Thursday, April 29, 2010

April 29 2010: Pandora's box of toxics

G. G. Bain Siren Sisters 1923
These singing siblings, Bobbe, Loryane and Patricia Brox, made it big in vaudeville and then on Broadway

Ilargi: As the European situation looks more dire and confusing by the day, and a sinister web of accusations and legal challenges spreads from Goldman Sachs through the rest of Wall Street, what do the stock markets do? Of course they’re dancing on their tables, party hats and all. So to speak. By now it may be time to really start wondering who’s buying all those shares. Anyone not involved in manipulation should perhaps have their heads examined. Leigh Skene at Lombard Street Research thinks it’s the very Wall Street investment banks which face increasing scrutiny that purchase the shares and keep the sputtering machinery afloat. He may well be right. Does that mean they’re buying stocks with your TARP funds? That, too, may well be right.

Still, what future is there in a scheme such as that, which "solves" a bank debt problem by turning it into a sovereign debt one, only for as long as the charade can last? And how long can it last? Well, look, our economies need a modest growth rate at all times just to keep from from spontaneous crumbling. If we were to pay off our debts, they would have to expand probably somewhere in the double digit percentages. For years to come.

But even then, we'd figure out at some point that paying off the debt is an illusion, a receding horizon the end of which, and the pot of gold, we'll never reach. It’s easy to pretend we can pay it off as long as interest rates keep being forced down artificially by governments and central banks operating under the illusion that it’s they who set the interest rates. Pretense like that, however, is as fleeting as it is temporary. The Acropolis is a fine place to find out how true that is, and why. Meanwhile, we’ve truly come to live in a financial hologram.

Let's see how all our genius economists and politicians fare once the bond markets push up interest on debt three or four-fold in your society too. Who will offer you bail-outs and loans when that time comes? Think you won't need them? Think again. Really, do. Even with ultra-high growth and ultra-low interest rates it would take many years to solve the debt in all but a few western nations, years in which austerity would have to be the leading principle. But austerity hinders growth, and it hinders our lifestyle. So we’re not going to pick that option unless and until we’re forced to, like it’s going to be forced on the Greek population soon. And then we’ll react like them too: we’ll be fighting in the streets.

If it’s the investment banks (and Fed, and Treasury) that keep the stock markets alive, what is likely to happen when the investigations and lawsuits move from civil to criminal, growing in number like so many bacteria in a petri dish? And what will become of the trillions of dollars that our governments handed to them? Will we get it back?

Finally, finally, there are people looking into the dealings of the main US ratings agencies, Fitch, S&P and Moody's, which have doled out AAA's for, or so it seems, anything that moves -money-. As is the case with SEC vs Goldman, a first official accusation against even one of these agencies could open and break the levees that hold Wall Street above water. Every single AAA rating given to a piece of crap paper, and there've been thousands upon thousands of them, is a potential court case. The individuals and institutions who've bought the stuff (invested?!) have often lost huge amounts of money, and will think nothing of a few million in lawyers' fees. Next step: the regulator for the agencies. When did they know what was happening? And so why was nothing done?

TARP Special Investigator General Neil Barofsky may be the first to open up Pandora‘s box of toxics for real: he threatens to go after the New York Fed for their actions in the AIG case. If this plays out the way it should, large swaths of government will be too mired in legal threats to do much governing while few or none of the main banks will be able to do anything but defend themselves in courtrooms.

In that light, it would make sense if either the courts become a massive sideshow to divert attention from the deteriorating economy, or they'll all just decide at one point that it's easier to simply let the economy go off a cliff, so no-one has time or money left for endless expensive litigation. If the debt is threatening to be forced out of the vaults and closets, a process lawyers can at least accelerate, all bets are off, and survival mode will kick in.

SEC sends Goldman case to prosecutors
by Zachary A. Goldfarb

The Securities and Exchange Commission has referred its investigation of Goldman Sachs to the Justice Department for possible criminal prosecution, less than two weeks after filing a civil securities fraud case against the firm, according to a source familiar with the matter.

Any probe by the Justice Department would be in a preliminary stage. No Goldman Sachs employees involved in the mortgage-related transactions that are the focus of the SEC case have been interviewed by Justice Department prosecutors or the FBI agents who often conduct probes on behalf of prosecutors, according to a source familiar with the matter. The sources spoke on condition of anonymity because they were not authorized to discuss the matter publicly.

The Justice Department usually investigates high-profile cases of securities fraud, but the threshold from criminal prosecution is significantly higher than that of civil cases. The SEC only files civil cases. The Wall Street Journal and Bloomberg News reported Thursday night that the U.S. Attorney's Office in Manhattan had followed up on the request and opened a criminal probe. The office declined to comment. "Given the recent focus on the firm, we're not surprised by the report of an inquiry," said Goldman spokesman Lucas Van Praag. "We would cooperate fully with any request for information."

It is very rare for the government to indict a firm, and the mere threat of criminal prosecution can destroy a company. A criminal investigation destroyed the infamous Wall Street firm Drexel Burnham Lambert in the 1980s even though the firm settled with authorities. And although the Supreme Court ultimately overturned the conviction, accounting firm Arthur Andersen collapsed after facing criminal charges in connection with the Enron corporate corruption in the early 2002. In that case, the justices said that lower courts had given juries far too broad principles by which to decide whether to convict the company. The decision, lawyers at the time said, would make it more difficult for prosecutors to bring criminal cases against corporations.

The SEC claims the firm and an employee named Fabrice Tourre broke the law and committed fraud when they sold clients a complex investment linked to the value of home loans that was secretly designed to fail. Another firm, Paulson & Co., a hedge fund, helped Goldman create the investment and planned to bet against it. But the SEC claims that relationship was not disclosed to Goldman's clients, ACA Financial Guaranty and the German bank IKB.

Goldman has steadfastly rejected charges that it committed securities fraud. Tourre has also denied the charges. Goldman says ACA and IKB were sophisticated investors and disclosure of Paulson's role was not legally required. Proving a criminal case could be challenging given that prosecutors must show "beyond a reasonable doubt" that Goldman and its employees committed fraud, compared to the threshold for a civil case, which only requires a "preponderance of evidence."

Under civil law, the SEC doesn't have to prove Goldman set out to defraud investors -- only that it did. But criminal law would require that prosecutors show that Goldman maliciously planned to mislead its investors. Since the SEC filed its lawsuit earlier this month, securities lawyers have debated the merits of the agency's case, with most agreeing that it represents an ambitious legal theory that big financial firms that knew they were engaging in speculative betting on home loans were defrauded because Paulson's role was not disclosed.

Goldman also says ACA was told about Paulson''s role, and the firm has written a letter to its investors strongly suggesting that was the case. The Justice Department suffered a setback earlier this year when a case against two Bear Stearns hedge fund managers failed. A jury rejected securities fraud charges against the hedge fund managers, who ran funds linked to subprime mortgages, after presenting evidence that the men knew about risks in the market but didn't disclose these to investors. The SEC is still pursuing the Bear Stearns case.

Goldman looking to settle SEC fraud case
by Mark DeCambre

Goldman Sachs may soon settle its fraud case with the Securities and Exchange Commission, opting to end the legal fight rather than endure a repeat of the public flogging it received Tuesday in Washington, sources familiar with the matter told The Post. After 11 hours of accusations by members of the Senate Subcommittee on Permanent Investigations, people close to the bank said Goldman is mulling closing the SEC fraud-case chapter on the belief the firm's reputation, already damaged, might not endure a street fight with the Wall Street watchdog.

"It's almost a certainty that there will be a settlement," said a source. As another person put it, the SEC has an "unlimited supply of ammunition" in the form of e-mails and records that it could release, and Goldman officials would like to avoid having those documents fired back at them the way they were on Tuesday.

The SEC on April 16 announced that it had sued the Wall Street giant on charges it misled investors about the details of a mortgage-securities deal in which billionaire hedge fund king John Paulson influenced some of the collateral used in the transaction and then bet against its performance. The SEC also sued Goldman mortgage trader Fabrice Tourre, who's been accused of concealing Paulson's involvement when marketing the deal to investors.

Up to now, Goldman, which has endured a withering fusillade of criticism from the public and politicians, has declared that the SEC's case against it and Tourre has "no basis in fact." However, the growing view inside the firm is that Goldman may not be able to afford going toe-to-toe with the SEC in the court of public opinion if the civil case were to head to trial. Indeed, the bank and how it does business was on full display Tuesday as senators took turns beating up on current and former employees over their alleged roles in the housing crisis, citing a slew of e-mails aimed at portraying the firm as unethical.

The SEC filed its charges after months of discussions with the bank over the claims. However, sources said the agency pulled the trigger on suing the bank out of frustration for what it saw as Goldman dragging its feet toward a resolution. One source refuted the notion that Goldman had a chance to settle the claims before the SEC sued, adding the agency "took the unprecedented step of filing its lawsuit against a public company in the middle of the morning while the stock was still trading. "So, the idea that [the firm] should have settled this months ago bears no resemblance to reality. [The firm] was never given the chance," the source said.

Meanwhile, according to reports late yesterday, Goldman is in talks over a possible settlement involving a hedge fund investor that claims it went bust after it took a $100 million investment in Timberwolf, an overnight sensation for being dubbed by a senior Goldman exec as a "shi- -y deal." Basis Yield Alpha Fund claims losses of $56 million, reports said, citing sources.

Lawmakers to US Attorney General Holder: Goldman, other firms not 'too big for jail'
by Greg Gordon

Maintaining that no Wall Street executive is "too big for jail," 62 members of the House of Representatives asked the Justice Department Wednesday to investigate whether Goldman Sachs and other Wall Street firms committed criminal fraud in the lead-up to the subprime mortgage meltdown. Two liberal-leaning activist groups, the Progressive Change Campaign Committee and, also said that they garnered the signatures of 140,000 Americans on a petition supporting the request.

The congressional letter asks Attorney General Eric Holder to order investigations into Wall Street's role in the financial crisis, and especially whether Goldman employees broke any laws in a 2007 offshore deal that led the Securities and Exchange Commission to file a civil fraud suit earlier this month. "If both global and domestic confidence in the integrity of the U.S. financial system is to be regained, there must be confidence that criminal acts will be vigorously pursued and perpetrators punished," wrote the House members, led by Rep. Marcy Kaptur, an Ohio Democrat.

Kaptur, a member of the Committee on Oversight and Government Reform, which has investigated aspects of the financial crisis, said that "an ever growing mountain of evidence" suggests that the SEC case against Goldman "is neither unique nor isolated." "The American people both demand and deserve justice in the matter of Wall Street banks, whom the American taxpayers bailed out, only to see unemployment and housing foreclosures rise," she said.

Others signing the letter included Michigan Democratic Rep. John Conyers, the chairman of the House Judiciary Committee, Republican Rep. Michael Burgess of Texas and conservative Democratic Reps. Bart Stupak of Michigan, Charlie Melancon of Louisiana, John Barrow of Georgia, Gene Taylor of Mississippi and Ben Chandler of Kentucky. The request came a day after a Senate panel took more than 10 hours of sworn testimony from Goldman chief executive Lloyd Blankfein and six other present and former company executives over allegations that the firm sold off billions of dollars in risky mortgages while secretly betting that they'd fail.

The SEC accused Goldman and one of its younger vice presidents of allowing a longtime client to stack an offshore deal with highly risky mortgages and then secretly bet that they'd fail. The investor, the hedge fund Paulson & Co., later made $1 billion on the deal while two European banks lost that amount. The SEC has declined to say whether it referred its evidence to the Justice Department, which with the FBI has been investigating a number of major corporations' roles in the financial crisis. Department spokeswoman Alisa Finelli said only that "the department will review the letter" from Congress.

How Much Did Lehman CEO Dick Fuld Really Make?
by James Sterngold

Oliver Budde, former Lehman Brothers associate general counsel, says Fuld failed to disclose hundreds of millions in compensation

Before Lloyd Blankfein of Goldman Sachs took his place, Richard S. Fuld Jr.'s angry face was the universal symbol of Wall Street greed. On Oct. 6, 2008, three weeks after Lehman Brothers filed the largest bankruptcy in U.S. history, Lehman's former CEO found himself before Representative Henry A. Waxman, the California Democrat who chaired the House Committee on Oversight and Government Reform. Waxman has stared down plenty of CEOs over the years, yet this had to be one of the most intense confrontations of his career.

"Mr. Fuld will do fine," Waxman said. "He can walk away from Lehman a wealthy man who earned over $500 million. But taxpayers are left with a $700 billion bill to rescue Wall Street and an economy in crisis."

Fuld said he was a victim, not an architect, of the collapse, blaming a "crisis of confidence" in the markets for dooming his firm. Reckless management had nothing to do with it. "Lehman Brothers," he said, "was a casualty."

Fuld and Waxman went on to disagree about just how much money Fuld had taken out of Lehman before it went under. Fuld, now 64, said his total compensation from 2000 through 2007 was less than $310 million, not the $485 million that appeared on Waxman's chart. He said 85% of his pay was in Lehman stock that had become worthless. "I never sold my shares," Fuld said at one point. At another, he said he had not sold the "vast majority" of them.

"That just seems to me an incredible amount of money," Waxman responded.

Among those closely observing Fuld was a 49-year-old former Lehman lawyer named Oliver Budde who was watching the hearing at home on C-Span. Budde (pronounced Boo-da) was certain Waxman's figures weren't too high. They were too low, and he could prove it. Fuld, he believed, had understated the amount he was paid during those years by more than $200 million, and now he had done it under oath, for the entire world to see.

For nine years, Budde had served as an associate general counsel at Lehman. Preparing the public filings on executive compensation had been one of his major responsibilities, and he had been infuriated by what he saw as the firm's intentional under-representation of how much top executives like Fuld were paid. Budde says he argued with his bosses for years over the matter, so much so that he eventually quit the firm. After he left, he couldn't let the matter rest. He contacted the Securities & Exchange Commission and the Lehman board of directors but says neither showed interest in meeting him. He was so shocked by Fuld's testimony in front of Congress that he started thinking about writing a book going public with his story, which is told here for the first time.

"I wasn't surprised, because these guys don't surprise me anymore," Budde says. "But it just struck me—they're doing it again. I wasn't going to sit back and watch."

By his own admission, Budde lacks the aggressive career drive usually found on Wall Street. He speaks proudly of having been a "free spirit" in his younger days when he was a ski bum and took a year off during college to sail the Caribbean as a steward on a yacht. He grew up in Cheshire, Conn., and went to Columbia University, where he received a BA in economics in 1983. After college, he drifted into a job as a cabdriver in New York, which ended when an irate driver sprayed him with a can of mace after a fender bender on the FDR Drive. The experience made an office job suddenly seem tempting, and he found work as a paralegal at Skadden Arps, eventually going to law school on the firm's dime. He served as an associate for six years, working long hours, handling mostly corporate and securities-related matters. In 1997, when it became clear that he would not make partner, he decided to leave, landing as a vice-president in Lehman's corporate general counsel's office.

