credit-related losses, such as payouts on loans they guarantee, would likely rise through 2008 as falling U.S. home prices aggravate defaults on mortgages.

But the collapse in the shares of Fannie Mae and Freddie Mac last month, which led to the U.S. Treasury and Congress extending them government support, suggests investors think the companies sorely underestimated the housing market debacle.

Since the two companies' May forecasts, the U.S. housing market has continued to deteriorate, leading credit rating agency Standard & Poor's this week to raise its loss estimates on risky loans which, in turn, may extend the vicious cycle of asset write-downs at banks.

In the market's view, Fannie Mae and Freddie Mac may not have enough capital to offset losses and maintain their roles as the engines of the U.S. housing market. "They've increased credit loss expectations for the past three quarters and this next one is probably going to be the fourth," Robert Napoli, an analyst at Piper Jaffray in Chicago, said in a recent interview.

Freddie Mac, which in May boosted its forecast for total credit losses in 2008 to 16 basis points or 0.16 percent of their total mortgage book, from 12 basis points, plans to report second-quarter results on Wednesday.

Fannie Mae in May ratcheted up its expectation for its 2008 credit loss ratio to 13 to 17 basis points, at least double its historical range, from a prior estimate of 11 to 15 basis points to 15 basis points. Fannie had not set a date for its second quarter results by Friday afternoon.

Upward revisions to loss forecasts may reignite scrutiny over whether the companies can contain their losses and meet political pressure to expand their support for the housing market. They own or guarantee nearly half of the $12 trillion mortgage market.

Doubts about their capital adequacy led to one of the stormiest months ever for the mortgage giants in July, leading the U.S. Treasury to make explicit its already tacit support for the two companies. The housing market legislation passed by Congress in July included provisions for the U.S. Treasury to buy equity capital in the two firms and extend credit to them.

Fannie Mae and Freddie Mac have said they have enough capital and their regulator, OFHEO, affirmed their statements. S&P, whose massive downgrades in the ratings of mortgage related assets in the summer of 2007 helped to exacerbate the credit crisis, this week again boosted its assumptions of losses on subprime and so-called "Alt-A" mortgages, which require less documentation and were often handed to borrowers with no equity stake in the property.

The new assumptions indicate up to $450 billion, or 85 percent of "AAA" rated 2006 vintage subprime securities will default, and may lead to a raft of downgrades that pressure financial institutions to face a "new reality," said Vivek Tawadey, head of credit strategy at BNP Paribas in London.

The pressure of credit downgrades for companies follows, and in turn may encourage, falling home prices. Through May U.S. house prices had already slumped 18.3 percent since the peak in July 2006, according to S&P/Case Shiller index of 20 metropolitan areas.

Deep downgrades on even the safest, "AAA" rated mortgage bonds will lead to more credit tightening due to the need to raise capital reserves and take mark-to-market losses, Tawadey said in a note about "Hurricane Housing" on Friday. "Turbulent market conditions lie ahead, would probably be an understatement" considering the early impact from Merrill Lynch & Co and other institutions that have taken "painful steps," he said.

For Fannie Mae and Freddie Mac, further drops in home prices since the first quarter will probably force them to increase reserves by a material amount, said Moshe Orenbuch, an analyst at Credit Suisse in New York. Their reluctance to deem market losses on Alt-A and subprime mortgage bonds they own as "other-than-temporary" will be challenged, he said in a note.

The more than 40 percent drop in the shares of Fannie Mae and Freddie Mac last month, and government plans to ensure backstop funding for the companies are indicators that writedowns for the companies are more likely, he said.
Analysts surveyed by Thomson Reuters expect Fannie Mae to report a second-quarter loss of $920.8 million, or 78 cents per share, compared with a $1.83 billion profit, or $1.86 a share a year ago.

Freddie Mac is seen losing $319 million, or 59 cents a share, compared with net income of $729 million, or 96 cents per share a year earlier. A monthly disclosure from Fannie Mae this week provided another clue on credit performance, according to Thomas Lawler, founder of Lawler Economic & Housing Consulting in Leesburg, Virginia, and a former portfolio manager at the company.

Delinquencies on mortgages with "credit enhancement" increased to 3.56 percent in May from 3.33 percent in April, representing a "disproportionate" jump for certain loans, including Alt-A, he said. Fannie Mae has about $70 billion in subprime and Alt-A securities in its portfolio. Freddie Mac is more at risk, with nearly $150 billion in the securities, analysts said

Fannie Mae, Freddie Mac to Report Losses Through 2008
Fannie Mae and Freddie Mac, the biggest U.S. mortgage-finance companies, may report net losses through the first quarter of 2009 as home-loan delinquencies rise to the highest on record, analysts' estimates show.

Freddie, based in McLean, Virginia, probably will say tomorrow when it releases second-quarter results that it had $1.9 billion in credit-related costs, while Washington-based Fannie will report $2.4 billion, according to Credit Suisse analyst Moshe Orenbuch in New York. The companies' regulator said July 22 that they may need to write down the value of $217 billion in securities.

"We see them continuing to lose money for the next several quarters," said Orenbuch, the top-ranked analyst covering the companies, according to Institutional Investor magazine. He rates Fannie and Freddie "underperform." "Their credit losses are still going to be stubbornly high and that's only partially offset by the better revenues" for guaranteeing loans from default, he said in an interview.

Freddie, led by 64-year-old Chief Executive Officer Richard Syron, will likely report a quarterly loss of about $388 million, or 60 cents a share, according to the average of 11 analysts surveyed by Bloomberg. Washington-based Fannie, led by CEO Daniel Mudd, 49, may post a loss of about $763 million, or 74 cents, the estimates show.

Freddie will continue to lose money through the second quarter of 2009, while Fannie's losses will extend through the first three months of next year, according to the analysts. Freddie spokesman Michael Cosgrove declined to comment before the earnings report, as did Fannie spokesman Jason Lobo. Fannie hasn't set a date yet for its earnings release.

Freddie tumbled 78 percent this year to $7.52 on the New York Stock Exchange, while Fannie plunged 70 percent to $11.83 on concern the companies, which own or guarantee 42 percent of the $12.1 trillion in U.S. home loans outstanding, may not have enough capital to survive the deepest housing slump since the Great Depression.

U.S. Treasury Secretary Henry Paulson announced a rescue plan on July 13, saying he would seek authority to buy unlimited equity stakes in the companies and their bonds if needed, while the Federal Reserve would lend directly to Fannie and Freddie. Congress included the proposals in a broader housing bill that President George W. Bush signed into law last week.

Fannie recorded $7.1 billion in losses the previous three quarters. Freddie posted $4.6 billion, after accounting changes allowed it to avoid at least $2.6 billion more, Chief Financial Officer Anthony Piszel said in a May 14 interview.
Freddie owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair-value accounting. Fannie's assets were valued at $12.2 billion more than its liabilities.

`There's a lot of pressure on them to come out with a good number," said Paul Miller, an analyst at Friedman, Billings, Ramsey & Co. in Arlington, Virginia. Fannie will lose an additional $45 billion and Freddie $30 billion on mortgage defaults over the next two to three years, and each may need to raise $15 billion in capital, Miller said.

There are few signs that the housing market has bottomed. The S&P/Case-Shiller home-price index dropped 15.8 percent in May from a year earlier, the biggest decline since records began seven years ago. Some 6.35 percent of home loans had at least one payment overdue as of the end of March, up from 4.84 percent a year earlier and the highest since at least 1979, the Washington- based Mortgage Bankers Association said June 5.

China Development Bank Said to Be Interested in Dresdner Bank
China Development Bank, which funds the nation's public works, is interested in buying Allianz SE's Dresdner Bank unit to gain a foothold in the European market, three people familiar with the matter said.

The Beijing-based lender has conducted due diligence on Dresdner Bank in Frankfurt, according to the people, who declined to be identified because they aren't permitted to publicly discuss the matter.

China Development Bank has acquired 3.1 percent of U.K. lender Barclays Plc as it seeks to expand overseas and pave the way for becoming a commercially oriented company. Allianz is also holding talks with other potential buyers including Commerzbank AG, the people said. The 23.5 billion-euro ($36.6 billion) acquisition of Dresdner Bank has been a drag on the insurer's profit and stock since 2001.

"There is potential for a political backlash" if Dresdner is sold to a buyer outside of western Europe, said Tony Silverman, an analyst at Standard & Poor's Equity Research in London. "The price would have to make up for the absence of strategic upside for Allianz in other deals."

Dresdner Bank spokesman Martin Halusa declined to comment. China Development Bank spokesman Xu Fei said he wasn't immediately able to comment. China Development Bank aims to gain expertise in areas such as investment banking through investments in foreign banks, according to analysts. The Chinese bank was initially interested in Dresdner Bank's securities unit and is now looking at the entire bank, including the retail business, because of its cheap valuation, the people said.

Dresdner, Germany's third-biggest bank by assets, would give a buyer 500 billion euros of assets, more than 1,000 branches and 6.3 million retail clients. Allianz wants to sell the securities unit Dresdner Kleinwort, which has contributed to more than 2.5 billion euros of subprime-related writedowns in the past year.

Dresdner Bank posted a 53 percent decline in net income last year, to 410 million euros. The investment bank, which is headed by Stefan Jentzsch and employs about 6,000 people, posted a 759 million-euro pretax loss in 2007 after writedowns. The unit was created from the merger of Dresdner Kleinwort and Bruce Wasserstein's Wasserstein Perella & Co.

Allianz Chief Executive Officer Michael Diekmann said in May that talks are taking place about a possible sale or merger of the bank. Dresdner plans to separate its consumer and investment banking units by the end of the month to give it more options in finding partners, the insurer has said. Allianz could sell the securities unit separately, according to Silverman at S&P.

Commerzbank, Germany's second-biggest bank by assets, is the most likely buyer of Dresdner Bank after holding talks and due diligence with the company, the people said. "You would have much lower synergies if you are a foreign bank looking at Dresdner, particularly in the retail bank," said Matthew Clark a London-based analyst at Keefe, Bruyette & Woods. "If a foreign company is prepared to pay a higher price it may be hard to block."