Budde says things were good at Lehman. His weekends were his own again. He owned a house near Stowe, a ski town in Vermont, and managed to escape there frequently. "It was a perfect arrangement," he says. "I left Friday afternoons for Vermont and came back Monday mornings. It was a job I was proud of. There was no 'ick' factor, at least at first."

At the time, Lehman made its money largely on bonds, and Fuld was a source of inspiration at the firm, a tough trader who was putting the company back in the game after a series of corporate missteps.

The first inklings of trouble for Budde came a couple of years into his tenure, when he says he objected to a tax deal that an outside accounting firm had proposed to lower medical insurance costs. This was an unusual move for a junior Wall Street lawyer. "My gut feeling was that this was just reshuffling some papers to get an expense off the balance sheet," he explains. "It was not the right thing, and I told them." Budde's bosses disagreed with him and O.K.'d the deal.

The incident opened his eyes to more serious issues, particularly what he began to see as a lack of transparency in how the firm disclosed restricted stock units, or RSUs, that it granted to senior executives. There were three types of RSUs: annual awards that usually vested in five years, longer-term awards that took until retirement to vest, and a final type that vested only if there were a change in control (i.e., if Lehman were acquired). In that 2000-07 time frame, Budde—relying on SEC filings—calculated that Fuld received $105 million in annual five-year RSU awards.

What Lehman failed to disclose properly, Budde says, were certain longer-term awards. Lehman took advantage of an interpretation of the SEC disclosure rules to underreport the value of these awards in the company's annual proxy statement and thereby mislead shareholders about just how much top executives were making. He complained to his superiors in the general counsel office, he says, and was told that the policy had been checked with outside attorneys at Simpson, Thacher & Bartlett. (Andrew Keller, the partner on the Lehman account, did not return calls seeking comment.) Those lawyers had deemed it acceptable to exclude unvested RSUs from the annual compensation tables in the SEC filings.

Budde thought this logic was flawed and believed the compensation committee made the problem worse when it pushed back the vesting of certain long-term RSUs. The firm's intention, says a former Lehman executive, was to promote long-term loyalty, but Budde suspected that it was a way to further postpone the disclosure of RSUs as compensation.

Lehman tweaked its policy in another way Budde found dubious. In its 2003 proxy statement, the firm reported that the board's compensation committee had decided to rewrite, retroactively, the terms under which the awards had been made in previous years. "Each tranche of the Extended RSUs will now vest following termination of employment with the Firm," the company disclosed. This meant the executives would get them when they left the firm, unless they were fired for cause. Lehman also disclosed that Fuld's extended RSUs were worth $90.4 million at the time. Budde believed that Lehman should have included that figure in the annual compensation table. Instead, the figure was put at the end of a long paragraph filled with financial jargon, where it was likely to be overlooked.

Budde says Lehman could also claim that it was disclosing these stock grants in its Section 16 statements, also known as "insider reports," which record top executives' transactions involving company stock. Budde created meticulous spreadsheets adding up Fuld's RSUs, options exercised, and any other shares bought or sold over the years. A disparity amounting to tens of millions of dollars shows up clearly if you compare the Section 16 information with the proxy statements, Budde says. "I just assumed that somebody was checking this stuff," he says. "They weren't."

According to W. Alan Kailer, a Dallas attorney with Hunton & Williams who has written articles and books on compensation disclosure, it would have been more transparent to disclose these types of awards in the compensation table the year they were granted to the executives, rather than waiting for them to vest. "This is an interpretation issue," he says, "but the best practice would be to report at the time that the award was originally made."

In February 2006, just after he received his bonus for the previous year, Budde resigned from Lehman. To Budde's delight, later that year the SEC announced that it would require clear reporting of unvested RSUs and other stock-based awards in the proxy statement.

The first year Lehman had to alter its proxy reporting was 2008. Budde was ready to see how the firm would handle the change. At his home in Vermont, he pored over the documents when they were released in March. "I looked several times, and my jaw just dropped," he said. "What happened to the RSUs? It took me, someone who has written these documents, two or three times to spot the problems."

Budde calculated that while Lehman reported Fuld's RSUs as worth $146 million, the real figure, based on the Section 16 reports, was $409.5 million. Lehman had counted just 2 of 15 RSU awards. "You just didn't need to do this to this degree," he says. "It was disgraceful."

Considering his options, Budde decided to go to the SEC as a whistleblower. He sent a detailed two-page e-mail on Apr. 14, 2008, to the SEC's Enforcement Div., under the subject line "Possible Material Noncompliance with New Executive Compensation Disclosure Rules." Lehman was already in crisis mode at the time, but the meltdown of the firm was still several months away. After detailing what he believed was Fuld's failure to disclose more than $250 million in restricted stock awards, Budde wrote: "The last thing the country needs right now is another investment bank in crisis. I have wrestled with this over the past five weeks, since I first read the proxy. This is not a shot at retribution, and I am in no way a disgruntled former employee (disappointed, even disgusted, yes). I walked away freely from Lehman, and my ethical concerns in a number of areas were no secret to my superiors there." He got a standardized form thanking him for his letter in return. He never heard anything else. (The SEC does not comment on private communication with its enforcement division.)

Budde also wrote to Lehman's board members but was ignored by them as well. A former Lehman official, who spoke anonymously because internal board business is confidential, confirmed that the board had received Budde's warnings. Budde said that Fuld had understated his compensation by more than $200 million during the October 2008 congressional hearing. While Fuld said he earned less than $310 million from 2000 through 2007, he actually had received $529.4 million, according to Budde's calculations.

In direct contradiction to Fuld's claim to Waxman that he had not sold the majority of his shares, Budde estimates that Fuld earned $469 million from stock sales between 2000 and 2008. These calculations are supported by the working paper from a Harvard University study that was made public late last year and is scheduled to be published this summer in the Yale Journal on Regulation. In "The Wages of Failure: Executive Compensation at Bear Stearns and Lehman, 2000-2008," Harvard Law professor Lucian Bebchuk; Alma Cohen, a visiting professor from Tel Aviv University; and Holger Spamann, a Harvard Law lecturer, calculate that Fuld earned $522.7 million from 2000 to 2007, only slightly less than Budde's tally. The study found that Fuld earned $461.2 million of that total from the sale of 12.4 million shares of Lehman stock, more than the 10.8 million shares, including unvested RSUs, he owned at the time of Lehman's bankruptcy.

The authors of the Harvard paper said they were motivated by an incorrect popular assumption that top executives of investment banks, particularly Bear Stearns and Lehman Brothers, had suffered big personal losses in their share holdings and that this proved the compensation systems at the firms were not to blame for the crisis. Instead, they concluded, executives including Fuld had sold many of their shares before the crisis hit and ended up losing much less than they let on.

Through his attorney Patricia Hynes, Fuld declines to comment. "We're not giving any interviews," says Hynes. Fuld did not respond to detailed questions faxed to his office. Calls to John Akers, former chairman of IBM, and John Macomber, former chairman of Celanese Corp., who both served on the compensation committee of Lehman's board, were not returned.

Fuld continued getting money out of Lehman Brothers right up until the end. In March 2008, with the credit crisis gathering force and talk circulating of Lehman's precarious state, Fuld and his lieutenants argued in the proxy statement that they deserved large incentive awards for "successfully navigating the difficult credit and mortgage environments and maintaining the firm's strong risk controls." The board agreed, awarding Fuld $40 million for his work in 2007, of which $35 million was in restricted stock.

When the bank collapsed in September 2008, the restricted stock was rendered worthless. However, the board did allow Fuld to cash in a Lehman investment partnership despite rules that normally allowed redemptions only if the executive left Lehman or died, according to a report on the bankruptcy by Anton R. Valukas, the bankruptcy examiner. Two months before Lehman filed for bankruptcy, the board agreed to pay Fuld $4 million for his limited partnership interest.

In advance of his testimony, Simpson Thacher & Bartlett racked up 889.3 hours of work prepping Fuld and producing documents for Congress. The bill, paid by the bankruptcy estate, came to $491,197.

One question that remains is why Budde stayed on at Lehman for as long as he did, given what he says he observed there. "It's kind of like the frog in the boiling water," he says. "It took a while to figure out how bad it was. My moral compass was always there, but I felt I was learning important stuff. I always told my boss how I felt, and I made my objections."

Budde doesn't have a job. He's living off savings in Vermont and says he's enjoying a simpler life. He is considering putting his financial background to a more productive use, by helping a pension fund do socially responsible investing, for example. "I don't want to come across as a Boy Scout," he says, "but this is the job you're licensed by society to do as a lawyer, to stand up."

Provision would break up nine biggest banks
by Ronald D. Orol

Nine of the largest financial institutions including Bank of America Corp., Citigroup Inc. and J.P. Morgan Chase & Co. would have to scale down by about 40%, according to legislation introduced by a group of eight Democrats on Thursday. The group is hoping the measure will be approved as part of sweeping bank reform legislation under consideration on Capitol Hill. The measure limits the size of non-deposit liabilities at financial institutions to 2% of U.S. gross domestic product, or about $300 billion. It's unclear whether congressional leaders will allow the measure to be voted upon by the full Senate or whether lawmakers would approve it.

Goldman Case Is Just ‘the Beginning’ for Banks: Bush Advisor
by Jennifer Ryan and Andrea Catherwood

Goldman Sachs Group Inc.’s Senate grilling may be the start of a series of inquiries into banks in the wake of the global crisis, said Pippa Malmgren, George W. Bush’s former chief financial-markets adviser. "Various U.S. investigators, from the Justice Department to the FBI to the Federal Reserve, bank examiners, have been crawling all over these institutions, not just Goldman but others, for now two years," she said in an interview today with Bloomberg Television from Singapore. "My guess is that we’re at the beginning of a process of uncovering all these sorts of stories. It’s not the end of it, it’s the beginning of it."

Executives of Goldman, the world’s most profitable securities firm, were questioned in Congress yesterday 12 days after the Securities and Exchange Commission sued the firm for fraud, saying it misled investors in a mortgage-linked investment. Malmgren said the point of the inquiry is to convince investors that it’s safe to put money into markets. "This is a phase of the cycle that is about showing the public that the so-called bad guys, bad practices are being removed from the system so it becomes safe to come back and invest in the markets again," she said. "I suspect that the actual legal case against Goldman Sachs is pretty weak. If what they were doing was selling something to someone knowing that somebody else valued it higher, that’s called a market, so this is not such a dramatic issue."

U.S. politicians are also under pressure to attract voters before mid-term elections in November, said Malmgren, who is now president of London-based Canonbury Group. This means that legislation to address the causes of the crisis or avert a new one, such as a banking bill written by Senate Banking Committee Chairman Christopher Dodd, probably won’t work, she said. "It’s highly unlikely that what the Dodd bill contains is going to prevent these kinds of crises in future or redress what’s happened in the past," Malmgren said. "What’s important is to be seen to be doing something about the incredible losses that have been incurred by the American public and frankly the global public as well. If it serves that purpose, there are votes in it, that’s the important thing." Malmgren was an adviser to President Bush before his election in 2000, and then served on the National Economic Council as special assistant to the president for economic policy, responsible for all financial-market issues.

SIGTARP Neil Barofsky Says Criminal Charges Possible in Alleged AIG Coverup, Including Against New York Fed
by Richard Teitelbaum

Neil Barofsky was unpacking boxes in December 2008 when the stench of sewage wafted through the hallways at the 168-year-old Main Treasury Building. The space assigned to him as head of the Office of the SpecialInspector General for the Troubled Asset Relief Program, or SIGTARP, was shoehorned into the basement, three floors below U.S. Treasury SecretaryHenry Paulson’s offices. "They eventually discovered a broken sewer main beneath the floor," says Barofsky, 40, adding that he doesn’t think any slight was intended by relegating him to the malodorous quarters. Still, he says with a smile, "I wasn’t given the prime real estate in Treasury." The incident was noted by Beltway insiders, Bloomberg Markets magazine reports in its June issue. "It became an apt metaphor for the foul relations between Treasury and SIGTARP," says Michael Smallberg, an investigator at the Project on Government Oversight, a Washington watchdog group.

That tense relationship has grown out of Barofsky’s mandate to monitor and root out fraud and waste in the management of TARP, the $700 billion program passed in October 2008 to remove toxic debt from the banks. The special inspector general, in a series of reports, interviews and congressional hearings, has heaped criticism on the Treasury Department’s operation of the program. Barofsky’s most recent broadside came on April 20, when a SIGTARP report labeled a housing-loan modification program funded with $50 billion of TARP money as ineffectual. 

230,000 Homeowners

Treasury spokesman Andrew Williams counters that the program has resulted in modifications for more than 230,000 homeowners. The TARP watchdog has also criticized Treasury Secretary Timothy F. Geithner in reports and in congressional testimony for his handling of the process by which insurance giant American International Group Inc. was saved from insolvency in 2008, when Geithner was head of the Federal Reserve Bank of New York. The secrecy that enveloped the deal was unwarranted, Barofsky says, adding that his probe of an alleged New York Fed coverup in the AIG case could result in criminal or civil charges. In Senate Finance Committee testimony on April 20, Barofsky said SIGTARP would investigate seven AIG-linked mortgage-related securities similar to Abacus 2007-AC1, the instrument underwritten by Goldman Sachs Group Inc.that is at the center of a U.S. Securities and Exchange Commission lawsuit filed against the investment bank on April 16.

"I’ve been in contact with the SEC," he told the committee. "We’re going to coordinate with them, but we’re going to lead the charge. We’re going to review these transactions." Barofsky and Geithner’s offices have gone toe-to-toe over AIG, alleged lax oversight of TARP funds and even over the question of whom Barofsky reports to. Barofsky, a former federal prosecutor who was once the target of a kidnapping plot by Colombian drug traffickers, says he’s also looking into possible insider trading connected to TARP. He says his agency would want to know if bankers bought stock in their companies before it was made public that their institutions would get TARP money, for example. "There was a time when, if you got that word the stock price would go up, and if you were to trade on that information prior to the public announcement, that would be classic insider trading," Barofsky says.

‘Tea Partiers’

A Democrat named by a Republican president, Barofsky says missteps by both the George W. Bush and Barack Obama administrations are to blame for TARP’s failures. "There’s a reason there are Tea Partiers out there, and when you look at it, anger at the bailout is one of the first things they talk about," says Barofsky, referring to the anti- Obama political movement. "This Treasury Department and the previous Treasury Department bear some of the responsibility for not being straightforward with the American people." Barofsky criticized Geithner’s predecessor, Paulson, in an October 2009 report, saying Paulson publicly described the initial nine TARP bank recipients as healthy when he knew that at least one of them risked failure. In a letter responding to Barofsky, Assistant Treasury Secretary Herbert Allison wrote: "Any review of such announcements must be considered in light of the unprecedented circumstances in which they were made." Geithner and Paulson both declined to comment for this story.