Massachusetts Residents Monthly Oil Heating Bill Forecast To Hit $3,000 In 2009
A 30 percent increase on heating fuel bills loom for Massachusetts residents. According to a report released Monday by the University of Massachusetts, residents may pay $1 billion more in 2008 for heating fuel compared to their 2007 bill.

By 2009, fuel costs could climb to $3,000 per monthly per household, said Robin Sherman, lead author of the study by the University of Massachusetts Donahue Institute.

The estimate was based on the current price of $4.70 a gallon for heating fuel. A year ago the cost was $2.59. With the almost doubling of price, Massachusetts residents would pay a total of $4.45 billion for gas and oil heat next year, up by $469 million expected for 2008.

According to Sherman, among the factors considered in computing the heating fuel cost are the price of oil and predictions of a cold winter, which could cause a further drop in prices as temperature forecasts drop. A previous study said good energy conservation measures would also help offset any increase in heating oil bills and keep production costs under control.

Commenting on the dire forecast, Joseph Kennedy II, chairman of the Citizens Energy Corporation, told the Boston Globe, "Maybe the people who are very, very wealthy won't bat an eyelash. But for the regular people who are working from paycheck to paycheck and week to week, and don't have anything in the bank account, this is devastating."

CRB Commodity Index Caps Biggest One-Day Decline Since March
Plunging prices for cocoa, natural gas and sugar sent the Reuters/Jefferies CRB Index of 19 commodities to its biggest one-day decline since March. The CRB index fell 3.4 percent to 401.98, which marks the largest slide since March 19. The gauge dropped to the lowest level since May 2 today, as did the UBS-Bloomberg Constant Maturity Commodity Index.

The CRB slid 10 percent in July, the most in any month since March 1980, when the U.S. economy was in a recession. A worsening global growth outlook and prospects for increased supply sent raw materials such as crude oil, soybeans and gasoline tumbling from records in the past month.

"Speculation had been driving these markets and they were due for a correction as so many prices had gotten overdone," said Peter Sorrentino, who helps manage $16.7 billion at Huntington Asset Advisors in Cincinnati. "There are moderating growth expectations that are going to hurt industrial commodities. Going forward, you have to be very selective."

Cocoa was today's biggest loser, dropping as much as 9.5 percent to a six-month low of $2,712 a metric ton on ICE Futures U.S., the former New York Board of Trade. Natural gas fell as much as 8.3 percent to $8.616 per million British thermal units on the New York Mercantile Exchange, and sugar was down as much as 6.5 percent to 13.21 cents a pound on ICE Futures.

The U.S. economy shrank at the end of the 2007 and grew less than forecast in this year's second quarter, signaling that the country is in worse shape than investors had anticipated, the Commerce Department said last week. Manufacturing in China, the world's fastest-growing major economy, contracted in July for the first time since a survey began in 2005.

Slowing global growth will mean "there won't be a tide to lift prices," Sorrentino said. "Before, you could look at commodities and buy across the board. Now, you have to be much more nimble." The CRB posted its best first half in 35 years, gaining 29 percent in the first six months of 2008 as investors stocked up on raw materials as an alternative to stocks and bonds and as a hedge against the weakening dollar.

Commodities are "at the beginning of a long-term bear market," after rallying the past seven years, Michael Aronstein, chief investment strategist at Oscar Gruss & Son Inc. in New York, said last week. Aronstein correctly said in June that prices for raw materials would start to decline. The CRB index has lost 13 percent since June 30.

Crude oil lost as much as 4.5 percent to $119.50 a barrel on the Nymex, the first drop below $120 since May, amid speculation that Tropical Storm Eduoard won't cause disruption to most offshore oil facilities as it approaches the coast of Texas. "Crude is leading everything down," said Hector Galvan, a senior market strategist for RJO Futures in Chicago. "People have that fear of not wanting to be the last one on the boat -- it's `abandon ship' for the short-term."

Copper tumbled as much as 4.3 percent to $3.426 a pound on the Comex division of the Nymex, the lowest price since Feb. 8. Inventories monitored by the London Metal Exchange reached the highest level since February. Aluminum, nickel and other industrial metals also fell. Platinum capped the biggest two-day decline in 22 years.

Falling prices may hurt profit for producers including BHP Billiton Ltd., the world's biggest diversified mining company, and Anglo Platinum Ltd., the world's largest producer of the metal. The Bloomberg World Mining Index of 139 companies tumbled 13 percent in July. The gauge lost as much as 4 percent today.

Corn and soybeans both fell more than 5 percent, dropping as much as the daily limit allowed on the Chicago Board of Trade, as favorable weather may boost the crops. The grains may continue to fall as demand from China, India and other emerging economies slows, said Daryll Ray, the director of the Agricultural Policy Analysis Center at the University of Tennessee in Knoxville.

"There has been much more optimism about China and India and the export market than facts support," Ray said. Prices may fall through 2009, he said. Gold, wheat, coffee and orange juice also declined. Hogs were the only commodity monitored by the CRB to gain today.

The U.S. Dollar: A New Accord
It was 1985 when world finance ministers from the G5 (then just France, Germany, Japan, the United Kingdom and the United States) led a coordinated effort to devalue the U.S. dollar.  It was known as the "Plaza Accord" because it was signed and agreed upon at the Plaza Hotel in New York City.  

The idea was to lower the value of the USD vs. its trading partners to reduce the United States' trade deficit, and to pull the economy out of a deep recession.  The Accord was a planned and systematic approach to revaluing the dollar in order to make American exports more competitive. 

Some 20 years later, it appears the world's finance ministers have converged to change the value of the USD à la the Plaza Accord all over again.   Structurally, the USD has become the "monkey in the middle" from all of the cross transactions in FX markets as money moves from one money center to the other in search of higher yield.  Since interest rates favor most other countries over the United States, the USD is left chasing the ball around.  

After several years of running around chasing, the Monkey in the middle is looking a bit weak and tired.  The popular, and consistently profitable "carry trade", whereby a currency in a lower yielding country (read: Japanese yen) is sold short vs. a currency that yields a higher interest rate, has eroded the value of the USD pushing it to the brink of historical levels, and in some cases beyond because of the structural imbalance.  

Take a look at one of the higher yielding currencies to give an example: As Australia's monetary conditions were attractive to the carry traders, money flowed into Australia at almost breakneck speed coming out of Japan where monetary policy has been sitting on the basement floor for what feels like an eternity.  

As these funds flooded into Australia, economic growth continually pushed higher, pushing the hand of the RBA to raise rates.  That, of course, drew more and more money into the healthier interest rate environment Down Under, which of course forced the hand of the RBA to continue to push rates higher and higher.  It was a continually vicious cycle as the allure of higher interest rates drew more and more flows into such a high yielding economy.  

All FX transactions flow through the USD in order to promote liquidity.  If you want to buy AUD/JPY you must sell JPY vs. USD and then sell USD vs. AUD.  AUDJPY is nothing more than a mathematical calculation of the the two currencies vs. USD from the resulting transaction.  So, the Monkey in the middle named the USD was getting drained of its power, and the world's economies were becoming more and more imbalanced.  

On Monday evening here in the U.S., there will be an announcement from the Reserve Bank of Australia about interest rates.  I'm predicting at the very least that there will be an extremely dovish tone, to at most a surprise lowering of the rate (Just like their neighbors did, the Reserve Bank of New Zealand).  There are plenty of reasons to lower interest rates at this point, and the minutes from the last meeting certainly suggest the Bank is ready.  

If that's the case, then the AUD will get pounded.  If you've been following the FX market as of late, that's nothing new from the past two weeks' trading - the AUD has lost almost 6% in a straight line down with expectations of such.  The economic outlook in Australia hasn't looked worse since the last recession, so an easing is absolutely in the cards.  

On Tuesday, the Federal Reserve meets to decide interest rates as well.  The likely outcome?  Hawkish at the very minimum to perhaps extremely hawkish at the maximum.  I'm expecting the wording to say something to the effect that the risks to inflation outweigh risks to growth.  Boom.  The USD just took off like a rocket.  

The interest rate differential is now beginning to narrow between the U.S. and its trading partners and the carry traders are now starting to move with deft speed out of AUD and NZD, the former highest yielding currencies, and into USD.   Next up this week is both the Bank of England and the European Central Bank on Thursday.  

First to hit is the BoE.  The Bank has some work to do as the economic data coming out of England is steep enough to make even the most seasoned cliff diver queasy.  I can argue six ways to Sunday as to why the Bank will lower rates, and the economic data all points to them doing so sooner rather than later.  We may very well get a move out of the Bank considering the most recent data and the continued decline in oil's price.  

If we don't get the decrease on Thursday, then when we see the minutes later in the month, the story will spell dovishness based on abysmal growth coupled with a medium-term inflation outlook that is within expectations (derived from lower demand and oil prices rapidly receding).  Boom. That's how you drop a currency by 2.5% in about a minute as GBP gets offered on every terminal across the globe.  

And the ECB?  Even Trichet knows that he painted himself into a corner when he took such a hawkish stance prior to the last meeting, raising rates, and virtually perpetuating the problem (squeezing the dollar and pushing oil higher).  His comments after raising rates last month weren't exactly firm with conviction that the Bank was poised to continue their direction.  

But, despite not wanting to lower rates until he actually sees the whites of inflation's contained eyes, Trichet is likely to mention medium-term inflation outlook is in line with expectations, and contained with the current price of oil falling as it has.  Boom.  Another currency loses another 2% in value. The stage is getting set for a major move in the FX markets, and currency traders around the world are starting to smell blood in the streets.  Lots of blood.

If you have all the major industrial central banks in the world lowering interest rates, while simultaneously the Fed is hawkishly about to raise rates, that in itself will perpetuate the flow of money.  Funds will flow into the U.S. and out of the rest of the world.  That forces the central banks around the world to continue to lower interest rates, chasing the flow down.  