Barofsky, who has thinning jet-black hair and favors dark- gray suits, has won praise from both sides of the aisle in Congress. "The special inspector general for TARP hit the ground running," says SenatorCharles Grassley, an Iowa Republican who helped draft the legislation creating SIGTARP. "He’s the kind of watchdog taxpayers need and deserve." From the day Congress created it, TARP has been troubled. Paulson crafted it as an initiative to buy the toxic assets that were then threatening to capsize the world’s banking system. Since then, the Treasury and Congress have transformed it into a hydra-headed beast encompassing 13 financial aid plans. TARP had invested $204.9 billion in 707 banks, thrifts and credit unions through its Capital Purchase Program as of March 31; $69.1 billion remained to be paid back. It has committed to paying out $39.9 billion to modify mortgages, though it has disbursed only $91 million.

Hydra-Headed TARP

The Treasury Department has pledged to dole out tens of billions more to programs as varied as the Unlocking Credit for Small Business initiative and the Automotive Industry Financing Program, through which it owns 60.8 percent of General Motors Co. and 9.9 percent of Chrysler Group LLC. Says Representative Jeb Hensarling, a Republican from Texas and former member of the Congressional Oversight Panel that guides TARP policy, "It’s almost a program that defies oversight." Of the $700 billion in TARP funding authorized by Congress in October 2008, the Treasury has planned for $545.1 billion in investments, committed $489.8 billion and disbursed $380.3 billion as of March 31. Institutions had repaid $180.8 billion. SIGTARP has more than 40 agents, including former Secret Service, Federal Bureau of Investigation and Internal Revenue Service investigators, who sport blue windbreakers emblazoned with the SIGTARP seal. They are authorized by Congress to carry guns -- Barofsky does not -- make arrests, and subpoena and seize records.

In its late-January report, SIGTARP said that the banks rescued by TARP remained "too big to fail." They still have an incentive to make risky wagers in order to generate the profits that will reward their executives, the report says. "The definition of insanity is repeating the same actions over and over again and expecting a different result," Barofsky says. "If the goal of TARP was to make sure we don’t have another financial collapse, well, obviously it’s made the likelihood of that much, much greater." Neil Michael Barofsky’s background prepared him well for a job that involves law enforcement, economics and political diplomacy. Born in Abington, Pennsylvania, a suburb of Philadelphia, he simultaneously earned degrees in economics and international relations from the University of Pennsylvania. He graduated magna cum laude from New York University Law School in 1995. He soon landed at what is now Morvillo, Abramowitz, Grand, Iason, Anello & Bohrer P.C., a New York-based firm filled with former prosecutors.

Dream Job

It was Barofsky’s ticket to what he says was his dream job, as a lawyer for the U.S. Attorney’s Office for the Southern District of New York, where he started in 2000. Toiling in the criminal division’s offices at 1 St. Andrews Plaza in Manhattan, Barofsky acquired a reputation as someone who worked prodigiously to build cases. "My impression was, Neil was always working," says his former boss, ex-Southern District U.S. Attorney Michael Garcia. Beginning in 2004, Barofsky worked on "Tango Chaser," an investigation into the Revolutionary Armed Forces of Colombia, or FARC, a rebel army that funds its operations partly through narcotics trafficking. The still-ongoing probe has resulted in the indictments of 50 traffickers. In 2005, Barofsky learned he had been the target of a kidnapping plot during one of his visits to Colombia. A female informant who was planning to set him up relented and later told him of the plan. Barofsky keeps a FARC bayonet on his office windowsill as a memento of the case.

Barofsky’s most prominent white-collar case was the successful prosecution of Refco Group Ltd. President Tone Grant, who was found guilty of conspiracy, fraud and money laundering in April 2008. Barofsky was running a mortgage fraud enforcement program for the Southern District in November 2008 when Garcia took a call from the White House personnel office, which was looking for a special inspector general for TARP. "The most qualified person for this job is you," Garcia recalls telling Barofsky. "This is the crisis of the hour." Then Garcia warned him: "People will not like you." Barofsky wasn’t intimidated. "Neil is not deterred by the prospect of powerful people or his supervisors coming down on him," says Anthony Barkow, executive director of the Center on the Administration of Criminal Law at New York University, who worked with Barofsky in the U.S. Attorney’s Office. "He is an independent thinker and not afraid to ruffle feathers."

Against the Grain

David Kotz, inspector general of the SEC, says, "Neil Barofsky has done a laudable job of taking aggressive positions where necessary. Inspector generals at one time or another must be prepared to go against the institutional grain." Geithner’s Treasury Department disputes the assertion that it has not been open about TARP. "This is frankly one of the most transparent programs in the government," says Tim Massad, chief counsel of Treasury’s Office of Financial Stability. "We’ve probably had 200 meetings with Neil and his staff." In April 2009, Treasury asked the Justice Department for a ruling on whether Barofsky and SIGTARP reported to Secretary Geithner. In a letter to Justice, Barofsky argued that he reported only to the president. "We are absolutely an independent agency," he says. Treasury withdrew its request.

In February of this year, the department moved to exclude the Small Business Lending Fund from Barofsky’s oversight. The program is funded with $30 billion of TARP money. "On its face, it looks like Treasury is trying to supersede SIGTARP’s position by having the program operate outside TARP," says Smallberg of the Project on Government Oversight. "Barofsky is certainly a thorn in the side of Geithner." Meanwhile, Barofsky’s investigators continue to lay into TARP. In a January report, SIGTARP cited an unnamed money manager in TARP’s Public-Private Investment Program, which buys toxic assets, saying the person sold a recently downgraded mortgage-backed bond from a company fund, then promptly purchased the same security in the same amount at a higher price for a fund backed by TARP money. Allison responded in a letter to Barofsky that the suspicious trade was referred to SIGTARP by Treasury compliance officers in the first place.

Insurance Banks

In a December report, Barofsky showed how insurance giants Hartford Financial Services Group Inc. and Lincoln National Corp. bought tiny thrifts -- one with just $7 million in assets -- to qualify for the TARP Capital Protection Program, which is designed to encourage bank lending. Hartford and Lincoln used the more than $4.3 billion in TARP funds they received almost entirely to finance insurance operations, according to the report. "Treasury didn’t have to approve that," Barofsky says. Allison wrote SIGTARP that buying troubled assets from insurance companies was part of TARP. Janet Tavakoli, founder of Chicago-based Tavakoli Structured Finance Inc., says Barofsky hasn’t been aggressive enough. She says SIGTARP should be running criminal probes of the bankers who underwrote and managed the collateralized debt obligations that were at the center of the financial meltdown. CDOs are bundles of mortgage-backed bonds and other debt sold to investors. Tavakoli says the CDO managers sometimes replaced relatively high-quality securities with new ones that were more likely to default.

"It is securities fraud if you take securities and package them and knowingly pass them off with phony labels," she says. Barofsky says investigations related to the underwriting and sale of CDOs are ongoing. Barofsky is no longer confined to a fetid basement office. SIGTARP is now in a brown-granite building on L Street, nine blocks away from the Treasury. Sitting in his office, the investigator says he was at first surprised by the resistance he got from the Treasury to his inquiries. "When I took the job, it wasn’t like I had really contemplated for a millisecond the political aspects," says the lawman, sipping from a can of Diet Coke. Barofsky says he’s battling an entrenched culture of secrecy in the Treasury and elsewhere. "One of the important lessons that I hope will be learned from this entire financial crisis is that the reflexive reaction against transparency, that disclosure will bring terrible things, has not been proven true," he says.

Culture of Secrecy

He offers the AIG bailout as an example. For more than a year, the New York Fed kept key aspects of the AIG bailout secret, including details of its own involvement and its decision to have AIG pay the insurer’s bank counterparties 100 cents on the dollar on the credit protection they’d bought against about $62 billion in CDOs. In a November report, SIGTARP criticized Geithner’s failed efforts to obtain discounts from the banks. After the banks had been paid in late 2008, a lawyer from the New York Fed sought to have AIG keep the banks’ identities under wraps, as well as data about the CDOs that would have revealed which firms had underwritten the toxic bonds and which ones had managed them. "There’s a lot of things about AIG that were not disclosed, based on the assumption that the sky would fall," Barofsky says. "Transparency does a lot more good than bad."

TARP Police

Barofsky says the question of whether the New York Fed engaged in a coverup will result in some sort of action. "We’re either going to have criminal or civil charges against individuals or we’re going to have a report," Barofsky says. "This is too important for us not to share our findings." He won’t say whether the investigation is targeting Geithner personally. In a statement, the New York Fed said: "Allegations that the New York Fed engaged in a coverup of its intervention in AIG are not true. The New York Fed has fully cooperated with the Special Inspector General." Barofsky’s to-do list grows. SIGTARP now has 120 employees, has initiated 20 audits and was involved with 84 investigations as of March 31. In January, it opened a New York office, with San Francisco and Los Angeles branches scheduled for later this year. As long as the Treasury Department continues throwing money at the financial crisis, Barofsky’s TARP police will be watching.

The Client Always Comes First At Goldman... Except When He Doesn't, Which Is Also Always
by Tyler Durden

One day after the Goldman hearings, we were left with the warm and fuzzy impression that the whole Goldman farce was for nothing, and that everything the firm had been doing for the past 5 years was perfectly legitimate. The prop trading abuse, the discount window generosity, the endless abundance of flow and prop inventory commingling, the endless client rape...All these allegations must have been for naught.

Which is why we were thoroughly disappointed when our sense of sudden enlightenment that we may have been wrong all along about Goldman, vanished promptly and without a trace once we had a chance to read the 2007 self-evaluation of Goldman Managing Director Michael Swenson.

The line penned by Michael, who incidentally was the least like of the three Goldman SPG MDs testifying on Tuesday based on peer feedback, that broke our collective heart is the following:

"Once the stress in the mortgage market started filtering into the cash market, I spent numerous hours on conference calls with clients discussing valuation methodologies for GS issued transactions in the subprime and second lien space [redacted] is prime example). I said "no" to clients who demanded that GS should "support the GSAMP" program as clients tried to gain leverage over us. Those were unpopular decisions but they saved the firm hundreds of millions of dollars."

Alas, we find that all of Goldman's sincere hypocritical lies before the Senate committee were... precisely just that.

As a refresher, the GSAMP, that Goldman was expected to support after demands by clients, refers to the Goldman Sachs Alternative Mortgage Product, or structured products such as the GSAMP 2006-S3 pictured below, which were originated by the firm in 2006, and which were largely wiped out by early 2007. See chart below (from Forbes):

So this is the GSAMP (in principle) that clients were asking for Goldman to support, incidentally at a time when Goldman was actively betting against it, and whose request denials were subsequently seen by Swenson as a boasting bullet that should be included in his self evaluation when demanding tens if not hundreds of millions of dollars in 2007 bonus.

But lets re-read Swenson's words again:

Once the stress in the mortgage market started filtering into the cash
market, I spent numerous hours on conference calls with clients
discussing valuation methodologies for GS issued transactions in the
subprime and second lien space. I said "no" to clients who demanded that GS should "support the GSAMP" program as clients tried to gain leverage over us. Those were unpopular decisions but they saved the firm hundreds of millions of dollars."

It is hilarious that Goldman would "spend countless hours" with clients to convince them of the Goldman trade only after the stops had been hit and Goldman was actively trying to cover shorts, i.e., when the stress in the mortgage market was plainly visible for all to see. Maybe Goldman should have spent just one hour with its clients when it itself decided to go short in the first place, instead of using its clients as spitoons for its toxic, HR Giger based saliva.

What is far more deplorable, is that Swenson admits that not only did the firm deny its client requests, but that these decisions lost the firm client credibility (although they saved Goldman "hundreds of millions").

And now you know why Lloyd Blankfein's statement that "the client always comes first" for Goldman is also merely another lie.

But we all knew that.

What deserves greater scrutiny is the question why Goldman thought it could get away with antagonizing clients in its pursuit for the almighty dollar? The answer is simple - Goldman knew then, just as it knows now, that it is a market monopoly, and that no matter how pissed off its clients get, they have no other options: Goldman has the biggest flow (which implicitly become prop) axes in the world, and the greatest "patzy" rolodex in the world. Well, after the implosion of every European bank, that rolodex was cut in half. But at least all the mutual and pension funds, not to mention momos, still remain, and are currently buying the market on the way up, just as Goldman keeps on hitting every new high bid. Yet the core premise remains: Goldman is a monopoly and the firm realizes this all too well.

But maybe not for long.

Very soon Zero Hedge will present our own proposal for regulatory reform, specifically as pertains to prop trading, which may hopefuilly make the lives of the incumbent market monopolist Goldman Sachs, for whom the client always comes last, just a tad more difficult.

Equity rally not driven by the usual investors
by Leigh Skene

The outperformance of risk assets over the past year suggests investors appear to believe that all credit problems have been solved – but nothing could be further from the truth, says Leigh Skene at Lombard Street Research. "Rising stock markets and narrowing credit spreads depend on buyers being more anxious to buy than the sellers are to sell," he says. "So who are the enthusiastic buyers of risk assets?"

Surprisingly, says Mr Skene, surveys show that the usual investors in major rallies – pension funds, hedge funds and retail investors – have not been net buyers of equities. And he says the most likely explanation for this anomaly in the biggest stock market rally since the 1930s is that major investment banks are the anxious buyers.

"Their buying would appear to be for one of two reasons. Firstly because they think the authorities will prevail in their (so far unsuccessful) efforts to inflate their way out of debt liquidation; or secondly because they are too big to fail and so can afford to take a huge gamble that enough buying will convince others to rush in and buy their inventory of risk assets at even higher prices. "Huge economic slack in most developed nations and falling money supplies in the two biggest currency areas indicate that government efforts to inflate will continue to be unsuccessful – so reason number one is bearish for risk assets; number two is catastrophic."

Germany reports big fall in unemployment
by Ralph Atkins

Germany on Thursday reported the biggest monthly drop in unemployment in more than two years, highlighting the strength of its economic rebound, even as the crisis over southern Europe’s public finances escalates. Seasonally-adjusted unemployment in Europe’s largest economy fell by a much larger-than-expected 68,000 in April to 3.28m, a pace of decline not seen since January 2008. The unemployment rate fell to 7.8 per cent of the workforce – the lowest since December 2008.

The surprisingly-sharp decline reflected the rebound in German industry, which has been helped by the Greece-related fall in the euro, as well as government measures to support the labour market. It also underlined the contrast with the US economy, where the impact of the global economic crisis has been focused largely on labour markets. "Given the recession that we have been through, the [German] labour market is remarkably strong," said Dirk Schumacher, economist at Goldman Sachs in Frankfurt. If contagion effects from Greece could be prevented, the impact of the crisis on growth need not be significant, he added. "Greece is the main theme in financial markets, but in the real economy it is not."