And the Fed is poised to continue to raise rates as more and more funds chase the higher yield.  
The vicious cycle breaks and actually reverses.   The wheels of change are upon us.  We have four banks meeting this week alone.  Another bank has already lowered interest rates just two weeks ago, the Reserve Bank of New Zealand.   

That was the highest yielding industrialized nation out there, and according to the accompanying statement, will go lower and lower.  If the other banks follow suit and take at the very least a dovish tone, while the same time the Federal Reserve takes a more hawkish tone, then the new trajectory for the USD will have been firmly established.  

And the course of the world's economies will be on a brand new path.  All of this in one coordinated move.   What's most interesting is that this is all occurring after the latest G7 Finance Meeting. The April meeting had this to say regarding exchange rates:
We reaffirm our shared interest in a strong and stable international financial system. Since our last meeting, there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability. We continue to monitor exchange markets closely, and cooperate as appropriate.

A shot across the bow.  The line in the communique was all but ignored, and the USD was continually sold off.  However, that line is tantamount to a Plaza like accord.  Just ask the French Finance Minister in a follow-up interview. Her take: The markets missed it.

There's an estimated $1.5 trillion USD in the carry trade.  If the USD becomes more attractive vs. its counterparties as the differential narrows, then over the course of the next few weeks/months/years, the USD will see a significant increase in demand as that money finds a new home with yields that are growing more and more attractive.
The first victim of a higher USD?  The price of oil.  

Oil prices will collapse in the face of a stronger USD and an outlook of higher interest rates, much like what we've seen the past couple of weeks since the Fed and some of its governors have come out touting higher interest rates to combat rampant inflation.  The fall in the price of oil actually takes this scenario even further, and pushes the value of the USD higher vs. its counterparties.  That, of course gives other central banks room to lower rates, which of course pushes the value of the USD higher and higher as its competitive advantage improves.

Think further beyond about the ramifications of the potential of $1.5 trillion USD flowing into the U.S. banking sector.  Wouldn't that be attractive to banks' balance sheets at the very moment that the world's #1 financial sector needs capital at all cost?  

If the world's biggest financial sector were to be propped up by a continual flow of funds into their banks, then the U.S. will be poised to move forward out of its current economic malaise flush with capital coming in from abroad.  And beyond that, the world's largest economy will then pull any other country out of recession. The best aspect of this is that any future recovery will be different this time.  

During the recovery from the recession of 2001, money was flowing out of the United States favoring an interest rate environment that was more attractive abroad.  As capital left the shores of the U.S., growth rates were lower than what they should have been.  Now, however, as capital flows back into the U.S., our recovery from this economic downturn has the potential to surpass expectations.  

And with that, growth rates in the rest of the world should follow with the same upbeat tone. Is it coincidence that we may see such a different outlook with regards to interest rates so quickly around the world?  Is it that the economic wheels of change are spinning in a new direction, and the timing is unique?  Or was it a coordinated hand shake deal at the April G7 meeting?  

History will only tell us that.  But, if you listen to Treasury Secretary Paulson, you have reason to believe that "benign neglect" is no longer the standing policy for the USD and that there is some kind of coordinated effort on the parts of the world's financial ministers to shore up the USD.  Regardless, this scenario of a stronger USD with a financial sector in a much healthier environment is in the very best interest of every single country out there.  

Most economic pundits are looking around for the next big upset in the financial sector.  And who's to blame them when we're all sitting around looking at dire news coming in left and right.  But, the world's financial ministers have been there every step of the way.  Look no further than the efforts of the Federal Reserve to stave off a potential catastophic event that keeps rearing its ugly head almost every other week.  

There is a plan, and it's the single best plan available to put a final nail in this imbalanced coffin.   Unlike the 1985 Plaza Accord, however, where the G5 finance ministers came out of the meeting pounding their chests about their intention for the USD, this time around, considering the fragile state of the world's financial system, finance ministers can't risk rocking the boat too much, too fast.  

So, quietly, they will walk....and carry a really big stick. 
And this week, that really big stick is going to be swung.... 
Very Hard.... 
Very Loud.... 
And Very Clear.

Cost of a wrong turn: The Big Freeze part 2 – the future of banking
On Friday August 3 last year, as US financial markets were approaching the summer doldrums and bankers began to head off for holidays on Long Island or Cape Cod, Bear Stearns held a conference call for investors.

Shares in the investment bank, the fifth largest in the world, had fallen as investors worried about the collapse of two hedge funds that it managed and its exposure to the troubled housing market. But few were prepared for the candour of Sam Molinaro, its chief financial officer. Instead of reassuring them about Bear Stearns’ financial condition, he scared them even more: “I’ve been at this for 22 years. It’s about as bad as I have seen it in the fixed income market during that period . . . [what] we have been seeing over the last eight weeks has been pretty extreme.”

Later that afternoon, Jim Cramer, the former hedge fund manager, whose show, Mad Money, on the CNBC financial cable channel had become a cult among US retail investors, took to the air to sound his own alarm. Mr Cramer chided Bear Stearns for admitting publicly that it was struggling to cope but then launched into an angry tirade. He lambasted Ben Bernanke, chairman of the Federal Reserve, for not cutting interest rates aggressively, and said bank executives were calling him in distress. “We have Armageddon. In the fixed income markets, we have Armageddon,” he shouted, as Erin Burnett, his co-host, tried to calm him down.

If all of this sounded bizarrely alarmist at the time, a year later it reads like a fair assessment of the havoc that was breaking out in financial markets as the liquidity that had washed through the US economy and the rest of the world abruptly froze.

As Americans defaulted on subprime mortgages in increasing numbers, bond markets became chaotic. Most of these mortgages had been securitised by banks and sold to investors in complex collateralised debt obligations, which were rated by credit agencies led by Moody’s and Standard & Poor’s. Investors knew that the lower-rated tranches would be at risk in any downturn, but few predicted the damage to investment grade securities (see below).

The chaos in the US housing market and structured finance rippled into the wholesale markets in which banks raise short-term finance. Trust evaporated as financial institutions hoarded cash and withdrew credit from others. The London interbank offered rate, the main measure of interbank lending rates, rose sharply.

The effect was devastating. Six weeks later, Northern Rock, the mortgage lender that relied on interbank funding, was rescued by the UK government after other institutions re?fused to lend to it. Seven months after Mr Molinaro’s warning, Bear Stearns itself succumbed to the market crisis. It was given emergency funding by the Federal Reserve and forced to sell itself to JPMorgan Chase for $2.1bn (€1.3bn, £1.1bn), paying the ultimate price for the market’s loss of confidence.

Total market value lost to Wall Street banks

Financial institutions are still fighting to restore stability. Banks such as Citigroup, UBS and Merrill Lynch have made billions of dollars worth of asset writedowns, forced out chief executives and repeatedly raised new capital. Lehman Brothers has fought to persuade investors that it is more stable than Bear Stearns.

It is impossible yet to know the full damage from the credit crisis. Bank writedowns are estimated at $476bn by the International Institute of Finance. This is still less than the $600bn of US bank failures in the savings and loans crisis of the early 1990s but $1,600bn has been cut from the global market capitalisation of banks.

Many bankers think the eventual bill will top the S&L crisis, although it may cause less financial harm than the Scandinavian and Japanese banking crises of the 1990s. But, whatever the ultimate bill, the impact on investment banking and financial regulation will be profound. “This has been a very deep and unusual crisis that involves the unwinding of a decade of excess. The impact on the financial sector has been seven on the Richter scale [a “major” earthquake], as dramatic as anything for 25 years,” says Bill Winters, co-head of the investment bank at JPMorgan Chase, which has navigated the crisis better than most.

The crisis has called into question the existence of independent investment banks, the institutions that have been among the biggest winners of the past three decades of financial and trade liberalisation. Investment banks led by Goldman Sachs have grown rapidly and rewarded their employees lavishly: Wall Street banks paid bonuses of $33bn last year.

But many analysts think that the crisis has shifted power in the direction of “universal” banks – those with retail as well as investment banking arms – and away from broker-dealers such as Goldman and Morgan Stanley. The latter may find it hard to keep on operating with small, highly leveraged balance sheets, relying on wholesale markets for funding. “It is pretty clear that retail deposit-taking institutions are in a stronger position . . . I think the business model will change significantly and there will be fewer independent investment banks,” says James Wiener, a partner in Oliver Wyman, the financial consultancy.

US investment banks

Not surprisingly, the universal banks that have expanded into investment banking in the past decade – many by investing heavily in bond operations – agree with this. They think the crisis will give them an opportunity to grab business from the independents, or acquire them. “Stand-alone investment banks will struggle to operate in anything like the way they were before the crisis,” says the head of investment banking at one commercial bank. “They are not going to be able to operate with the same degree of flexibility and leverage.”

Writedowns since beginning of 2007

Investment banks have two challenges. One is to reassure investors that they are financially stable. Bear Stearns collapsed while it was making money and had, theoretically at least, a sound balance sheet. Its former leaders still complain that short-selling hedge funds spread false rumours to bring their institution down.

While they argue this point, however, the four remaining big investment banks have rushed to reduce their leverage and raise their capital reserves. Goldman Sachs, the strongest of them, now holds $90bn in cash and liquid assets and its balance sheet debt has an average maturity of eight years. This makes them safer but it adds to their second challenge of making enough money to satisfy shareholders and keep their most highly valued employees from joining hedge funds or private equity groups.

Banks enjoyed a run from 1998 onwards (with a brief interruption after the September 11 2001 attacks) of rising profits and high ratings. They had been valued at one to 1.5 times their book value because of their earnings volatility but their share prices rose as they persuaded investors that they had learnt how to manage risk.

Few people believe that now and banks’ share prices have fallen abruptly. Not only are their earnings back to being rated as they were before, but the banks have to find ways to replace the huge revenues from bond financing over the past decade.