German unemployment peaked in the middle of last year at almost 3.5m. Earlier this year, the economy was hit by the severe winter, which could have wiped-out any growth in the first quarter. But activity is likely to have picked-up markedly in the current quarter, helping the lifting the eurozone’s overall performance. A surge in German optimism helped lift the European Commission’s eurozone "economic sentiment indicator," also released on Thursday, from 97.9 in March to 100.6 in April – the highest since February 2008.

However, the robustness of Germany’s labour market has not eased concerns about the strength of the eurozone recovery. Even before the escalation of the Greece crisis, growth would have been hit by the phasing out of emergency government measures to support the economy. Under pressure from financial markets, eurozone finance ministers may accelerate the withdrawal of fiscal stimulus programmes.

Separately European Central Bank data have shown weaknesses remaining in eurozone credit markets. Lending to the private sector continued to contract in March, with loans to companies falling at an annual rate of 2.4 per cent – the same as the previous month, according to the latest ECB credit data. However, annual growth in loans to households accelerated from 1.8 per cent to 2.2 per cent. The figures added to evidence that credit flows are not yet oiling the wheels of economic recovery. An ECB bank lending survey earlier this week showed demand for bank loans from business and house buyers weakened unexpectedly in the first quarter of this year.

US Initial Jobless Claims Fall Slightly, 4-Week Moving Average Up
by Sarah N. Lynch And Jeff Bater

The number of U.S. workers filing new claims for jobless benefits continued to fall last week, but the overall level remains elevated. The Labor Department said in its weekly report Thursday that initial claims for jobless benefits declined by 11,000 to 448,000 in the week ended April 24. That is exactly in line with the predictions of economists surveyed by Dow Jones Newswires. The previous week's level was revised slightly upward to 459,000 from 456,000.

Claims are edging down again after two weeks of unexpected surges in early April. U.S. Labor Department economists had said the increases were due to holiday factors and not more layoffs. This now marks the second week of declines, and appears to support the Labor Department's assertion. Although initial claims are decreasing, the overall trend for initial claims continued to rise slightly last week. The four-week moving average, which aims to smooth volatility in the data to help paint a better picture of the underlying trend, rose for the week ended April 17. The Labor Department said the four-week moving average went up by 1,500 to 462,500 from the previous week's revised average of 461,000. Total claims lasting more than one week, meanwhile, fell.

Jobless claims continue to remain stubbornly high even though the U.S. economy is growing. The Labor Department's March report showed that nonfarm payrolls rose by 162,000, although some of that was due to temporary hiring for the 2010 Census. Overall, unemployment still remains at 9.7%. On Wednesday, the Federal Reserve said it was going to continue to keep interest-rates near zero for an extended period of time even though the economy is getting better because of high unemployment and its impact on consumer spending.

"Information received since the Federal Open Market Committee met in March suggests that economic activity has continued to strengthen and the labor market is beginning to improve," the FOMC said in a statement. In the Labor Department's Thursday report, the number of continuing claims--those drawn by workers for more than one week in the week ended April 17--decreased by 18,000 to 4,645,000 from the preceding week's revised level of 4,663,000. The unemployment rate for workers with unemployment insurance for the week ended April 17 was 3.6%, unchanged from the prior week's unrevised rate.

The largest decreases in claims for the week ended April 17 were led by New York and California. New York reported fewer layoffs in the service and transportation sectors while California had fewer layoffs in the service and manufacturing industries. Other states with decreases included Pennsylvania, Oregon and New Jersey. The largest increases in claims occurred in Puerto Rico, which did not provide the Labor Department with an explanation for the rise.

Spain jobless rate above 20 percent
pain's jobless rate topped 20 percent of the workforce in the first quarter, its highest level since 1997, a report said Tuesday, citing figures accidentally released by statistics institute INE ahead of schedule. The number of unemployed jumped by 286,200 during the first three months of the year compared with the final quarter of 2009 to reach 4.61 million or 20.05 percent of the workforce, conservative daily ABC reported. The figure was posted on INE's web site for several minutes on Monday, it said. INE will publish the first official quarterly unemployment figures on Friday. Spain's unemployment rate stood at 18.83 percent in the fourth quarter of 2009 with 4.33 million people out of work, according to INE figures published on January 29.

In a statement, INE confirmed that a technological "incident" had made "certain data" from its quarterly unemployment study visible on its web site but it did not confirm the figures published by ABC. Spain is grappling with a collapse of its labor-intensive construction industry at the end of 2008. It has the highest unemployment rate in the 16-nation euro zone and accounts for half the region?s job losses over the last two years, according to the European Union?s statistics office Eurostat. The continued rise in the unemployment rate could make Spain's Socialist government, which is struggling to rein in a ballooning public deficit that has rattled financial markets, spend more on benefits.

Prime Minister Jose Luis Rodríguez Zapatero admitted Tuesday the unemployment rate was "too high" but predicted it would begin to decline "slightly" in April. "We should see a positive trend in the coming months," he told the Senate. Earlier this month Bank of Spain governor Miguel Angel Fernandez Ordonez warned that "mass unemployment" was the greatest risk faced by the country's banks, which will suffer from less business and higher defaults as a result. In January, Finance Minister Elena Salgado raised the government's estimate for the 2010 unemployment rate to 19 percent from 18.9 percent.

The Spanish economy, Europe's fifth largest, shrank by 0.1 percent in the last three months of 2009, making it the last major economy still in recession. The government has forecast a return to growth in the second half of 2010. The Spanish economy has proved especially vulnerable to the global credit crunch because growth relied heavily on credit-fuelled domestic demand and a property boom boosted by easy access to loans that has collapsed.

French investment bank Natixis estimates that prior to the crisis 30 percent of Spain's working population worked directly or indirectly for the construction industry. "This was pure madness," it said in a research note last month, adding there are 1.2 million unsold housing units currently on the market in Spain.

Elizabeth Warren Challenges Republicans To Stand Up For Families
by Shahien Nasiripour

It's time for senators -- especially the Republicans -- to square their upcoming votes on financial reform with their long-professed desire to protect families, said consumer advocate and federal bailout watchdog Elizabeth Warren on Wednesday in an interview with the Huffington Post. "Everyone in Washington claims to be on the side of families and to support reform," said Warren, a member of the 2010 TIME 100 list of the world's most influential people.

"But the test is who votes to paper over problems with another regulatory system designed to fail and who votes for real Wall Street accountability even if it means that some donors will be disappointed. "I'm tired of hearing politicians claim to support families and, at the same time, vote with the big banks on the most important financial reform package in generations. I'm deep-down tired of it."

Of all the proposals in the 1,400-page Senate bill attempting to reform Wall Street and protect American consumers, none is more contentious than the one calling for the creation of a consumer-focused agency dedicated to protecting borrowers from abusive lenders. Reform-minded Democrats want a powerful independent entity able to defend powerless families from the banks and financial firms that squeeze profits out of customers through tricks, traps and outright predatory loans. Moderates want to say that they voted for a bill that protects consumers -- even if it really doesn't. Republicans profess a desire to protect consumers, acknowledging regulators' past failures, but they also don't want to stem the flow of credit or needlessly harm lenders' ability to make a buck.

The Senate bill, authored by the banking committee's chairman, Christopher Dodd, a Connecticut Democrat, calls for a consumer entity to be housed inside the Federal Reserve. It largely, though, adheres to Warren's four tests: a chief appointed by the president, an independent source of funding, the authority to write consumer rules and the ability to enforce them against unscrupulous lenders. The unit, thus, focuses squarely on consumers. Ensuring banks' profitability is left to banking regulators.

The Republicans' counter-proposal, released this week, fails all four of Warren's tests. It calls for a council led by the heads of the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Reserve. They'd issue rules, supervise "our nation's largest financial institutions, large non-bank mortgage originators, and other financial services providers who have violated the consumer protection statutes," and enforce the rules.

Warren isn't thrilled with the idea of allowing bank regulators -- whose top priority is to ensure the profitability of the nation's banks -- to continue to oversee consumer protection, particularly when the OCC is involved. "The problem with consumer protection is structure. Our current consumer regulatory process is designed to fail, and if we don't fix it, it will fail again," she said. "In every major dispute between customers and banks, the OCC entered the fray on the side of the banks. Clearly, banks -- not their customers -- were the OCC's primary interest. The idea that the OCC would now be in a position to veto the new consumer agency is shameful.

"If our goal was to take any lessons from the crisis, we would do the reverse: Let's give a consumer regulator a veto over the OCC," Warren added. After all, "it wasn't a consumer regulator who presided over the biggest financial meltdown in generations." She didn't hold back in singling out the GOP's plan, which the Harvard Law professor and bankruptcy expert said was "pure genius -- for the banks who want to keep running things." "The substitute language on consumer protection is designed to paper over very real structural problems with a new system that is designed to fail as much as the status quo is," Warren said. "The whole idea of the substitute is to take a bunch of regulators that already failed and throw them in a committee together."

Asked if she thought Republicans such as Senate Minority Leader Mitch McConnell of Kentucky and Richard Shelby of Alabama are trying to protect families from predatory lenders, Warren let loose. "It isn't possible to protect families and at the same time to paper over the sorts of problems that led to the crisis with just another system that is designed to fail," she said of the duo leading the GOP effort against the consumer agency. "The time has come for choosing."

With Republicans abandoning their effort to prevent Dodd's bill from being considered on the Senate floor (the bill passed a procedural hurdle on Wednesday), senators will soon begin offering and debating amendments.
Shelby hopes to weaken the consumer agency. "This bill still contains a sprawling new consumer protection bureau that will find and force its way into facets of our economy that had nothing to do with the housing crisis," he said in a Wednesday statement. "This massive new bureaucracy would have unchecked authority to regulate whatever it wants, whenever it wants, however it wants. I am aware of no other arm of the federal government this powerful, yet so unaccountable."

On Tuesday, Shelby told reporters that the agency was "the biggest obstacle" keeping Democrats and Republicans from reaching a deal. McConnell also has attacked the agency, as has Democrat Ben Nelson of Nebraska. To dilute the agency's power, Shelby and others will push proposals to give bank regulators more authority to rein it in, like replacing it altogether or giving bank regulators stronger veto authority. The GOP proposal, for example, calls for the Fed chairman, currently Ben Bernanke, to be one of three leaders atop the consumer council.

"Can someone please ask Ben Bernanke if he actually wants to spend his time serving on that committee?" Warren asked. "How much time does he plan to carve out of his day to think about kickbacks on car loans or payday rollovers? "Let's give those issues to people who have the time and expertise to deal with them," she added. Sources who have been in meetings with Bernanke and have heard him discuss these issues privately say it's "very hard to believe that he has any real interest" serving on a consumer council like the one envisioned by the GOP.

Another way Republicans and bank-friendly Democrats will try to weaken the bill's consumer protection provisions is by repealing the portion of the bill that attempts to give states more power in going after big banks that violate consumers. At present, states are largely unable to thanks to an aggressive legal campaign over the past decade by the OCC. National banks like Wells Fargo, JPMorgan Chase, Bank of America and Citibank argue that it's too difficult and costly to comply with different consumer protection regimes in 50 states, so they need a national standard. The OCC agrees, and also touts the legal precedent set by numerous U.S. Supreme Court decisions interpreting the National Bank Act, the 19th-century law that forms the basis of the nation's banking system.

States and consumer advocates say the OCC protects big banks at the expense of consumers. State officials argue that the OCC essentially allows for consumers to be preyed upon and defrauded. The OCC vigorously denies the accusations. Warren points out, though, that other industries don't get the special treatment afforded to national banks. In his proposal last summer, President Obama said the bill should end the OCC practice, known as preemption.

"Walmart operates in all 50 states, and it doesn't come to Washington demanding that Congress protect it from state laws that demand workplace safety or environmental standards or anything else," she said. "Every other industry views compliance with state laws as a minor administrative cost of doing business. The big banks aren't worried about the difficulty of following local laws -- they have lawyers and computers to figure it out. Besides, thousands of little banks do it every day," she added.

In the House, bank-friendly Democrats led by Melissa Bean of Illinois watered down what was initially a strong provision that effectively neutered the OCC's authority to preempt state laws on everything from capping ATM fees to reducing overdraft charges and banning abusive home mortgage loans. The bill now essentially resembles the status quo. Bean touts her vote on the House bill, which passed in December, as one for reform. So do the other legislators who voted against giving states more authority to crack down on abusive lenders, yet ultimately voted for the bill.

"There were others that thought they could get away with voting for the overall reform package while doing everything they could behind the scenes to hold water for the big banks and earn all those campaign contributions," Warren said. "We're about to find out if any senators want to play those games." She hopes to find out soon.

"Every day that goes by without a clear set of rules in place to guide our economy into the future is a day that costs us money," she said. "Every credit card, payday loan, car loan and check overdraft that hides another fee or another bizarre interest calculation in the fine print costs American families. Every Too Big to Fail that takes on a little more risk, or leverages up just a little more, or that sucks capital away from another business that doesn't have a government guarantee at no charge costs American families. Every lousy product sold to a family, to a retirement fund, or to a local township costs American families. "We cannot rebuild a strong and reliable economy without new rules," she continued. "We need those rules now. Not next month, not in six months, not in a year. Now."

CDO fees flow to ratings agencies
by Aline van Duyn

Credit rating agencies are still being paid millions of dollars a year to report on the performance of collateralised debt obligations that have lost most of their value despite having been issued in many cases with triple A stamps of approval. The fees, known as "ratings surveillance" payments, are paid to the agencies ahead of any payments to investors under the terms of the CDO contracts – and without regard to how accurate the original ratings were. US regulators including the Federal Deposit Insurance Corporation have proposed new rules to link such fees to the performance of the underlying deals. This was not a common practice in the run-up to the financial crisis.

The terms of the CDO contracts highlight how lucrative these instruments were for the agencies, with annual pay-outs of up to $50,000 made to track deals. Such payments come on top of the fees received to rate the initial transactions. The fees paid to the rating agencies have become controversial following the collapse of so many securities that were issued with the highest ratings. A congressional investigation found last week that Moody’s Investors Service and Standard & Poor’s, the biggest rating agencies, were unduly influenced in assigning ratings on CDOs by the banks that paid these fees.

Ratings surveillance fees are still being paid on CDOs that have suffered "an event of default", meaning payments to some investors have ceased. Such CDOs often escape liquidation because of the complexity of the underlying contracts. Ramius, which handles CDO liquidations, estimated that 290 mortgage-related CDOs that have had an "event of default" have not been liquidated yet. As long as these CDOs are not liquidated, they typically allow for payments to service providers, including ratings agencies.

These payments are at the top of the "waterfall", the term used to describe the way money is passed through CDOs, which pool debts or securities and distribute the cash to investors. Even the most distressed CDOs often still generate some cash. From 2004 to 2007, Moody’s and S&P produced a record number of ratings and record revenues, primarily because they expanded their business rating mortgage-backed securities and CDOs. The liquidation of CDOs has created friction between investors in different tranches. In some cases the rights of various investors are not clear in the contracts underpinning the deals. These legal battles mean even toxic CDOs can continue to exist for many years.

US Ratings Firms' Influence Under Fire in Europe
by Stephen Fidler And Tom Lauricella

Europeans took aim Wednesday at debt-rating agencies, accusing them of worsening the plight of financially stretched governments such as Greece that are struggling with heavy debts. Standard & Poor's was in the line of fire Wednesday, as it downgraded Spain one notch to AA from AA-plus. This came a day after it provoked a selloff in financial markets around the world by cutting the ratings of both Greece and Portugal. Greece became the first of the 16 nations that use the euro to have its debt rated as "junk."

The downgrades came at a sensitive time as euro-zone governments and the International Monetary Fund attempt to fashion a financial-rescue package for Greece, which has yet to win approval by the German parliament. The ratings moves heightened fears that the package, even when finally delivered, wouldn't be enough to avoid a debt restructuring by Greece in which bondholders would be forced to take losses. S&P estimated that if Greece needed to restructure, investors would lose between 50% and 70% of their capital. "We have a vicious circle in the last few days with Greek debt," said Sylvain Broyer, economist with the French bank Natixis.

He said actions by ratings firms had been a reaction to previous sharp declines in government-bond markets, and were now a cause of further bond-market declines. "The behavior of the rating agencies is entirely pro-cyclical," he said. S&P defended the timing of its announcement, which it said is tied to decisions by its credit committee, a panel that makes the technical call on a rating. Once a decision is made, it is announced quickly to avoid the possibility of leaks. "Our policy is to release ratings decisions as soon as possible after they have been determined by our ratings committees," said Martin Winn of Standard & Poor's in London. He said that if ratings had influence in the market that was because investors regarded them as credible.

On Wednesday, the yield spreads between benchmark German 10-year bunds and Greek, Spanish and Portuguese debt of comparable maturities all widened. IMF chief Dominique Strauss-Kahn said it wasn't clear whether the rating firms were reacting to the financial markets, or vice versa. "You shouldn't believe too much what they say even if it may be useful," he said in Berlin. Ratings agencies have been strongly criticized for their role in the U.S. financial crisis, in particular over conflicts of interest and their failure to recognize the high risks inherent in complex structured products. They have also been panned for throwing fuel onto the fire of crises by belatedly ratcheting down ratings, stirring many investors to scramble to sell securities.

Many European investment institutions, like those in the U.S., are highly sensitive to debt ratings. Life-insurance companies typically seek to hold only very safe investments, which means that when bonds are downgraded to junk, they sell them. Many institutions have in-house rules that assign a percentage of a portfolio to top-rated triple-A bonds, and a smaller percentage to lower-rated double-A bonds and so on down the ratings ladder.

After a downgrade, the institutions adjust their holdings, selling the downgraded debt and seeking to replenish their quota of high-rated debt. Many rely on just one agency and for investors in government bonds that was most commonly S&P, Mr. Broyer said. Banks, also big investors in government bonds in Europe, are also sensitive to debt ratings. They are forced to increase the capital they must have as a cushion against losses if bonds they hold are downgraded to junk. This reduces their profitability, and encourages them to sell.

Another way the feedback loop between the markets and rating agencies can be extended is through portfolios tied to indexes mandating certain holdings of Greek debt—but only if the bonds maintain a certain credit quality. For example, the Barclays Euro Government Bond Index uses whichever rating is lower from S&P and Moody's. Greece has been 4% of that index but will be excluded starting May 1, due to S&P's downgrade. That in turn would likely force selling from investors tracking that index.

Some indexes have different methodologies. For Barclays Global Aggregate and European Aggregate indexes, inclusion is based on the middle rating among S&P, Moody's and Fitch. So while the S&P downgrade wasn't enough have Greece ejected from those Barclays' indexes, if either Fitch or Moody's downgrades Greek debt to junk, the country would be removed. Greece comprises 0.7% of the Global Aggregate and more than 2% of the widely followed European Aggregate.

In the U.S., the ratings agencies have been under significant scrutiny, including a year-and-a-half-long investigation by a U.S. Senate subcommittee. Questions have been raised about whether the agencies were too lenient in their evaluation of mortgage-related debts in order to win business from Wall Street firms. As with Greece, rating-firm actions reinforced market declines already under way, for example, with companies such as Lehman Brothers and American International Group, which both carried investment-grade ratings almost to the day they collapsed. The mortgage deal at the center of the recent civil-fraud charges against Goldman Sachs, known as Abacus 2007-AC1, was granted the highest rating possible by both S&P & Moody's. Within a year 100% of the bonds chosen for Abacus were downgraded.

Many U.S. institutional investors, such as pension funds and mutual funds, retain guidelines on the credit quality of securities that they can hold and a downgrade from S&P or Moody's to junk status can force selling. But in the wake of the financial crisis, there have been some moves away from relying on their ratings. Insurance companies, for example, have traditionally leaned heavily on the major bond-rating agencies when deciding how much capital should be held to guard against potential losses on bond holdings.

Now the National Association of Insurance Commissioners, an influential organization of state insurance regulators, is moving ahead on a proposal to have an outside firm assess the risk on residential and commercial mortgage-backed securities rather than rely on the ratings agencies. In 2009, it hired giant bond fund manager Pacific Investment Management Co. to estimate expected losses in residential mortgage-backed debt.

In Brussels, answering questions at a news briefing yesterday from reporters critical of the rating firms, Chantal Hughes, a spokeswoman for the European Commission, the European Union's executive arm, said it expected firms to take account of the joint IMF-euro-zone rescue package. "We of course expect that credit-rating agencies, like other financial players, and in particular during this difficult and sensitive period, act in a responsible and rigorous way," she said. New EU regulations aimed at avoiding conflicts of interest, and increasing information about the agencies' rating methods are due to go into force in December.

Time to rein in the rating agencies
by John Gapper

Goldman Sachs executives suffered a marathon grilling in front of the Senate investigations subcommittee on Tuesday. But just as important a hearing of the body – arguably more important – occurred last week. The organisations on political trial last Friday were the ratings agencies Moody’s and Standard & Poor’s, which played a more central role than any investment bank in the failure of so many investment-grade securities. If all the subprime mortgage securities they rated triple A had not turned to junk, no bail-outs would have been required.

The stories that former Moody’s and S&P employees told at that hearing – of the agencies trying to please investment banks that were paying big fees to get high ratings – cast doubt on a central plank of how the fixed-income markets are supposed to work. Why should investors place faith in these over-rated bond market guardians again? Ratings agencies have been criticised in past crises – most recently in the aftermath of Enron’s collapse – for lending their approval to dubious bonds and issuers.

Their failings in the housing bubble were much greater. Yet, despite shareholder lawsuits against the agencies and some political heat, there is little sign that their quasi-official status – or their business models – will be substantially changed. The financial reform bill that is still blocked on Capitol Hill has placed other priorities, such as derivatives regulation, above them. That is unfortunate. If the crisis proves anything, it is that the agencies enjoy too much authority among investors and regulators. Any reform that would loosen their grip on bond markets deserves a shot.

This was a triple-A crisis. The banks and insurance companies that came close to failure believed so implicitly in the safety of "super-senior" mortgage debt that they were willing to stuff their balance sheets with it. They would never have taken such a punt on high-yield securities or equity tranches of collateralised debt obligations (CDOs). In the case of Goldman, it managed to get the Abacus 2007 deal, over which it is accused of securities fraud, rated as investment grade by the agencies. That sufficiently reassured IKB, the German bank with a long position on the deal, and the bond insurer ACA, that they took on the risk that Abacus’s senior tranches would fail – as they did.

The ratings failures went beyond synthetic mortgage CDOs. James Robinson, a non-executive director of the pharmaceuticals company Bristol-Myers Squibb, recounted at the Milken Global Conference in Beverly Hills this week how BMS’s audit committee had questioned its treasury staff about whether they were making any risky investments. "They said everything was in treasuries and nothing more than 90 days [maturity], triple A. What were they in to the tune of $800m? Auction rate notes, triple-A rated by the agencies," he said. Mr Robinson said that this cost BMS $600m when the auction rate note market collapsed in February 2008.

It is not only investors and companies that have placed too much reliance on bond ratings. The ratings agencies were first given official status by the Securities and Exchange Commission in 1975 as a means for regulators to assess capital charges for broker-dealers. Since then, their influence has spread into unexpected quarters. American International Group’s financial products unit, which used its triple-A rating to insure CDOs for banks, offered them a regulatory arbitrage based on ratings. The banks that wrapped senior debt tranches with AIG did not have to set aside so much regulatory capital.

In all kinds of ways, ratings agencies have extended their grip and lulled investors and institutions into a false sense of security. "Throughout the world, the ratings agencies were instrumental in building up a house of cards. They were behind the scenes everywhere you looked," says James Barth, a senior fellow at the Milken Institute. What should be done about it? A place to start would be to remove their "regulatory licences" – the status of Nationally Recognised Statistical Rating Organisation – or at least to open the status up more broadly. That might worry regulators who like some official seal of approval, but it would also reduce the halo effect.

Frank Partnoy, a law professor at San Diego University, argues that there is an alternative market mechanism for judging risky investments in credit default swap spreads (which have proved better predictors of forthcoming defaults than ratings). Instead of being told to invest in only triple-A securities, investors could buy bonds with low swap spreads. He also argues in favour of removing the protection that ratings agencies enjoy under US securities law from investor lawsuits relating to securities they rate before they are underwritten. At the moment, they are far more protected than banks or accountants.

Last, politicians and regulators must take a long, hard look at the conflict of interest in agencies being paid by issuers, and so having an incentive to boost ratings. The subcommittee heard stories of analysts being placed under strong pressure to "maintain market share". None of these reforms would be easy to implement. Some have been mooted in previous crises without any big changes to the status quo. But this crisis was of a severity beyond others in the past, and triple-A securities were at its heart. It is time to curb the power and influence of the agencies behind them.

Euro Rises After I.M.F. Boosts Pledge to Aid Greece
by Landon Thomas Jr. and Nicholas Kulish

European stocks rose modestly and the euro halted its decline Thursday, a day after the International Monetary Fund promised to increase the 45 billion-euro aid package for Greece to as much as 120 billion euros over three years to quell the fund’s biggest crisis since the Asian woes of 1997. The fund is racing to conclude an agreement for more painful austerity measures from Greece by Monday, clearing the way for the government to receive funding and reassuring investors worldwide that European debt is safe.

On Wednesday, Dominique Strauss-Kahn, the I.M.F.’s forceful managing director, made the higher aid pledge in a private meeting with German legislators. The package would be the equivalent of up to $160 billion and would come from both the I.M.F. and from other countries using the euro. But as has frequently been the case during Europe’s debt crisis, the promise of help was overshadowed by more disturbing news — in this case a cut in the debt rating of Spain by a major agency just a day after downgrades for Portugal and Greece.

The growing fear is that the fallout from Greece and even Portugal — which together compose just 5 percent of European economic activity — could be a mere sideshow if Spain, with its much larger economy, has difficulty repaying its debt. In European morning trading, the euro was at $1.3237, up slightly from $1.3220 late Wednesday in New York. The Euro Stoxx 50 index, a barometer of euro-zone blue chips, rose 0.8 percent, and the FTSE-100 index in London rose 0.5 percent. Trading in U.S. index futures suggested Wall Street stocks would open slightly higher, after the Dow Jones industrial average rose 53 points Wednesday to close at 11,045.27.

Most major Asian markets fell, with both the Hang Seng index in Hong Kong and the S&P/ASX 200 index in Sydney dropping 0.8 percent. Tokyo markets were closed for a holiday. In many ways, the current troubles in Europe go to the heart of the fund’s new mission to serve as a firewall in the financial crisis — an objective that was bolstered by $750 billion in fresh capital from Group of 20 countries last year. Unlike its previous efforts in smaller, emerging economies in Asia in 1997, and more recently in Hungary, Romania, Latvia and Iceland, the fund has been hamstrung in its efforts to act quickly and decisively by political concerns within the European Union, which insists on assuming a leading role.

"It is a problem," said Alessandro Leipold, a former acting director of the I.M.F.’s European department. "It should not be that difficult — they did it in Hungary and Latvia. But the egos are different in industrialized countries." A case can be made that if Greece had sought help from the fund late last year after the forecast for its budget deficit doubled, the amount of support needed to reassure investors would have been much less than the 120 billion euros that even now might not be enough. In that vein, Mr. Leipold said Portugal and Spain should ignore any stigma associated with an I.M.F. program and make the case to the European Commission in Brussels that asking proactively now for aid would soothe skeptical markets and save Europe billions in the future. "The market has seen its worst fears come true," he said. "What it needs is a surprise on the upside."

Concerns have already surfaced in Congress that the broad demands of the sovereign debt crisis will quickly exhaust the I.M.F.’s reserves and leave the United States, the fund’s largest shareholder, with the bill.
Representative Mark Kirk, a Republican from Illinois, said such a drain could occur if Portugal, Ireland and Spain sought I.M.F. aid at the same time. Mr. Kirk worked at the World Bank during the 1982 debt crisis in Mexico, which came close to depleting the fund’s reserves. "We have seen this movie before," he said. "Spain is five times as big as Greece — that would mean a package of 500 billion." Mr. Kirk sits on the House Appropriations Committee that oversees I.M.F. funds and said that he had already asked for hearings on the fund’s ability to handle a European collapse.

In Athens, the Greek government had no choice but to seek an I.M.F. solution after its costs of borrowing skyrocketed, but that has not made the negotiations for aid any easier. The fund has sent one its most senior staff members, Poul Thomsen, who has overseen complex fund negotiations in Iceland and Russia, to assist Bob Traa, the official responsible for Greece, to work out a solution. According to people who have been briefed on the talks, the aim is to secure from Greece a letter of intent for even deeper budget cuts than the tough measures imposed so far, like reductions in civil service pay, in exchange for emergency funds.

Steps being discussed include closing down parts of the little-used Greek railway system, which employs 7,000 people and is estimated to lose a few million euros a day; limiting unions’ ability to impose collective bargaining agreements, which lead to ever-higher public sector pay; cutting out the two months of pay that private-sector workers get on top of their annual pay packages; increasing the retirement age and cutting back on pensions; and opening up the country’s trucking market in an effort to lower extremely high transportation rates that have hindered the country’s competitiveness. With Greece now shut out of the debt markets, it has little leverage to resist — especially in light of the 8 billion euros it needs to repay bondholders on May 19. Analysts expect a deal by next week at the latest.