The optimists point to the industry’s history of migrating from one business to another. The chief executive of one bank says that investment banks often lose 70 per cent of their revenues in financial crises and replace them with new ones. “Investment banks have shown an amazing ability to reinvent themselves,” says Mr Wiener.

Indeed, Scott Sprinzen, an S&P analyst, says investment bank revenues have held up well so far, although results have been hurt by writedowns. Their troubles have even brought them some business – they have earned fees raising capital for each other.

But their longer-term outlook is clouded. The credit crisis has brought home once again the need for investment banks to have diverse earnings streams so that mishaps in one area can be offset elsewhere. In practice, only Goldman Sachs has had sufficient depth and breadth to ride out this crisis reasonably unscathed.

Before the crisis, others were trying to mimic Goldman’s expertise in hedge funds and trading. Bear Stearns was trying to build its fund management arm, Merrill was continuing a long push to transcend its roots as a retail broker and Lehman was expanding outside fixed income. But Bear has gone and others have been set back.

Their capacity to bounce back is constrained by new limits on their balance sheets and freedom of manoeuvre. The market is imposing its own disciplines and regulators are likely to impose others. Bear Stearns’ near-collapse prompted the biggest government intervention in the financial system since the splitting of banks and investment banks and the setting up of the Securities and Exchange Commission in the wake of the Great Depression.

The Federal Reserve has long provided a funding back-stop to banks that took retail deposits through its discount window, but investment banks were not given the same explicit backing. That policy changed during Bear’s rescue, when the Treasury and the Fed judged that it was too central to the US financial system to be allowed to fail.

The Fed gave investment banks temporary access to the discount window and has since extended the guarantee. Even if it eventually closes off access, the precedent has been clearly established: in times of financial distress, the Fed will give financial backing to investment banks.

In return, the Fed will demand much closer oversight. Reforms to the regulatory system await the next president and Congress but the Fed is very likely to gain some oversight of investment banks as well as large retail banks.

Indeed, officials hope that the Bear rescue, which was carried out on terms that involved the bank’s shareholders and executives suffering heavy losses, will serve as a warning. “Investment banks should have a deep interest in making the Fed comfortable. They will not want it to escalate late [launch emergency action in response to a funding crisis],” says one banker.

Fed oversight of investment banks, instead of them being supervised mostly by the SEC, would come at a cost. “A government back-stop would reduce the risks of the business but it could also take away some of the profit potential,” says Mr Sprinzen of S&P.

When there was no implicit government guarantee, investment banks could run highly leveraged balance sheets, carry out a lot of proprietary trading and lend to hedge funds and private equity groups. Now they face scrutiny of, and perhaps curbs on, their most profitable activities.

Some investment bankers remain sanguine, arguing that the past few years was an era of super-profitability that is not likely to return in a hurry. They say that investment banks will be able to adapt after a year or two and resume as normal, albeit with lower revenues and share prices.

But the fear is that investment banks’ advantages over their universal bank rivals have been eroded by this crisis. There are not many independents in any case. The disappearance of Bear leaves only Goldman, Morgan Stanley, Merrill Lynch and Lehman Brothers as big broker-dealers.

It may be that merchant banks such as Lazard, private equity groups such as Kohlberg Kravis Roberts, or hedge funds such as Citadel or Fortress will expand to fill the gap left by Bear. Consolidation in financial services has often prompted the rise of new players.

But there is another possibility: that investment banks such as Lehman and Merrill will give up the unequal struggle to match Goldman and be swallowed up into universal banks. Partners at Goldman, who have traditionally worried about being outsmarted by Morgan Stanley and others, now have another concern.

If their rivals cannot bounce back from the credit crisis of 2007, Goldman could end up as an industry of one.

Sources for charts: Thomson Datastream; Office of the New York State Comptroller; Sifma

How risk refused to be sliced and diced

Last week, after a year of continuous, shocking writedowns of banking balance sheets, Merrill Lynch sold a $30bn portfolio of structured securities based on US mortgages for 22 cents on the dollar.

The portfolio was made up of collateralised debt obligations, the structured finance vehicles that lay at the heart of the credit crisis that broke out a year ago. It was described by William Tanona, a Goldman Sachs analyst, as a “capitulation trade” that was painful but necessary.

John Thain (below), Merrill’s chief executive, clearly wanted to draw a line on the past year and move on. But the irony is that CDOs were designed to relieve banks of the necessity to hold loan risks on their balance sheets at all.

The Merrill trade is a sad epitaph for a period in which banks thought they had transformed themselves from lenders to intermediaries in credit markets, and investment banks believed they could lend money as effectively as commercial banks.

In practice, it did not work out that way. When the credit markets froze in August last year, many banks had not yet passed on the risk to others. Many were holding asset-backed securities in “warehouses” and were working on splicing them up into CDOs, getting them rated by a credit agency such as Moody’s or Standard & Poor’s.

This version of banking had developed over two decades with the evolution of credit derivatives and structured finance. Instead of a bank making loans and then either holding them on its balance sheet or syndicating them to others, it structured them into new securities.

This opened up the market for credit to all kinds of investors. The cashflow from a portfolio of mortgages could be spliced into a variety of securities with different interest rates, appealing to a wide range of buyers. Hedge funds and insurance companies became the holders of mortgage loans.

The collapse of the CDO market and recriminations among bankers, credit agencies, investors and regulators has called all of this into question. If the CDO market was riddled with such flawed assumptions and lax calculations, what does that say about the theory behind it?

Few believe the CDO debacle will cause a return to old ways. “We are not going back to the days when banks made loans and kept them all on their books. We have seen that movie and we know what happens in the end,” says one senior banker.

Indeed, the reason why banks moved first to loan syndication and then to securitisation was that they suffered so badly in past banking crises when the borrowers defaulted. Although CDOs failed to protect them, that was not entirely the fault of structured finance techniques.

For one thing, several banks were caught out not only because it took time to structure the securities but because they deliberately held on to what they regarded as “safe” tranches of loans. UBS was badly damaged by retaining “super-senior” CDO debt.

But banks will be a lot warier about treating structured finance as the cure-all for lending risk in future. They are unlikely to be given much choice: investors in such securities will demand more transparency and may well require an originating bank to keep some exposure.

The ultimate lesson of the CDO collapse is that technology does not obviate the need to assess a borrower carefully. Neither banks nor credit agencies did this well enough on behalf of investors and it proved a painful experience for everyone.

Fewest Treasury Traders Since 1960 Hit Taxpayers
For the first time since 1960, when it created the network of securities firms obligated to buy and sell Treasury bonds, the U.S. government has the fewest bond traders making markets in its debt and a bigger burden for American taxpayers financing record federal deficits.

The number of so-called primary government securities dealers declined to 19 last month when Bank of America Corp., based in Charlotte, North Carolina, acquired the troubled Countrywide Financial Corp. The sale was the climax of dozens of bank failures, triggered by the biggest decline in residential real estate since the Great Depression and the seizing up of credit markets from New York to London.

The Federal Reserve Bank of New York, the agent of the U.S. Treasury, plans to shrink the dealers again when JPMorgan Chase & Co. completes its takeover of Bear Stearns Cos. Fewer firms bidding for U.S. bonds means "you're going to have sloppier auctions," said Mark MacQueen, a money manager in Austin, Texas, at Sage Advisory Services, who traded Treasuries at dealer Merrill Lynch & Co. in the 1980s. "The taxpayer and the government are paying more no matter what happens."

The paucity of primary dealers coincides with the largest borrowing requirement in American history and the acknowledgment by the administration of President George W. Bush that the U.S. will finance a budget deficit totaling a record $482 billion next year. When the dealer system began 48 years ago with 18 firms, the U.S. had a $300 million surplus. The group has shrunk from a peak of 46 in 1988.

While the interest rate on the benchmark 10-year Treasury note today is less than half the 9.14 percent yield of 20 years ago, the dwindling number of dealers and contraction of credit markets means that yields on 10-year notes sold this year have averaged 1 basis point higher than in pre-auction trading, compared with no difference in 2007, data from Stone & McCarthy Research Associates in Skillman, New Jersey, show.

In the three years before 2007, such sales drew a yield just below the pre- auction rate. One basis point, or 0.01 percentage point, spread over $171 billion -- the amount the Treasury said it may borrow this quarter -- represents $17.1 million in interest.

Traders refer to yields that are higher at auction than typically forecast as a tail. The Treasury's July 22 sale of 20- year Treasury Inflation Protected Securities, for example, drew a tail of 5 basis points, or 0.05 percentage point, according to RBS Greenwich Capital in Greenwich, Connecticut.

Taxpayers already are reeling from the highest unemployment rate since 2004 and the worst economy since 2001, a slump that was caused partly by the collapse of confidence in the fixed- income market. Bond investors who readily provided financing for everything from subprime mortgages to high-yield, high-risk companies 18 months ago, cut their credit lines last summer in a relentless reduction of money lending.

Four of the five firms reporting the biggest credit-market losses since the start of 2007 -- Citigroup Inc., Merrill Lynch, UBS AG, and Bank of America -- are dealers. Sixteen have lost a total of $266.9 billion as the U.S. housing slump roiled financial markets, according to data compiled by Bloomberg.

Yields on the current benchmark 10-year note fell 17 basis points last week to 3.93 percent, the most since the week ended June 27, according to New York-based BGCantor Market Data. The 3.875 percent security due in May 2018 gained 1 10/32, or $13.13 per $1,000 face amount, to 99 17/32. The yield rose 2 basis points to 3.95 percent as of 7:25 a.m. in New York.

Almost all of the firms that were dealers when the Fed formalized rules in 1960 have changed their names, been acquired by other securities companies or gone out of business. First Boston is now part of Zurich-based Credit Suisse Group; Salomon Brothers is now owned by Citigroup in New York; and PaineWebber Inc. is owned by UBS AG, also in Zurich.

A common way for traders to profit is to sell the securities before the auction -- a strategy made possible by the government, which allows trading of bonds as if they were already sold. If the auction draws a yield higher than in the so-called when-issued market, traders can buy the new debt at a lower price, pocketing the difference as profit. Bond prices move inversely to yields.

"Larger auctions simply mean that each primary dealer probably has to buy and distribute more," said Raymond Remy, 48, the head of fixed income in New York at Daiwa Securities America Inc., one of the dealers. "And that could be an opportunity or that could be a giant, giant headache."

The Treasury this week will sell $17 billion of 10-year notes in its quarterly sale of the securities, the most since 2003. It will also auction $10 billion of 30-year bonds, the most in two years. The government said July 30 that it's considering more frequent auctions of both securities, and will announce a decision in November.

Dealers are just one category of participants at auction and a smaller number doesn't automatically doom the government to higher rates or guarantee profits for firms. Indirect bidders, a class of investors that includes foreign central banks, bought 27 percent of the two-year notes that sold in the past year. That compares with an average of 34 percent in the preceding 12 months.

Indicators of economic growth and world events have a bigger impact on demand at auctions than the number of dealers, said Craig Coats Jr., who co-headed Salomon's fixed-income desk during the 1980s, when it was the world's biggest bond trader.

"The auction process is really going to be dependent upon what is going on in the market at the time," said Coats, who began trading bonds in 1969. So far this year, four dealers traded at least 41 percent of Treasury bills and notes, while the least active four traded as little as 0.8 percent, according to Fed data.

While more than 800 financial institutions were set up to bid directly in Treasury auctions, dealers bought 71 percent of the bonds in the 576 sales between May 2003 and December 2005, according to a 2007 paper by Michael Fleming, a researcher at the Federal Reserve Bank of New York.

"The Fed and the Treasury will be nervous if the dealer community fell to too-low of a number because somebody's got to underwrite more of this debt," said Charles Comiskey, the head of Treasury trading in New York at dealer HSBC Securities USA Inc. "It's pretty obvious it would be good for the dealers. If there's less competitors, it's more of a share of the pie for less people."

Loonie Loses Currency Wings as Canada Hurt by U.S. Slump
Currency traders are beginning to realize that for all its riches in oil, copper and lumber, Canada's economy may not be so different than the U.S. after all.

While Canadians celebrated last year as the country's dollar reached parity with its U.S. counterpart for the first time since 1976, traders now predict the currency will fall as much as 17 percent through 2009.

After soaring 17 percent in 2007, the loonie, as the currency is known because of the aquatic bird on the one-dollar coin, is down 3.1 percent in 2008 amid a shrinking economy and an 13 percent drop in oil prices the past month. It's one of five of the 16 most-widely traded currencies to drop against the U.S. greenback, joining the New Zealand dollar, South Korean won, South African rand and British pound.

"The way energy prices and certain commodities have boomed, many thought we would weather the downturn better," said Steve Butler, director of foreign-exchange trading in Toronto at Scotia Capital Inc., a unit of Canada's third-largest bank. "You've got a pessimistic look at the economy by the market. It's forced a lot of people to rethink that view."

Canada's economy shrank 0.1 percent in May, as the extraction of natural gas slowed and car production dropped, Statistics Canada said last week in Ottawa. Economists surveyed by Bloomberg predicted a 0.2 percent expansion, according to the median of 24 estimates.

The Bank of Canada cut its 2008 growth forecast on July 15 to 1 percent from 1.4 percent. That's even less than the U.S., where the economy is likely to expand 1.5 percent, according to the median estimate of 81 analysts in a separate poll.

The loonie will slide to C$1.05 by the end of December, and to C$1.09 by the start of 2010, according to the median estimate of 31 strategists surveyed by Bloomberg. New York-based Lehman Brothers Holdings Inc. is the biggest bear, predicting the currency will weaken to C$1.15 this year and C$1.20 in 2009. Paris-based BNP Paribas, the most accurate foreign-exchange forecaster in a 2007 Bloomberg survey, predicts C$1.12 this year.

"The Canadian dollar is extremely overvalued at these levels," said Momtchil Pojarliev, head of currencies at London- based Hermes Pension Management Ltd, which has about $70 billion under management. "Oil prices have come down quite a lot from their peak but the Canadian dollar still hasn't moved at all. The currency should also weaken due to the weaker economic data."

Commodities such as gold and crude oil account for 54 percent of Canada's exports. As the price of crude oil soared 57 percent in 2007 to $95.83 a barrel, Canada's economy expanded 2.54 percent, compared with 2 percent in the U.S.

And though oil surged 53 percent this year to a record of $147.27 a barrel on July 11, it has since slid to $126.22 on speculation high prices will cut demand for fuel in the U.S., the world's largest energy consumer. U.S. motorists drove less for a seventh consecutive month in May, pointing toward the first annual drop in road travel since 1980, the Federal Highway Administration said in a report last week.

"From a technical and fundamental perspective, we are looking for the Canadian dollar to weaken," said George Davis, chief technical analyst in Toronto at RBC Capital Markets, a unit of the Royal Bank of Canada, the country's biggest bank. `Continued contraction in global growth, would be negative for the Canadian dollar."

If the currency weakens past C$1.0343, a so-called level of resistance where strategists say orders to buy the loonie may be clustered based on past trading patterns, then it may depreciate to about C$1.0460, Davis said. The downturn in the Canadian economy is already largely priced into the currency, said Bettina Mueller, a fund manager at Deutsche Bank AG's DWS Investments unit in Frankfurt, which manages $398 billion.

"Commodities are still a positive story, as the strategic direction is upward," Mueller said. "The Canadian dollar is underpinned from this point of view." Canada's fixed-income securities are losing their interest- rate advantage over the U.S., further weighing on the currency.

Three-month deposit rates in Canada exceed those in the U.S. by 0.55 percentage point, compared with 0.91 percent in the first quarter. By year-end, the gap will shrink to 0.09 percentage point, according to the median estimate of 47 strategists surveyed by Bloomberg News.

"Canada's own sluggish domestic fundamentals suggest their interest-rate cycle will lag" behind an increase in U.S. rates, said Peter Pontikis, a treasury strategist at Brisbane, Australia-based Suncorp-Metway Ltd., the country's third-largest general insurer. "Like many good stories, as the Canadian dollar had been, it is over. We are targeting a retracement back to more comfortable levels at C$1.14 per U.S. dollar, if not higher into end 2008."

Interest rates "will take a back seat to another catalyst: the end of the oil rally," said Kathy Lien, director of research at online currency dealer GFT Forex in New York. "The exchange rate will push higher as the rally in oil prices reverses" with the Canadian dollar weakening, she said.

Columbus taxpayers shoulder city employees’ pension tab
If you work in the private sector, the government takes 6.2 percent from every paycheck for the Social Security benefits you'll receive after retirement. If you work for the state of Ohio, Columbus schools or Ohio State University, 10 percent of your income goes toward your future public-employee pension.

If you work for the city of Columbus, though, it's likely you're getting a free ride into your golden years. And if you're a city resident or taxpayer, you're picking up the tab.

Columbus kicked in an extra $39.2 million last year toward city workers' pensions. That's on top of the $85.2 million it was required to contribute as their employer. City government pays more than 80 percent of what employee pension funds demand from employees themselves, a benefit unduplicated elsewhere in Ohio on such a large scale.

For more than 5,700 people -- almost two-thirds of the city's work force -- the city pays the entire employee share. "It's a very generous benefit," said City Auditor Hugh J. Dorrian, who said the pension pickup started in 1983. It originally was accompanied by a corresponding pay cut, he said, but quickly evolved into a fringe benefit.

A commission appointed by Mayor Michael B. Coleman to examine city finances will discuss the pension payments this month as part of a broader look at employee pay and benefits. "There are some expenses in these times that need a closer look," said Chairman Robert Howarth, a lawyer who advised Gov. James A. Rhodes and Mayor Dana G. Rinehart during the 1980s.

With a $75 million general-fund deficit projected for 2009, Coleman has declared no budget expense off-limits for cuts and no fee or tax off-limits for an increase. On Friday, he ordered city departments to eliminate 102 jobs, including 42 that will require layoffs.

A similar advisory group he convened earlier in the decade recommended that city employees pay a bigger share of their health-care premiums. Since 2001, their contribution has increased from 1 percent to about 9 percent.

Finance Director Joel S. Taylor said most of the pension contributions are locked into labor contracts and would be impossible to change unless union negotiators agreed. Coleman said he "would not ever consider" breaking agreements with city workers, but that the issue might be fodder for future talks.

Dorrian said he would like to see the benefit phased out over time by discontinuing it for new employees but keeping it for those already on the payroll. It would be an injustice, he said, to take it away from people already on the job.
Union leaders say the benefit, like others, was offered and accepted long ago in place of higher salaries.

"Everything that has any economic impact in the contract was received in lieu of pay," said Jack Reall, president of the city's 1,500-member firefighters union. In May, a state mediator ordered the city to increase its pension contribution for firefighters even though the union hadn't asked. Reall said his union's members decided in their previous contract that they'd prefer bigger pay raises.

Just as with Social Security in the private sector, employers and employees both contribute toward government workers' retirement benefits. As an employer, Columbus pays an amount equal to 24 percent of each firefighter's salary into the Ohio Police & Fire Pension Fund. For police officers covered by the same system, the city is required to contribute an amount equal to 19.5 percent of every salary.

All other city workers are covered by the Ohio Public Employees Retirement System. For them, the city contributes an amount equal to 14 percent of each person's salary.

Each pension system requires workers to contribute 10 percent of their own pay, but the city pays most or all of that, too: 6 percent for part-timers, 6.5 percent for firefighters, 7.5 percent for police and the entire share for full-time workers in every other department.

Ilargi: Stockton, CA, is the epicenter of the housing crisis.

Stockton, California Police Refuse To Make Pay Concessions Despite $10 Million Budget Gap
It was disappointing that the union representing Stockton's rank-and-file police officers believed it necessary to file a claim against the city.