But whether a Greek resolution calms investor fears about the ability of Portugal and Spain to repay their own maturing debt remains unclear. In a recent note to investors, Ray Dalio, founder of Bridgewater Associates, one of the world’s largest hedge funds, described the market concern as intensely focused on Spain. "Spain’s cash flows (current-account and budget deficit) are extremely bad," Mr. Dalio and his colleagues wrote in a February letter. "Spain’s living standards are reliant on not just the roll of old debt, but also on significant further external lending. For these reasons, we don’t want to hold Spanish debt at these spreads."

Euro Decline is Slow and Steady
by Katie Martin

Amid all the stress on the euro system right now, one thing stands out: the currency isn't in free-fall. Greek bonds are getting hammered as investors take fright at the euro-zone member's crushing debt problem. Bonds from other indebted states like Portugal and Spain are also tumbling fast. But even as the currency has nudged down to fresh one-year lows against the dollar Wednesday, and despite noisy predictions of its imminent demise, the euro's decline has been remarkably slow and steady. Indeed, in all, it has shed only 3% of its value against the dollar in the past two months -- a modest decline even compared with its 6% thrashing in the first three weeks of December.

It's not that traders like the euro. Instead, the reason for this stability is that the currency has now been flogged so hard for so long that there's now a huge buildup of negative bets. That pressure makes traders nervous that a very sharp turnaround could be around the corner -- something that is bugging other currencies now, too. "Unless people become much more favorable towards the dollar, we don't expect the euro to keep falling. It already has a large risk premium priced in," said Michael Sneyd, a currencies economist at Barclays Wealth in London.

That view may sound overly relaxed. Many analysts are extremely gloomy about the euro's prospects, judging that even aside from the short-term strain that the currency suffers as the European sovereign crisis gathers momentum, the long-term picture for the euro is grim. "Any euro rebound remains an aggressive sell," said analysts at French bank BNP Paribas Wednesday. The bank expects to see the euro sink to $1.2650.
Stress in Greece, Portugal and elsewhere will probably keep euro-zone growth and interest rates super-low for the long haul, pessimists point out. Once other key interest rates streak ahead, the euro will surely tumble, they say.

Moreover, heavy-hitting long-term investors such as central bank reserve managers are likely to take a dim view of the lack of coordination within the euro zone in dealing with the Greek issue. Without support from these kinds of investors, the euro would probably trade at around $1.20 -- far below current levels of around $1.32. Still, even with all those well-known negative factors in the background, the currency still isn't tumbling in a meaningful way.

A heavy buildup of identical bets is the key reason. Despite the currency's relatively slow decline in the past two months, the euro has already fallen by nearly 13% against the dollar since the start of December. That means firstly that most euro bears have already placed their bets. It also means that the fear of some or all of these bets suddenly folding makes it difficult for new would-be sellers to dump the currency with confidence.

"Last week we saw a rebound in the euro, and people are worried that if they sell the euro now, they might meet something like that on the other side again," said Jeremy Stretch, a currencies analyst at Rabobank in London. A positive signal, such as the delivery of aid to Greece by the European Union and the International Monetary Fund, or even clarification on the rescue's terms, could easily trigger a sharp recovery in the currency, Stretch added. That view was echoed by Stephen Jen, a currencies investor at hedge fund BlueGold Capital in London. "The euro is held back by conflicting forces. The worse the situation gets, the more the chance that the IMF might come in with another 'shock and awe' move. So we're in a tug of war."

This sort of stickiness in the currencies market isn't restricted to the euro. On the flip side, currencies that have performed well of late -- generally those from countries that export commodities -- are running into similar buffers as they climb. "The Australian and Canadian dollars are already expensive, which limits scope for further appreciation," said Sneyd at Barclays Wealth. "The expected returns from [buying these] commodity currencies are not that compelling, while the downside risks are quite large."

This suits some currencies investors, many of whom have already made handsome returns in the opening weeks of this year. "I'm glad everything is moving more gradually now. It's better than having sharp moves," said Thanos Papasavvas, one such investor at Investec in London. For euro bashers, though, the next few weeks and months may be tougher than one might imagine.

Roubini: Euro Zone May Collapse Within Days
by Dan Weil

New York University economist Nouriel Roubini says the euro zone’s days may be numbered, and he’s not talking about some day far off in the future. "In a few days, there might not be a euro zone for us to discuss," he said at a Los Angeles conference sponsored by the Milken Institute, Reuters reports. European policy makers may have to fork over 600 billion euros ($794 billion) in aid or buy government bonds to erase the debt crisis, economists tell Bloomberg.

Roubini says Greece can’t come up with the 10 percent spending reduction necessary to prevent its debt from exploding out of control. And even if it could, its economy would get ruined in the process, he maintains. Roubini compares Greece to Argentina in 2001, shortly before it defaulted on its debt. Greece’s budget deficit, at 13.6 percent of GDP, is much higher than Argentina’s back then. Greece’s debt-to-GDP ratio and current account deficit also are much higher, Roubini points out.

The solution, Roubini says: a debt restructuring that reduces interest rates and extends maturities. In addition, Greece should exit the euro, he says. Roubini’s not the only one calling for drastic measures. "It may now be time for the euro area to do something much more dramatic in order to prevent the stress from creating another broad-based financial crisis which pushes the region back into recession."David Mackie, chief European economist at JPMorgan, told Bloomberg.

Now It's a European Banking Crisis
by Simon Kennedy, Niklas Magnusson and Fabio Benedetti-Valentini

For months the top leaders of the European Union resisted the idea of a bailout for Greece, wringing their hands over the estimated $61 billion cost. While the jawboning continued, the infection took hold. Bond vigilantes drove the Greeks' borrowing costs into the double digits. Investors, fearing a contagion in Europe's southern tier, dumped the stocks and bonds of Portugal and Spain. As it spread, markets started to pummel European banks and insurers for their exposure to what could prove to be one of the worst sovereign debt disasters ever. A bank crisis and a debt crisis rolled into one—the medical bills for this extreme case will make Europe long for the modest $61 billion of just a few weeks past.

Europe's banks and insurers hold some $193 billion in Greek debt. That's a fair piece of change, but it's no longer the central issue. For one thing, the debt is distributed among dozens of companies. Commerzbank and ING each hold $3.9 billion in Greek government debt. Writing off 50% of that would hurt, but it wouldn't send a major European banking institution toppling. The bigger issue is metastasis. Nomura International analyst Daragh Quinn noted, "Sovereign risk concerns are spreading to Portugal and Spain, as witnessed by a widening of bond spreads in these countries." In late April, ratings agency Standard & Poor's not only downgraded Greek debt to junk, it knocked Portuguese sovereigns down two notches as well, and lowered Spain the next day.

Since investors are now worried about the fiscal health of the weaker European players, the borrowing costs of the Spanish, Portuguese, and Irish governments are jumping. Each of these countries may ultimately be forced to seek a bailout and break its pledge to pay off its debts in full.

Banks' Exposure
Even if the worst doesn't come to pass, Europe's banks will have a lot of pain to absorb through writedowns of billions in bonds and loans. Belgian-Dutch insurer Fortis, for example, holds $5.4 billion in Greek government debt—and $4.1 billion of Portuguese government debt, according to bank statements and public documents. Europe's banks aren't saying how much in vulnerable debt they hold overall, but it adds up. The banks' exposure to Portugal comes to $240 billion; exposure to Spanish debt is another $832 billion. Some of the big banks are also heavily involved in Greece. France's Crédit Agricole and Société Générale have big stakes in Greek banks. SocGen's Greek affiliate has lost money every year since 2003.

The second Greek problem for the banks is the collateral issue. The European Central Bank keeps the Continent's banking system functioning day by day through short-term loans to commercial banks. In these cases the ECB usually accepts the banks' holdings of government bonds as collateral. Greek debt is now rated as junk by S&P: Under current ECB rules, Greek bonds can't be used as collateral by the ECB if Fitch Ratings and Moody's Investors Service cut them to junk as well.

The Frankfurt-based central bank may have to dilute its collateral rules to keep the Greek banks operating. The ECB's problem of securing solid collateral for its loans will expand greatly if Spain and Portugal lose their investment-grade status, too. In the view of Jacques Cailloux, chief European economist at Royal Bank of Scotland Group, the central bank may have to start accepting all government debt regardless of its rating and revive last year's policy of lending unlimited amounts for periods up to a year to support the region's banks.

Continental Contagion
The final problem for the banks is an indirect one. On Apr. 27, the day S&P downgraded Greek debt, shares in London-based Lloyds Banking Group slid 8%. Lloyds doesn't have any "material exposure" to Greece, Finance Director Tim Tookey told analysts. That won't matter if panicked investors go on strike and stop buying financial securities of any kind in Europe. "It's all about sovereign risk," says Andrew Lim, an analyst at Matrix Corporate Capital in London commenting on the decline in Lloyds shares. "Ultimately it could lead to contagion for funding costs, and Lloyds is going to be hit."

The fear of a monumental banking crisis is triggering calls for an EU-led bailout that goes beyond Greece. "It is perhaps time to think of policy options of the last resort," says David Mackie, chief European economist at JPMorgan Chase in London. "It may now be time for the euro area to do something much more dramatic." What Mackie has in mind is akin to the Troubled Asset Relief Program that supplied hundreds of billions in assistance to the top U.S. banks, while in Europe's case governments would be the beneficiaries. Mackie calculates that in a worst-case contagion, supporting Spain, Portugal, Ireland, and Greece may cost 8% of the euro zone's GDP. That's equivalent to about $792 billion.

"This is a big number, but the region has the fiscal capacity to backstop both banks and these countries," says Mackie. The alternative—an unplanned series of sovereign defaults and an implosion of the banking system—could be far worse.

Greek crisis endangers private sector
by Mohamed El-Erian

I suggested last week, in what seemed like a counter-intuitive phenomenon to some, that sharply lower prices for Greek bonds would bring out sellers rather than buyers. Such sellers, and there are potentially too many of them, would be reacting late to the recognition that "safe" instruments that they bought for their "interest rate bucket" have turned out to be something else – namely, volatile credit exposure that is subjecting them to both financial loss and reputational damage.

No wonder late-moving sellers have been looking over the past few days to reduce their holdings of Greek bonds. This has accentuated market volatility and illiquidity. Combined with this week’s downgrades in the credit ratings of peripheral European countries, the result has been a dramatic sell-off in European equities, a further disorderly widening in sovereign risk spreads and pressure on the euro.

The Greek debt crisis is now morphing into something much broader. No wonder the European Union and the International Monetary Fund are scrambling to regain control of the rapidly deteriorating situation. There is talk of a bigger bail-out package for Greece. The heads of the European Central Bank and IMF have made the trip to Germany that is reminiscent of the Ben Bernanke-Hank Paulson trip to Congress in the midst of the US financial crisis.

Markets are now catching up to the reality of over-burdened public finances in the aftermath of the global financial crisis. These developments are of particular concern to countries with elevated debt levels and challenging maturity profiles for this debt. Indeed, absent some dramatic change in sentiment, they will need to worry not only about their ability to mobilise new funding from the private sector at reasonable cost, but also about keeping their existing creditors on board. As a result, credit downgrades will multiply. And once a package is approved for Greece, there will be questions as to whether similar packages can be secured for other vulnerable countries in the European Union.

So, what else should the "official sector" be doing in its urgent quest to find a circuit breaker for the widening European crisis? A number of things have to happen very fast over the next few days to have some chance of salvaging the situation. At the very minimum, the government in Greece must come up with a credible multi-year adjustment plan that, critically, has the support of Greek society; EU members must come up with sizeable funds that can be quickly released and which are underpinned by the relevant approval of national parliaments; and the IMF must secure sufficient assurances from Greece (in the form of clear policy actions) and the EU (in the form of unambiguous financing assurances) to lead and co-ordinate the process.

This is a daunting challenge. The numbers involved are large and getting larger; the socio-political stakes are high and getting higher; and the official sector has yet to prove itself effective at crisis management. Meanwhile, the disorderly market moves of recent days will place even greater pressure on the balance sheets of Greek banks and their counterparties in Europe and elsewhere. The already material risks of disorderly bank deposit outflows and capital flights are increasing. The bottom line is simple yet consequential: the Greek debt crisis has morphed into something that is potentially more sinister for Europe and the global economy. What started out as a public finance issue is quickly turning into a banking problem too; and, what started out as a Greek issue has become a full-blown crisis for Europe.

Absent some remarkable change in the next few days, things will get even more complex for the official sector. It may have no choice but to combine its own exceptional financing efforts with talks on a controversial approach that will be familiar to veteran emerging market observers – PSI, or "private sector involvement". PSI is the polite way to talk about the restructuring of some of the sovereign debt held by the private sector. It is based on a concept of burden-sharing in a disorderly world. It can appeal to governments as a seemingly easy way to ensure that massive public sector support to crisis countries does not flow back out in the form of payments to private creditors. Yet PSI is also hard to design comprehensively, harder to implement well and involves collateral damage and unintended consequences.

Mohamed El-Erian is chief executive and co-chief investment officer of Pimco

Max Keiser: The IMF is a Financial Mafia
by Vassili Daliani, translation Helen Skopis

At a time when Greece is being dragged through the mud by the international press, Max Keiser, one of the most radical and outspoken financial analysts, stands by our side and talks openly about a "financial mafia" and "financial terrorists" that drove this country to its destruction.

As a former Wall Street broker for almost 25 years, he knows how the financial system operates. Max Keiser had foreseen the financial collapse of Iceland, he asks for the arrest of Goldman Sachs bankers and encourages Greeks to hold a referendum on whether the country should turn to the International Monetary Fund.

He is a presenter of financial shows on major worldwide TV networks, including the BBC, the English Al Jazeera and Russia Today. Max Keiser told "THEMA" that the government’s measures are unsubstantial maintaining that the IMF will impose the real measures. He believes that Greece is a country that will be sacrificed by the international markets and urges the Greek people to fight this prospective.

PT: Is the International Monetary Fund Greece’s only solution, or are there other alternatives?

MK: The only solution for Greece is to arrest the Goldman Sachs bankers immediately and all those involved in the fabrication of Greek economic data in 2000, when you became a member of the eurozone. The next step is to nationalize all banks like Sweden did in 1993. The International Monetary Fund is that last thing you need. You will lose your sovereignty. It exercises terrorism. You will be raped in such a way, that it will be the worst pain you have ever felt.