Police say a 9.5 percent raise is not enough. They want the full 15.35 percent they say they have coming under the terms of a 2005 memorandum of understanding. That MOU says Stockton's officers should be compensated in line with the "bottom of the top one-third" of cities surveyed.

By that formula, the Stockton Police Officers Association contends, officers' pay should be boosted 15.35 percent. That's $855 per month at the top of the pay scale, increasing monthly pay from $5,570 to $6,425. It is true that Stockton competes with cities statewide for the available pool of men and women qualified to be police officers.

The competition is fierce, and often, especially in the larger urban areas, pay and benefits packages are used as recruitment tools. Stockton's police union representatives have made it a point to suggest that officers here could leave if their pay is not increased.

It also is true, though, that public unions in this state work hard to win agreements that base pay on what other public agencies are paying. This has the effect of keeping salaries moving higher. Every time one city increases its pay, salaries at other cities are forced up. Certainly if a Stockton officer feels the pay here is not good enough, there are other options available.

For the city and its taxpayers, the options are much more limited, especially this year, with the city facing a $10 million deficit. We would urge the police union to keep that reality in mind. Stockton's Police Department already consumes about half the city's general fund budget, most of that going for salaries and benefits.

Stockton police are not underpaid. According to the department's Web site, salaries range from more than $49,000 a year to more than $73,000 a year. In addition, there are overtime pay, longevity bonuses, a generous benefits package and a retirement plan that is second to none. The average gross salary in the department is more than $83,000 per year. The police union should think hard about the message it is sending to Stockton taxpayers.

Companies Tap Pension Plans To Fund Executive Benefits
At a time when scores of companies are freezing pensions for their workers, some are quietly converting their pension plans into resources to finance their executives' retirement benefits and pay.

In recent years, companies from Intel Corp. to CenturyTel Inc. collectively have moved hundreds of millions of dollars of obligations for executive benefits into rank-and-file pension plans. This lets companies capture tax breaks intended for pensions of regular workers and use them to pay for executives' supplemental benefits and compensation.

The practice has drawn scant notice. A close examination by The Wall Street Journal shows how it works and reveals that the maneuver, besides being a dubious use of tax law, risks harming regular workers. It can drain assets from pension plans and make them more likely to fail. Now, with the current bear market in stocks weakening many pension plans, this practice could put more in jeopardy.

How many is impossible to tell. Neither the Internal Revenue Service nor other agencies track this maneuver. Employers generally reveal little about it. Some benefits consultants have warned them not to, in order to forestall a backlash by regulators and lower-level workers.

The background: Federal law encourages employers to offer pensions by giving companies a tax deduction when they contribute cash to a pension plan, and by letting the money in the plan grow tax free. Executives, like anyone else, can participate in these plans.

But their benefits can't be disproportionately large. IRS rules say pension plans must not "discriminate in favor of highly compensated employees." If a company wants to give its executives larger pensions -- as most do -- it must provide "supplemental" executive pensions, which don't carry any tax advantages.

The trick is to find a way to move some of the obligations for supplemental pensions into the plan that qualifies for tax breaks. Benefits consultants market sophisticated techniques to help companies do just that, without running afoul of IRS rules against favoring the highly paid.

Intel's case shows how lucrative such a move can be. It involves Intel's obligation to pay deferred compensation to executives when they retire or leave. In 2005, the chip maker moved more than $200 million of its deferred-comp IOUs into its pension plan. Then it contributed at least $187 million of cash to the plan. Now, when the executives get ready to collect their deferred salaries, Intel won't have to pay them out of cash; the pension plan will pay them.

Normally, companies can deduct the cost of deferred comp only when they actually pay it, often many years after the obligation is incurred. But Intel's contribution to the pension plan was deductible immediately. Its tax saving: $65 million in the first year. In other words, taxpayers helped finance Intel's executive compensation.

Meanwhile, the move is enabling Intel to book as much as an extra $136 million of profit over the 10 years that began in 2005. That reflects the investment return Intel assumes on the $187 million. Fred Thiele, Intel's global retirement manager, said the benefit was probably somewhat lower, because if Intel hadn't contributed this $187 million to the pension plan, it would have invested the cash or used it in some other productive way.

The company said the move aided shareholders and didn't hurt lower-paid employees because most don't benefit from Intel's pension plan. Instead, they receive their retirement benefits mainly from a profit-sharing plan, with the pension plan serving as a backup in case profit-sharing falls short.

The result, though, is that a majority of the tax-advantaged assets in Intel's pension plan are dedicated not to providing pensions for the rank and file but to paying deferred compensation of the company's most highly paid employees, roughly 4% of the work force.

And taxpayers are on the hook in other ways. When deferred executive salaries and bonuses are part of a pension plan, they can be rolled over into an Individual Retirement Account -- another tax-advantaged vehicle. Many companies are phasing out their pension plans, typically by "freezing" them, i.e., ending workers' buildup of new benefits.

This leaves more pension assets available to cover executives' compensation and supplemental benefits. A number of companies have shifted executive benefits into frozen pension plans. Technically, a company makes this move by increasing an executive's benefit in the regular pension plan by X dollars and canceling X dollars of the executive's deferred comp or supplemental pension.

So how can companies boost regular pension benefits for select executives while still passing the IRS's nondiscrimination tests? Benefits consultants help them figure out how. To prove they don't discriminate, companies are supposed to compare what low-paid and high-paid employees receive from the pension plan.

They don't have to compare actual individuals; they can compare ratios of the benefits received by groups of highly paid vs. groups of lower-paid employees. Such a measure creates the potential for gerrymandering -- carefully moving employees about, in various theoretical groupings, to achieve a desired outcome.

New Zealand finance sector faces crisis of confidence
More than 30 New Zealand financiers and investment trusts have failed or have been forced to stop investors withdrawing their money in the past two years, underlining the exposure of Australian banks to a wave of bad debts in the country.

The move by AMP on Friday to halt redemptions from a New Zealand property trust is the latest sign of collapsing confidence in mortgage and property firms in the country's ailing economy. This collapse, and the decline of property prices - particularly in Queenstown and Auckland - will have repercussions for the earnings of Australian banks as more home mortgages, credit cards and corporate loans turn sour.

And the rapid fall from grace of New Zealand economy - which last year was experiencing a housing boom - highlights the risk to Australia posed by inflated property prices and high interest rates. Last year central banks in both countries lifted rates several times to ward off inflation. But the Reserve Bank of New Zealand has started to cut rates as it becomes clear the economy has entered a sustained period of weakness.

"None of us were talking about a recession in the economy until three to four months ago," said the chief economist at the Bank of New Zealand, Tony Alexander. Among Australian banks, ANZ is the most exposed to the New Zealand economy, with about 22 per cent of earnings coming from the country, excluding the bank's institutional arm, Deutsche Bank says. The other big banks earn 9 per cent to 13 per cent from the country.

Pressures on the New Zealand property market have been compounded by collapsed or troubled finance companies in the country, including Bridgecorp, Hanover Finance and Dominion Finance, creating panic among investors. On Friday AMP Capital froze its $NZ420 million ($329 million) NZ Property Fund because of concerns about a rush of withdrawals. It has high-quality assets - and government tenants - but confidence has fallen so far all property funds are under pressure.

The website interest.co.nz says there have been 36 closures or failures of finance companies, mortgage trusts and investment funds since May 2006 that have frozen $NZ5.2 billion of funds invested by 157,286 account holders. Mr Alexander said small finance companies had played a role in property development, and their retreat was helping drive down prices. "That's where there's quite a rout going through at the moment."

In its most recent investor update ANZ said its percentage of unsecured business loans more than 90 days late had almost doubled in a year, and by March was more than 1 per cent. After a trip to New Zealand, Ross Brown, of Deutsche Bank, said Westpac had no material exposure to property development finance but had increased loan collection staff by 30 per cent.
The Commonwealth Bank had a $20 million loan to Auckland-based Dominion Finance.

Repel the calls to contain competitive markets
By Alan Greenspan

The surprise of recent months is not that global economic growth is slowing, but that there is any growth at all. The credit crunch of the past year has not followed the path of recent economically debilitating episodes characterised by a temporary freezing up of liquidity – 1982, 1989, 1997-8 come to mind. This crisis is different – a once or twice a century event deeply rooted in fears of insolvency of major financial institutions.

This crisis was not brought to closure by the world’s central banks’ injection of huge doses of short-term liquidity. Only when sovereign credits were substituted for private bank credit, first in the case of the UK (Northern Rock) and subsequently in the case of the US (Bear Stearns), was a semblance of stability restored to markets.

But the London Interbank Offered Rate spreads on overnight index swaps and credit default swaps of financial institutions have not returned to the modest pre-crisis levels. Fears of insolvency have not, as yet, been fully set aside. There may be numbers of banks and other financial institutions that, at the edge of defaulting, will end up being bailed out by governments.

The insolvency crisis will come to an end only as home prices in the US begin to stabilise and clarify the level of equity in homes, the ultimate collateral support for much of the financial world’s mortgage-backed securities. However, US home prices will stabilise only when the absorption of the huge excess of single-family vacant homes that emerged as the US housing boom peaked in 2006 is much further advanced than it is now.

New single-family home completions are currently barely under the rate of home demand generated by household formation and replacement needs. Only later this year will the current suppressed level of housing starts be reflected in completion levels consistent with a rapid rate of liquidation of the inventory glut, and this, of course, assumes that current levels of demand for housing hold up.

Pending that outcome, the price of equities worldwide will determine whether the international financial system can maintain a modicum of stability as it eases out of its credit crunch, or falls back into another period of angst and turmoil. The optimistic case rests on the business world beyond finance.

Given this past year’s vast impairment of financial intermediation, nonfinancial corporate business has held up surprisingly well, contributing to a flow of corporate earnings that has helped sustain a stressed global stock market. To be sure, global stock prices are off a fifth from their October 2007 peaks, but still hover at levels last seen in 2006, a demonstrably less fear-ridden period than currently prevails.

A sustained level of global equity prices will be critical if banks are to recapitalise themselves at the higher levels daunted investors now require. The pool of capital is being augmented by a reasonably high level of saving (nearly 24 per cent of world gross domestic product), up significantly from earlier this decade. The flow of new saving will provide some support.

Capital gains, however, are just as important. This can best be observed in the context of the consolidated balance sheet of the world economy. All debt and derivative claims offset in global accounting, leaving real physical and intellectual assets and their market value reflected as net worth. Capital gains cannot finance new physical investment, but do add to global net worth.

If, for whatever reason, discounting of prospective future earnings engendered by the world’s physical capital stock declines, the market value of that capital stock rises with no offsetting liability. There is accordingly a larger value of equity shoring up the capital of financial or nonfinancial businesses.

Should that discount rate reverse, the value of world equity will fall. Consequently, lower global stock prices could impede the recapitalisation of banks and other financial institutions. Debt issuance would also be suppressed as it leverages off the level of equity.

Globalisation is at the root of the past decade’s unprecedented surge in world economic activity. The growth in the volume of global trade has far exceeded the pace of world real GDP growth for decades. Between 2001 and 2007 global cross-border investments (at market values) rose almost two-thirds faster than world nominal GDP, according to data from the International Monetary Fund.

The economic edifice – market capitalism – that has fostered this expansion is now being pilloried for the pause and partial retrenchment. The cause of our economic despair, however, is human nature’s propensity to sway from fear to euphoria and back, a condition that no economic paradigm has proved capable of suppressing without severe hardship. Regulation, the alleged effective solution to today’s crisis, has never been able to eliminate history’s crises.

A financial crisis is heralded, in fact defined, by sharp discontinuities of asset prices. The crisis must thus be unanticipated. The fact that risk was heavily underpriced for much of this decade was broadly recognised in the financial community, but the timing of the sharp price correction was nonetheless a surprise.

Recent history is replete with such underpricing persisting for years. Those market players who withdraw from “long” commitments at the first sign of an excess of exuberance, risk losing market share. They thus continue “to dance” as Chuck Prince, the former Citigroup chairman put it, but always assume they will have time to exit the markets.

The vast majority invariably fail. When the current crisis emerged, it was assumed that the weak links would be unregulated hedge and private funds. The losses, however, have been predominately in the most heavily regulated institutions – banks.

We may not easily confront or accept the price dynamics of home and equity prices, but we can fend off cries of political despair which counsel the containment of competitive markets. It is essential that we do so. The remarkably strong performance of the world economy since the near universal adoption of market capitalism is testament to the benefits of increasing economic flexibility.

It has become hard for democratic societies accustomed to prosperity to see it as anything other than the result of their deft political management. In reality, the past decade has seen mounting global forces (the international version of Adam Smith’s invisible hand) quietly displacing government control of economic affairs. Since early this decade, central banks have had to cede control of long-term interest rates to global market forces.

Previously heavily controlled economies – such as China, Russia and India – have embraced competitive markets in lieu of bureaucratic edict. The danger is that some governments, bedevilled by emerging inflationary forces, will endeavour to reassert their grip on economic affairs. If that becomes widespread, globalisation could reverse – at awesome cost.

Everybody gets a trophy!
Let me take you to a magical land called NannyState, where once upon a time everyone was happy, inflation was low and real estate always went up. Or did. Times are a’ changing in NannyState and all is not well.   

Everyone was elated in NannyState in 2002-2006, because real estate really went up. Way up. There was no need to sacrifice or save because you could buy a home with no money down. Everyone could enjoy the American Dream! In fact, banks offered a 125% loan so you could upgrade the house and take a nice vacation. Everyone deserved the opportunity to buy McMansions and drive Hummers. NannyState made sure interest rates were low, and inflation was “under control” and money was plentiful. Life was great!

False Facades

Unfortunately, those years were much like visiting a Hollywood western movie set. It was an economy of false facades propped up by a few 2x4’s behind the scenes. The decades of misallocations, distortions and bubbles were beginning to take a toll. However, NannyState still wants desperately to keep up appearances. High interest rates are mean-spirited. So is inflation. If it can keep the inflation figures low (even if they are fudged), everyone will feel better.

NannyState believes the public can’t deal with hard times and must be continually lied to in order to preserve a false prosperity. The truth is slowly dawning on some citizens anyway, and they are not amused. 

A Growth Industry

If everyone is going to be able to get a trophy, then continued growth is a necessity. More government jobs are created every year in NannyState. It doesn’t produce anything that will add to the nation’s wealth, so it diligently issues more rules, laws, regulations and programs to justify its existence and create the need to hire more government workers. It is a very successful growth industry and its prospects look bright for continued growth in the future. NannyState is insatiable.

0804.1  0804.2  0804.3

Bailouts R Us

NannyState seeks more control over the economy. Although charged with the good intentions, it constantly interferes with the self-correcting mechanisms that make a free market economy dynamic and productive. But the ends justify the means because it would never want to endanger the self-esteem of millions of registered voters.

Bailouts of Fannie Mae, Freddie Mac and Bear Stearns, as well as stimulus checks and housing bills are all part of the NannyState vision for the future. Trophies for everyone! Unfortunately, NannyState doesn’t produce anything (except inflation). It can only give everyone a trophy until the till is empty, or keep printing money until the cost of trophies, and everything else, is through the roof. The odds favor the latter scenario.

The Central Bank of NannyState is at the center of the problem. By printing money in increasing amounts and throwing it at every economic hiccup for the last twenty years, they created imbalances and bubbles. When the bubbles popped more money was printed to “paper over” the resultant mess. So by wanting to cushion the blow of the downside of the business cycle, the NannyState central bank, buckling under intense political pressure, has made the imbalances and dislocations much worse. Fixing the mess will be the job of future politicians and central bankers. Most of the current group will be in comfortable retirement when the real heavy lifting is necessary.

Trillions in Future Promises

The great NannyState safety net is looking a little stressed-out. It has promised to pay over $50 trillion in future decades (unfunded mandates) for Medicare and Social Security costs. This number is subject to rise considerably in the future as inflation devalues NannyState dollars. Unfortunately, it has no idea how it will pay for these programs, but perhaps taxing the “rich” their fair share and making greedy oil companies return some of their obscene profits would be a good start. As for the rest of the money, well, the NannyState dollar is the reserve currency of the world. So it can just print the money and give it to everyone who needs it, right?

The Tipping Point

Alas, NannyState sometimes forgets that Joe Citizen has been paying Social Security and Medicare taxes for years, or even decades. But it needed that money for other programs and trophies. That money is gone. NannyState has an issue with balancing its checkbook. It can’t.

Eventually when too many people either work for NannyState or rely on it for their survival, a tipping point will be reached. It wants to grow ever larger, but its engine (taxpayers and the private sector) will eventually be too small to move its enormous girth. It may ultimately collapse under its own weight. Since NannyState borrows over $2 billion per day from foreigners to keep chugging along, the risks are growing. But it won’t grind to a halt without a fight. Printing money in unlimited amounts will keep things going for a good while.

Collective Denial

There is a collective denial between NannyState and its citizens. The people have lived the good life for decades on the back of foreign savings and the toil and sacrifice of earlier generations. Well, the party is wrapping up and denial is staring into the face of reality.

Reality is often times not pleasant, and NannyState wants to avoid unpleasant choices. It has run up a $9.5 trillion debt (soon to be higher) trying to satisfy everybody, and of course get incumbents reelected. The “leadership” of NannyState has never said “No! Enough! Stop spending and start saving!” NannyState has never been able to stop spending itself, so it figures why should it demand that its citizens do so? That would be unpleasant!

'Little Roar' of Britain's Bees Goes Silent as Colonies Die Off
John Chapple stands among a hum of honeybees flying in and out of 10 hives in the gardens of Lambeth Palace, the Archbishop of Canterbury's London residence by the River Thames. The insects are buzzing. For now.

Eighteen months ago about two-thirds of the 40 hives that Chapple keeps across the capital died off, including all 12 in his own back yard. London's beekeepers collectively lost half of their colonies in the past two years. During last winter alone, almost a third of hives across the U.K. lost their bees.

"If you give hives a thump, you get a little roar coming back, and I didn't get any roars," Chapple, chairman of the London Beekeepers Association, said of the vanishing insects. "Some had bees but the mysterious ones had virtually nothing. Everything had disappeared."

Beekeepers say Britain may harbor Colony Collapse Disorder, an unexplained phenomenon that's led to the loss of more than 35 percent of U.S. hives this year. The government estimates bee pollination is worth as much as 200 million pounds ($395 million) to agriculture and in April began a public inquiry on improving the health of honeybees, which wraps up this month.

Aside from the loss to crop pollination, a dearth of bees would also jeopardize the U.K.'s honey production, valued at as much as 30 million pounds a year by the Department of Environment, Food and Rural Affairs.

In the U.S., where the Department of Agriculture estimates bee pollination adds $15 billion to crop values, government researchers are studying whether pesticides, parasites, diseases, or a combination of stresses are responsible for the losses. U.K. bees typically die off because of viruses, unusually damp weather and the varroa mite, a pest found locally since the early 1990s.

"We have all the components here of the American-style disorder in terms of disease," said Tim Lovett, president of the British Beekeepers' Association, listing a "toxic mix" of varroa, viruses, and a parasite called nosema. "Probably these sorts of losses haven't been seen since the early 1900s. There is clearly something taking place over and above the normal vicissitudes of beekeeping."

Lovett said the onus is on the government to act because it benefits from taxes it wouldn't receive from agriculture without pollination by honeybees. The association estimates bee pollination is worth 86 million pounds to apple growing, 25 million pounds to oilseed rape cultivation, and 20 million pounds to raspberry growers, among other crops.