PT: There are those who believe that the IMF is not the "bad wolf" but the only solution for Greece

MK: If someone burns down your house in order to sell you charcoal, would you consider this logical? That is exactly what Goldman Sachs did to the Greek economy. They burned you down like arsonists and then they tell you not to worry they’ll give you charcoal. It’s outrageous. The IMF has said that it can provide Greece with help. The Wall Street investment hedge funds are attacking Greece’s bond market so that the Greek economy collapses. And they’re doing this for a simple reason; to force the Greek people to ask for help from the IMF. The IMF will say, we came because you asked for our help. Wall Street bankers work very closely with the IMF. It’s a financial mafia and the hedge funds are the assassins. Research conducted on Goldman Sachs in the USA and in Europe show how big a mafia it is. They are involved in illegal activity throughout the world.

PT: Where is the European Union? How would you explain the stance of France and Germany?

MK: Germany is on the side of the Wall Street bankers. Germany doesn’t care about Greece or the euro. The euro replaced a cheap capital in order to uphold competitiveness in its export market. As long as Greece is a problem, the euro falls, which is something that is in Germany’s interest.

The European Union and the euro are competing with the dollar. Unfortunately, the crisis will destroy the euro. The financial terrorists on Wall Street intend to destroy Portugal, and other countries, after Greece. The destruction of the euro will allow the dollar to be the only international currency, the only fiscal reserve. If a country wants to buy petroleum, it must purchase dollars first. If a country wants to buy copper, it must purchase dollars first. Because these and many other commodities are only sold in dollars. This means that the U.S. is making a continuous profit. The whole world is obliged to buy dollars. The euro threatened the empire of the dollar. It was naturally not appreciated by Wall Street bankers. They are using the crisis to destroy the euro. The Greek people must stand up to the bankers, just like the Icelandic people did.

What do you propose? How can we manage to borrow from the markets?

MK: You should hold a referendum just like they did in Iceland. 93% of the Icelandic people decided not to give some bankers 5 billion euros. You have to decide if you want the IMF in your country. Your government does not have the mandate to go ahead with this. Do they consider you stupid and that is why they aren’t asking you for your opinion? Do they believe you’re babies and that you don’t have the right to voice your opinion? That you can’t decide for your own lives? Ask for a referendum. Do you want the IMF in your country or not? You have the power. You have to fight. If a referendum is not held then you need to have elections. Nationalize all banks immediately, create two or three state banks and restructure your economy. Just look at what Sweden implemented in 1993.

Greece Will Need up to €135 Billion
The aid package for Greece from the European Union and the International Monetary Fund (IMF) will amount to €135 billion ($179 billion) over the next three years, according to an announcement made Wednesday by German Economy Minister Rainer Brüderle. Under the current arrangement, Germany is supposed to annually contribute €8.4 billion to the package. But, according to Brüderle, the figure could go much higher. "I can't exclude the possibility that the amount will be higher," he told reporters while on a trip in Sao Paulo, Brazil.

Germany's opposition had already stated that Greece would need up to €120 billion over three years. This was the figure that Thomas Oppermann, a senior official in the parliamentary faction of the center-left Social Democratic Party (SPD), and Jürgen Trittin, the head of the parliamentary faction for the Green Party, had named after meeting earlier Wednesday in Berlin with European Central Bank (ECB) President Jean-Claude Trichet and International Monetary Fund chief Dominique Strauss-Kahn.

Trittin added that the €45 billion in loans for 2010 was just the beginning and that, in the end, everything depended on a consolidation requirement in the order of between €100 billion and €120 billion. For his part, Oppermann stated that this meant that the €8.4 billion that Germany was expected to have to contribute this year will actually be up to €25 billion, calling the situation "dramatic, but not uncontrollable."

Merkel Rebukes Charges of Hesitating
Trittin also took the occasion to blast Chancellor Angela Merkel. "The indecisiveness and dithering of the European Union, instigated by the chancellor, have exacerbated the crisis and driven the consolidation requirement into the heavens." As he sees it, it's time for immediate action. Oppermann also cited IMF estimates, communicated to him by IMF chief Strauss-Kahn, that suggest that the EU has waited far too long to manage the crisis.

Chancellor Merkel vehemently denied the opposition's accusations of hesitancy. Her deputy spokeswoman, Sabine Heimbach, told reporters Wednesday that: "From the very beginning, the chancellor has marked out a clear course of action together with her colleagues in the Eurogroup," referring to the body made up of the finance minister of countries belonging to the euro zone, and that Merkel's behavior had been "absolutely clear and in line with her course of action." And in an obvious reference to the repeated criticism from abroad about Germany's role, Heimbach added that the chancellor had "always given solid assurances" that she would help Greece given certain preconditions.

In terms of domestic politics, the question is now when the Bundestag, the lower house of the German parliament, will be able to approve the aid package for Greece and whether the opposition will allow an accelerated process. Oppermann said he could not imagine that "the Bundestag will agree without drastic measures on the currency and financial markets." He assumes that other parliamentary groups will not agree to a "blank check" that could encourage other countries to follow Greece's example.

The ECB and the IMF, on the other hand, are urging the Bundestag to approve the aid quickly. Strauss-Kahn said on Wednesday that trust in the euro zone is at stake, and that every day of hesitation only makes the situation worse. Trichet added that a speedy decision by the Bundestag is urgently required.

Merkel Waits on IMF Negotiations
The IMF and ECB are also putting Greece under massive pressure to pass a three-year savings plan as quickly as possible in order to stave off bankruptcy. It is extremely important that the talks in Athens are concluded within the next few days, Trichet said, adding that he was certain things would end well. He also stated that a rapid decision on the international aid package for Greece was absolutely urgent, given the fact that the country has until May 19 to secure €8.5 billion it owes to investors and thereby avoid insolvency.

Chancellor Merkel wants to await the results of the direct negotiations between the IMF and Athens on its savings plan before making any more decisions about the financial crisis. "At the moment, we now have a phase in which the International Monetary Fund and the European Commission have to work out a program with Greece," she said. "I hope that this will happen by the end of the week. Everything else depends on that."
Merkel's cabinet will draw up legislation on the German aid package for Greece on Monday at the earliest. The spokeswoman for the Finance Ministry, Jeanette Schwamberger, said that the draft legislation would be discussed on Monday in the cabinet so that the consultations with the Bundesrat, Germany's upper house of parliament, could be concluded by May 7.

The Euro Zone Needs New Rules
by Peter Bofinger

Europe is in the worst crisis of the postwar era. For months, the governments of the European Union member states have proven to be incapable of developing a convincing solution for the serious debt problems of individual countries, as well as for the reduction of imbalances within the monetary union. Uncertainty among investors has grown in recent weeks, which is primarily attributable to the helplessness of political leaders, and only secondarily to the influence of speculators.

The banking crisis of the fall of 2008 teaches us that case-by-case bailout packages approved in response to market pressures fail to have the desired effect in the event of a massive crisis of confidence. At the time, it took the comprehensive approach of the Financial Market Stabilization Act to finally bring about stabilization in Germany. Today, the euro zone needs a common strategy that successfully combines sound public finances with solidarity between member states. On the one hand, the member states must be protected against the excesses of the financial markets. On the other hand, steps must be taken to ensure that the solidarity of member states doesn't undermine efforts to achieve fiscal consolidation in individual countries. In other words, what is needed is the appropriate balance of support and requirements.

A European consolidation pact should serve as the basis of the "requirements" part of the equation. It would obligate all member states to formulate a consolidation strategy designed for the medium term, which would determine, based on concrete and publicly verifiable measures, how the return to a largely balanced budget could be achieved. Instead of deficit targets, which are often difficult for politicians to monitor, spending paths and mandatory timetables for tax increases should be established and, if necessary, the criminal code for tax offences should be tightened.

The advantage of such a pact, in addition to enabling the monitoring of national commitments, would be that a coordinated approach for the euro zone would make it possible to determine the extent of the overall negative effect on demand caused by the consolidation. This would make it possible to prevent a collective over-consolidation from leading to yet another economic downturn and, ultimately, to even higher deficits. If necessary, a slower consolidation process ought to be considered for countries in a relative strong fiscal position, so as to avoid stalling the euro-zone economy.

Common Financing Mechanism
The basis of the "support" principle should be a common financing mechanism with facilities available to all countries that abide by the measures stipulated under the consolidation pact. To avoid excessive use, funds provided by the mechanism should, as a matter of principle, be disbursed with an interest rate that is 150 basis points higher than the benchmark rate. For a country like Greece, this would represent a substantial saving in terms of interest costs. If a country failed to abide by the consolidation requirements, its access to these funds, with their preferential interest rates, would be blocked immediately.

To ensure sound fiscal policy in all member states in the long term, an additional sanction mechanism would have to be incorporated into the Stability and Growth Pact. For countries that show an "excessive deficit," the community would have to be granted, in national constitutions, the possibility of adding a surcharge to the national income tax or value-added tax. The advantage of such a measure, as opposed to the sanctions currently provided for under the Stability and Growth Pact, is that it would reduce, rather than increase, an individual country's problems.

The future of the monetary union, however, depends on more than just solving the current debt crisis. An improved balance of growth is also needed, and Germany plays an important part in that respect. The fact that domestic consumption in the largest euro-zone member has been stagnant for more than a decade is a state of affairs that is unacceptable for the entire system. Anyone who sees this as a virtue must ask themselves whether Germany's export successes would have been possible if other countries had behaved as "virtuously" as we have. It says a lot about the level of the debate that such simple and fundamental insights are apparently difficult to get across in Berlin. There is no other way to explain the current approach of waiting for an upturn in exports, in the hope that that will revive our economy again.

Without massive efforts on our part to create a more dynamic domestic economy in Germany, the euro zone has no future. Anyone in Germany who still believes that losing the euro wouldn't be such a bad thing fails to recognize how important the euro zone is as a market for our industry. But Europe's future is also at stake. A failure of the monetary union would call the whole European project into question. European integration has made it possible to transform a continent devastated by wars into a place of peace and prosperity for over half a century. In other words, it's not just money that is at stake today. It's also a question of political stability in Europe.

Spain’s Rating Cut to AA by S&P as Contagion Spreads
by Emma Ross-Thomas

Spain had its credit rating cut one step by Standard & Poor’s to AA, putting it on a par with Slovenia, as contagion from Greece’s debt crisis spreads through the euro region. S&P said in a statement today that its outlook on Spain is negative, indicating possible further downgrade if the "budgetary position underperforms to a greater extent than we currently anticipate." Spain, which has the euro-region’s third- largest deficit after Ireland and Greece, was last cut by S&P in January 2009.

The risk premium investors demand to hold Spanish bonds surged to the highest in more than a year today and the price of insuring Spanish bonds against default reached a record as concerns about Greece’s ability to pay its debt spilled over into Spanish and Portuguese markets. S&P’s move on Spain follows yesterday’s downgrades of Portugal and Greece, which the rating company cut to junk status, the first euro-region country rated less than investment grade since the start of the euro. The cut was announced as EU policy makers pushed to speed distribution of 45 billion euros ($59 billion) in emergency aid already pledged to Greece by the euro region and the International Monetary Fund on April 11.

IMF Managing Director Dominique Strauss-Kahn said in Berlin today he’s "really confident" the terms of the loans will be agreed on quickly and said further delays would cause "a lot of consequences on the rest of the European Union." The extra yield investors demand to hold Spanish debt rather than German equivalents rose to 112.5 basis points today, the highest in more than a year. Spain’s benchmark Ibex-35 stock index fell 3 percent and the euro slipped to a one-year low, trading at 1.3136 at 4:43 p.m. in London.

S&P said that the rise in Spain’s borrowing costs and a recession that would likely be prolonged would make it difficult to reduce a deficit that reached 11.2 percent of gross domestic product last year, more than three times the EU limit. "We now project that real GDP growth will average 0.7 percent annually in 2010-2016," S&P said. "Increases in Spain’s borrowing costs, beyond what we factor into our base case, could in our opinion also reduce the government’s ability to meet its fiscal targets this year and next," it said.

Spain is rated Aaa by Moody’s Investors Service and AAA by Fitch Ratings, and Win Thin, a senior currency strategist at Brown Brothers Harriman & Co in New York said more downgrades would follow. "Spain is the 800 pound gorilla in the room," he wrote in a note. "Greece and Portugal are small countries, but Spain is about five times their size with regards to GDP." Spain’s 1.1 trillion-euro economy is more than four times the size of Greece’s and more than six times that of Portugal.

S&P said Spain was underestimating its fiscal problems and overestimating its growth prospects. It expects Spain’s budget deficit to exceed 5 percent in 2013, the year Finance Minister Elena Salgado has pledged to cut the shortfall to within the EU’s 3 percent limit. The public debt burden may rise to 85 percent of GDP in 2013, from 40 percent in 2008, S&P said. S&P’s growth forecast contrasts with the government’s estimate that the economy will expand 1.8 percent in 2011, 2.9 percent in 2012 and 3.1 percent in 2013. S&P downgraded Portugal two notches yesterday and cut Greece’s rating three places to junk, saying bondholders may recover as little as 30 percent of their investments if the euro-region’s second-most indebted nation defaults. That downgrade puts Greek debt on a par with bonds from Azerbaijan and Egypt.

Greek regulator bans short-selling on Athens Exchange
by Polya Lesova

Greece's market regulator banned all short-selling of stocks listed on the Athens Exchange for the next two months on Wednesday, after local equities suffered a string of sell-offs in recent weeks as fears over the nation's debt crisis escalated. The Hellenic Capital Market Commission said Wednesday it banned short-selling "after taking into account the conditions prevailing in the Greek market." The ban became effective on Wednesday and will remain in force until June 28.

The Greek regulator's decision to slap a ban on short-selling comes a day after Standard & Poor's downgraded Greece's credit rating to junk status, triggering dramatic declines in local equities and bonds. The ASE benchmark stock index dropped 6% on Tuesday, bringing its year-to-date decline to 23%. The Greek index rebounded on Wednesday; it was up 1.6% to 1,723 points in afternoon trading.

Talks over the details of an aid package for Greece should be completed within "a few days," European Central Bank President Jean-Claude Trichet told reporters in Berlin on Wednesday. German Finance Minister Wolfgang Schaeuble and International Monetary Fund Managing Director Dominique Strauss-Kahn also spoke at the news conference. Trichet and Strauss-Kahn called for quick completion of the negotiations between the Greek government, the European Union, the ECB and the IMF. "Every day that is lost is a day in which the situation gets worse and worse not only in Greece," but in the European Union, Strauss-Kahn said.

Separately, Juergen Trittin, a leader for the German opposition Green Party, said that the E.U.-IMF aid package for Greece could be worth between 100 billion to 120 billion euros ($159 billion) over three years, German television station N-TV reported. The existing package is 45 billion euros this year.

Meanwhile, the cost of insuring Greek government debt against default continued to rise. The spread on five-year Greek credit-default swaps widened to 871.5 basis points from 824 basis points late Tuesday, according to CMA Datavision. That means it would now cost an unprecedented $871,500 a year to insure $10 million of Greek government debt against default for five years. Read more on Greece.