"Because bees pollinate a third of everything that we eat -- most fruits and nuts, vegetables and seeds, the plants we use for cattle feed -- we'd end up with a food shortage and very high prices" without the insects, said Alison Benjamin, co-author of "A World Without Bees" (Guardian Newspapers Ltd., 2008). "Most people just think honeybees equals honey."

The government spends 1.3 million pounds a year on its National Bee Unit inspectorate and 200,000 pounds on research. The beekeepers' association says an extra 7.7 million pounds is needed over five years to fund studies of varroa, other bee diseases and breeding techniques.

"In the sum of the whole of the agriculture business, it's a drop in the ocean," said Colliers CRE Plc Chairman Sir John Ritblat, who's kept bees as a hobby for 30 years. "There's insufficient allocation for research, and bees are so fundamental to our environment."

Funding of the government's bee health program is unlikely to change next year, though an additional 90,000 pounds is being spent this year for the National Bee Unit to study the winter losses, the environment, food and rural affairs department said in an e-mailed response to questions.

"What is most important is that we have a clear understanding of disease threats and how to tackle them," the e- mail said. "That is why we are developing a bee health strategy which will set out the objectives and priorities for the bee health program over the next 10 years."

Because British beekeeping is largely amateur, the U.K. shortage could get worse than in the U.S., where "big commercial setups" dominate the scene and there's more incentive to restock when hives die out, Lovett said. He is not optimistic the consultation will help.

"The bee health strategy is proving to be a delaying tactic," Lovett said, referring to the government's consultation document. "It's a fig-leaf for not spending the money that's really needed." This year, U.K. beekeepers have restocked since the winter.

At Park Beekeeping Supplies, sales of queen bees and one-kilogram (2.2-pound) packages of bees are more than double two years ago, said Rupert Munro, whose father, Godfrey, set up the London-based store over two decades ago. "This year's probably the biggest business year that we've ever had," said Munro. "That's in terms of demand for bees and the amount of people who want to re-queen their colonies."

Threats remain, said Chapple, a beekeeper for 25 years. "The bees are not behaving as they normally do. Something has upset them," Chapple said. "Lots of people have lost queens, they haven't mated properly, or they've gone off laying - - all weird things that are difficult to explain."


DJ said...


I read Derringer's post as well, and I've seen that stuff from him before. However, I still sent it around b/c of the mention of the correlation between the amount the debt ceiling was raised and the amount these investors own in Fannie/Freddie. I find it hard to believe there's a coincidence there, but to blame the investors is pretty ridiculous. The U.S. govt is the one doing the looting. How can you fault an investor for wanting to cover their mistakes?

Anonymous said...

Ilargi, You have outdone yourself. Well said and great links.

One additional point regarding the link between finance and energy. Chesapeake (CHK) (and others as far as I know) can only get bank financing on the HEDGED portion of their assets. So ceteris paribus the only EP companies that will be producing flat out will be ones funding production from cash flow. Bottom line is that credit also unavailable to growing oil companies -so energy availability is going to be an issue sooner than 5 years IMO.

Ilargi said...

thanks for the kind words

"energy availability is going to be an issue sooner than 5 years IMO."

Why would anything be an issue that you can't afford to begin with?

But yes, you're right in that vanishing credit will wreak havoc on energy production too. And raise the price of what remains.

Development of for instance the oil sands will look like a sick joke.

Anonymous said...

So I take out my savings from the bank and safeguard the cash. But eventually, I will not be able to afford to purchase electricity with my cash? Or there will not be any electricity? Or both?
Anonymous Reader

Ilargi said...

"...eventually, I will not be able to afford to purchase electricity with my cash? Or there will not be any electricity?.."

Does that come as a surprise?

Anonymous said...


SeekingAlpha sounds VERY optimistic. Everything will be just fine...

He writes:
If you have all the major industrial central banks in the world lowering interest rates, while simultaneously the Fed is hawkishly about to raise rates, that in itself will perpetuate the flow of money. Funds will flow into the U.S. and out of the rest of the world. That forces the central banks around the world to continue to lower interest rates, chasing the flow down.

I do not understand why money flowing out of Europe would force the ECB to lower rates "chasing the flow down".

Any ideas ?


Anonymous said...

Ilargi - the Massachusetts heating bit is a mess - $3,000 is the cost through the heating season - $4.70/gallon - assumes 650 gallons used which seems a bit light to me - I think 800+ is a more realistic number. It isn't going to be $3,000/month ... at least not yet :-)

Anonymous said...

Surprised? Well, it's been in the back of my mind since reading your website. I just needed to see it in print for confirmation.
Those of us who read here, are fortunate to get a headstart in planning, though will any of us in the modern world be totally prepared.
Anonymous Reader

Ilargi said...

Ilargi - the Massachusetts heating bit is a mess

I saw that this morning, though a bit late. Thought I'd let that stand, as comic relief. $3000 a month can heat a small village.

Ilargi said...


"..If you have all the major industrial central banks in the world lowering interest rates, while simultaneously the Fed is hawkishly about to raise rates, that in itself will perpetuate the flow of money. Funds will flow into the U.S. and out of the rest of the world. That forces the central banks around the world to continue to lower interest rates, chasing the flow down..."

That whole paragraph is crap, if not the entire article. I decided to let a counterpoint slip in.

Even if there were a covenant to boost the dollar, I doubt this one would work. Maybe it's wishful thinking.

Anyway, the Fed just decided to let rates stay where they are.

Unknown said...

other things being equal, people will withdraw their money out of countries paying low interest rates and deposit it into countries paying a high interest rate. Other things are not equal.

Unknown said...

Well anonymous, you can use your cash to purchase rooftop solar panels. Then you'll always have electricity no matter how badly they screw up the grid.

Anonymous said...

"We will shortly be back to profitability," Thain told CNBC in his first public comments since the firm raised $9.8 billion in a share sale last week. He declined to be specific about when the New York-based firm would end the losses.

I think Thain meant "shortly" in geologic time. What comes after the Holocene?

Re solar electric. An MIT prof recently claims to have made a big breakthrough involving a catalyst which will cheaply and efficiently hydrolyze water. The H2 can be stored in a tank and converted back to electricity through a fuel cell when sunlight isn't available or the drain is greater than the immediate production. If true, this would eliminate the need for huge banks of lead-acid batteries. This, of course assumes that the fuel cell is cheaper than batteries.

Unfortunately, the MIT web article doesn't give the actual efficiency which would be the energy required by the catalyst divided by the actual free energy to break the H-O bonds, and the published article is by subscription.

Anyway, for you solar electric types, here's the link:


Anonymous said...

Good horror show illuminating stuff, ilargi, quite enjoyed how you put things this way:

Therefore, as the money available in our societies decreases, a substantial part of it still has to go into paying off debts incurred in times of plenty.

An editor, on a site that should know better than to be giving out dangerous council, seems to think, that in deflation, old debts will be forgotten debts, but if they aren't forgiven in good times they sure won't be in 'hongry' ones.

The only variance in opinion I have with your editorial is on this:

We need to focus on the actual problem at hand: deflation.

I would just add to that by saying that one species problem is many another species solution.

Ilargi said...


We all dream of being forgiven.

Every day of our lives.

Anonymous said...

Your last article caught my attention...I have 40 hives now,and am feeding them between 40-50lb of sugar every 3 days[heavy syrup]trying to build up the hives to 100lb ...the norm for a rough winter in this area.The way some,such as myself are dealing with colony collapse,and normal winter dieoff[10-20%] is to rapidly divide the hives in the spring with "Mississippi splits" [1to4 w/new queens]...Rapid division,and breeding the most resistant stock possible is how we are trying to deal with what has turned into a race to multiple you stock before you get wiped out


Anonymous said...

I forgive you....;-)

Anonymous said...

Re François: Could it be that this supposed coordination of central banks are in fact a pump & dump operation?

team10tim said...

Hey hey François,

I believe the reasoning behind the SeekingAlpha article is circular and suspect, but I think that this is the answer that you are looking for:

What the article is implying is that central banks lower rates when the economy is in trouble and that causes capital to flee to countries with higher rates. That causes the country's banks to have a problem financing the country's industry which causes more economic hardship which causes the central banks to again lower interest rates.

The United States has a financial problem because banks are under capitalized(not insolvent and hopelessly doomed), therefore if the fed raises rates then capital will flock to the USA seeking a higher rate of return. Then the banks will have access to funds which will solve our problem, leading to growth which will allow the fed to raise rates which will further the process.

The same basic reasoning applies to currency valuations; raising interest rates makes the currency stronger, which brings more investment, which makes the economy stronger, which engenders higher rates ad nauseum.

The problem with this train of thought is that if it were even remotely true then central banks could bolster the economy AND fight inflation by raising rates. Every country in the world would raise rates again and again to attract capital until aliens civilizations descended upon the Earth to seek the wisdom of our handsome and clever politicians and milk and honey fell from the sky.


Anonymous said...

@team10tim - "The same basic reasoning applies to currency valuations; raising interest rates makes the currency stronger, which brings more investment, which makes the economy stronger, which engenders higher rates ad nauseum."

So why did the FED leave rates unchanged yesterday? It seems to me that rates have to be raised eventually.
Anonymous Reader

team10tim said...

Re: anonymous,

I believe the reasoning behind the SeekingAlpha article is circular and suspect

The problem with this train of thought is that if it were even remotely true then central banks could bolster the economy AND fight inflation by raising rates.

They didn't raise rates because the it would kill the economy. As for needing to raise rates eventually it may be wise but, they don't have to do it. How long has Japan been at 1%?


Anonymous said...

@team10tim - "They didn't raise rates because the it would kill the economy."

But the economy is already dying. So if rates were raised, the economy would be killed faster. So keep rates unchanged so people won't panic so the greedy can squeeze out more and more wealth. Do I understand this?

Sometimes I'm a little slow for this forum.
Anonymous Reader

Anonymous said...

Revealing narrative. You sound like Captain Willard from Apocalypse Now. "He [Kurtz] and his men were playing hit-and-run all the way into cambodia".

The system has been tested. Nice.