California Declares War on State Bond Short-Sellers
by Joe Mysak

California wants to know why underwriters take its money to sell the state’s bonds, and then talk trash behind its back. That’s what California Treasurer Bill Lockyer asked in March of six banks that have made $215 million from selling the state’s general obligation bonds since 2007. "We have information that indicates your firm, which sells California GO bonds, may participate in the municipal credit default swaps market," the letter said. Lockyer wanted to know why, and to what extent.

The treasurer posted the banks’ responses on his Web site last week. And the answer, I conclude, is: Because you can’t short munis. That’s too bad, because the municipal market would benefit from an army of short-sellers analyzing state and local credits. The nearest thing to short-selling municipals is the credit-default swaps market. As the Lockyer inquiry shows, public officials have little to fear. The market in municipal credit-default swaps is just too small. Credit-default swaps don’t drive up borrowing costs, anyway. Bad financial management does that. I do tip my hat to the treasurer for getting some straight answers.

How Big?
The municipal market has a denominator problem. Consider interest-rate swaps. During the late 1990s and into the 2000s, states and municipalities were sold on the things, not least because they were told that everyone was doing them. It was in the interest of those selling these instruments to make it seem so. We still don’t know how many issuers used swaps in their financing. The number was smaller than people implied. Last October, Moody’s Investors Service said 500 municipal bond issuers it rated used swaps.

Standard & Poor’s in 2007 put the number at 750. That’s still too many, if we calculate the number of state and local issuers sophisticated enough to figure out how to use them, a number that is probably in the low hundreds. Now take credit-default swaps. These were all but unknown in the municipal market until maybe three years ago. If investors wanted protection against default, they bought bonds insured by one of the financial guarantors. At one time these companies, known by an alphabet-soup of acronyms, insured almost 60 percent of all new issues. The insurers’ involvement in the subprime mortgage market has cost all of them their AAA ratings; a couple are near bankruptcy.

How to Make Money
Enter the credit-default swap. The instrument allows investors to purchase default protection. It also allows speculators to express a point of view on a particular credit or basket of credits, without owning any bonds at all. In May 2008, London-based Markit Group Ltd. introduced an index tied to the debt of 50 municipal bond issuers. How does this work? Let’s say you have a dim view of the financial prospects of state "A." You enter a contract protecting $10 million of "A" debt for five years. Let’s say it costs 50 basis points. A basis point on a credit-default swap protecting $10 million of debt for five years is equivalent to $1,000 annually, so you pay $50,000. Then everyone starts worrying about state "A" and comparing it with Greece. Now people are willing to pay 200 basis points to protect $10 million of debt for five years. That makes your contract more valuable. You sell your CDS and pocket $150,000.

Perception of Risk
That’s the theory. In practice, you need lots of investors who are interested in buying such contracts, which is what makes the little table included in Morgan Stanley’s letter to Lockyer so interesting. The table shows that credit-default swaps for the five most active municipal issuers had a gross notional value of $17.5 billion, according to Depository Trust & Clearing Corp., which tracks such things. That’s the top five, a list that includes California, New Jersey and New York. How big is the municipal credit-default swap market? Could it be $50 billion? Maybe it’s $100 billion. It’s nowhere near the size of the $2.8 trillion municipal bond market. It’s certainly not the bazillion billion proponents will have you think.

In an overview of the municipal CDS market in January, included in its Lockyer submission, Barclays Plc said, "Liquidity is expected to remain challenging in 2010." What was Lockyer concerned about? "Data reported in the news media and other sources show that the prices, or spreads, on California CDS wrongly brand our bonds as a greater risk than those issued by such nations as Kazakhstan, Croatia, Bulgaria and Thailand," he wrote. "The perception of risk could adversely affect the price of our bonds when we go to market." If California stops spending more than it takes in, and cuts back on the generous pensions and benefits it gives to public employees, then it won’t have to obsess about credit- default swaps.

49 Out Of 50 State Economies Are Still Underwater
by Vincent Fernando and Kamelia Angelova

49 out of 50 U.S. states are still showing less economic activity than a year ago, based on February 2010 coincident economic indicators from the Federal Reserve of Philadelphia. The chart below is organized from top to bottom, from the most growth in economic activity to the largest declines in economic activity.

States like West Virginia (WV), Maryland (MD), Idaho (ID), and Wyoming (WY) are the worst off year over year. Their February 2010 economic activity remained 13.5%, 6.3%, 6.3%, and 6.2% lower year over year. Thus their economies, along with those of another 45 states, all the red ones, are all underwater on an annual basis.

North Dakota (ND) is the only state to currently have a higher level of economic activity year over year. Its February 2010 economic activity was 1.1% higher than February 2009, as shown by the green dot in the chart below.

Moreover, 28 out of 50 states even exhibited less economic activity in February 2010 than just three months earlier (not directly shown below). This means they have been deteriorating most recently as well.

In fact, the chart below is organized from left to right by the change in economic activity in the last three months (February 2010 vs. November 2009).

Thus West Virginia (WV), Maryland (MD), Montana (MT), and Delaware (DE), have seen their economic activity fall since November 2009 the most, given that they are the left-most dots. For example, West Virginia's economic activity fell 3.1% vs. November 2009 (percentage not shown). In contrast, Michigan has done the best most recently, given that it is the right-most dot, rising 1.5% vs. November 2009 (percentage not shown).

Net-net what this tells us is that 49 out of 50 state economies are still underwater on a one year basis, and 28 out of 50 are even still falling vs. November.

Greek bank woes pose new risk in debt crisis
by Michael Winfrey

They did not cause the debt crisis but Greece's banks may soon become its victims, and increasing pressure on their balance sheets could add another chapter to Athens' fiscal tragedy. Greece's downgrade to speculative status by ratings agency Standard & Poor's on Tuesday was also applied to Greek lenders, a move that simultaneously hit the value of government bonds in the banks' portfolios and their own ability to raise credit. That added to a bleak environment of more possible downgrades by other agencies, an economic downturn expected to squeeze earnings and push up non-performing loans, and a rising worry among analysts that Greece may restructure its debt. 

If this last possibility happened, it would be a major blow to Greek banks, which hold around 40 billion euros in debt on their books, and raise the specter of capital hikes in a market that has seen foreign investors flee as the debt crisis intensifies. Analysts agree the Greek banking sector is relatively well capitalized and has a comparatively low loan-to-deposit ratio, and they are not yet predicting a banking crisis. But the crux of the issue remains whether a multi-billion-euro aid package Athens is trying to secure from euro zone states and the International Monetary Fund will tide it over long enough to cut a bloated public sector and tackle a 300 billion euro debt pile. 

Markets have not passed final judgment, but see that as increasingly unlikely, with Greek five-year credit default swaps briefly rising to a record 911.6 basis points on Wednesday, indicating an implied default rate of 52.6 percent. Such a development would also ratchet up pressure on public finances despite the government having already imposed a raft of painful austerity measures to save itself from bankruptcy. "If the situation really deteriorates sharply and with it systemic risk for the Greek bank sector, I don't think the Greek government has any money left to support that or any other sector of the economy," said Diego Iscaro, a senior economist for IHS Global insight.

Analysts say default or restructuring could shave anywhere from 20 to 50 percent off the value of Greek debt, a major part of the portfolios of Greek banks. National Bank has the biggest exposure with 17.9 billion euros or 16 percent of total assets and 223 percent of equity, followed by Eurobank with 7 bln euros, and Piraeus with 6.5 billion. According to UniCredit, even a 20 percent haircut would chop NBG's equity Tier-1 capital to 4.7 from 10 percent, Piraeus' to 4.1 pct from 7.7 pct, and Eurobank's to 5.1 pct from 7.9 pct, making recapitalizations necessary. Other drags for the sector, which has shed 37 percent of its market value since the start of the year, is the upward pressure on funding costs and government deficit-cutting measures expected to deepen last year's recession into 2011. Greek two-year government yields spiked to almost 16 percent this week, posing problems for banks looking for funding in the market, while domestic competition for deposits will become more fierce, compressing profit margins.

With other European banks staying away, Greek lenders have been using liquidity facilities offered by the European Central Bank for short-term financing, but that too faces some uncertainty. Under ECB rules, if S&P rival Moody's also cuts Greece to speculative level, Greek banks would receive 5 percent less cash when they use Greek bonds as collateral, exacerbating tight borrowing costs. Economists also expect a 3-5 percent economic contraction and a jump in unemployment to over 12 percent this year, which will boost non-performing credits, squeeze borrowing demand and prompt lenders to shut their vaults to consumers and businesses. "We expect Greek banks' asset quality to remain under pressure in 2010 as the country's economy is expected to undergo an even deeper recession than in 2009," Standard & Poor's said.

Other issues include public confidence, after domestic non-government deposits fell by nearly 9 billion euros, or about 4 percent, in January and February, a figure analysts said was not alarming but also not insignificant. Greece's government has guaranteed deposits and, earlier this month, said it would release 17 billion euros -- 7 percent of gross domestic product and more than the entire amount the government hopes to cut from last year's fiscal gap -- remaining from a 28 billion euro support scheme launched in 2008. Either guarantee, if tapped, would put further pressure on Athens' strained public finances, and investor aversion to Greek assets would mean any capital hikes would require more state cash. "If it was the case that they needed capital, it probably would probably have to be government who would pay, so once again would have further nasty implications for public finances," said Ben May, an economist at Capital Economics.

Merkel Pressed to Enlist Banks in Greek Rescue as Bill Drafted
by Rainer Buergin and Tony Czuczka

German lawmakers considering a bill to aid Greece challenged Chancellor Angela Merkel to involve banks in the rescue, refusing to back down after her government said that would send a "fatal signal" to markets. The main opposition Social Democratic Party threatened to withhold support for aid next week when the bill is fast-tracked through parliament unless banks are asked to contribute. Members of Merkel’s Christian Democrats said the government should ask banks to voluntarily accept losses on their investments.

Talks "should at least be held" with all investors in Greek bonds, Leo Dautzenberg, parliamentary finance spokesman for Merkel’s CDU/CSU bloc, told reporters in Berlin today. Norbert Barthle, a fellow CDU lawmaker, said yesterday that he favors involving the "private sector" in a bailout. Growing support for asking banks to help shoulder a bailout of at least 45 billion euros ($60 billion) this year poses a dilemma for Merkel as she campaigns for May 9 elections in North Rhine-Westphalia, Germany’s most populous state. Almost two- thirds of Germans want banks to participate in a rescue, a poll showed today.

The government may reverse its opposition and ask banks to help contribute to a Greek rescue, Deutsche Presse-Agentur reported, citing unnamed government sources. Government officials plan to meet this weekend with representatives of German banks that have invested in Greece to discuss their participation in a rescue, DPA said. The government refused to comment on the report. Finance Minister Wolfgang Schaeuble stepped up his opposition to bank involvement yesterday, saying that debating such a move risked creating "the misunderstanding in financial markets that we’re not talking about ensuring the solvency of Greece." "This would create a fatal signal that would cause markets to explode completely," Schaeuble said in an interview on ZDF television.

European Central Bank President Jean-Claude Trichet and Dominique Strauss-Kahn, managing director of the International Monetary Fund, told lawmakers in Berlin yesterday that the move would "undermine market confidence so much" that a Greek bailout would "take longer and cost that much more," a German politician who was briefed by the officials said. Strauss-Kahn and Trichet made it clear they’re "not doing such a restructuring at this time," Hans-Peter Friedrich, the parliamentary leader of Merkel’s CSU Bavarian allies, said today in a radio interview on Deutschlandfunk. "Right now, they reject it."

Pending a successful outcome of aid talks in Athens between Greece and the IMF, ECB and European Union, Merkel’s Cabinet can agree on a bill to go to parliament on May 3 that would come before the upper house for approval on May 7, Schaeuble said. Foreign Minister Guido Westerwelle today canceled a trip to the United Nations in New York to remain in Germany for talks on Greece, Deutsche Presse-Agentur reported. A draft bill circulated to lawmakers and dated April 27 asks lawmakers to approve 8.4 billion euros in aid for Greece for this year and unspecified further amounts for "the following two years."

"Germany will help as soon as the conditions are right," Merkel said in a speech in Berlin today, citing a "sustainable, credible and unsparing" deficit-reduction plan for Greece. "There’s no alternative to this path." While polls consistently show German voters oppose funding a Greek rescue, 62 percent of 1,000 respondents to an Emnid poll for N24 television today said they want banks to share in the Greek recue. Just 19 percent said they believe the Greek government would repay the loans, which are to be provided by Germany’s state-owned KfW development bank. The poll was conducted yesterday. No margin of error was given.

As Merkel left to campaign in North Rhine-Westphalia, where she has two appearances later today, opposition lawmakers reiterated their calls to make banks help pay for Greece. Merkel’s government committed "a grave mistake" by ruling out their participation, Gerhard Schick, the Green Party’s ranking member on parliament’s finance committee, said in an interview. The Social Democrats "support fast-track handling of aid through parliament, but that doesn’t necessarily mean we’ll vote to approve the aid," Carsten Schneider, the party’s budget spokesman, said in an interview. "There will be conditions."

How Reversible Is The Euro?
by Paul Krugman

For a long time my view on the euro has been that it may well have been a mistake, but that bygones were bygones — it could not be undone. I was strongly influenced by the view expressed by Barry Eichengreen in a classic 2007 article (although I had heard that argument — maybe from Barry? — long before that piece was published): as Eichengreen argued, any move to leave the euro would require time and preparation, and during the transition period there would be devastating bank runs. So the idea of a euro breakup was a non-starter.

But now I’m reconsidering, for a simple reason: the Eichengreen argument is a reason not to plan on leaving the euro — but what if the bank runs and financial crisis happen anyway? In that case the marginal cost of leaving falls dramatically, and in fact the decision may effectively be taken out of policymakers’ hands.

Actually, Argentina’s departure from the convertibility law had some of that aspect. A deliberate decision to change the law would have triggered a banking crisis; but by 2001 a banking crisis was already in full swing, as were emergency restrictions on bank withdrawals. So the infeasible became feasible.

Think of it this way: the Greek government cannot announce a policy of leaving the euro — and I’m sure it has no intention of doing that. But at this point it’s all too easy to imagine a default on debt, triggering a crisis of confidence, which forces the government to impose a banking holiday — and at that point the logic of hanging on to the common currency come hell or high water becomes a lot less compelling.

And if Greece is in effect forced out of the euro, what happens to other shaky members?

I think I’ll go hide under the table now.

Tourre Testimony Raises Legal Questions
by Amir Efrati And Kara Scannell

Goldman Sachs Group Inc. trader Fabrice Tourre's sworn testimony Tuesday on Capitol Hill could strengthen the Securities and Exchange Commission's civil-fraud case against him and the securities firm, some legal experts said. The 31-year-old Mr. Tourre's responses to questions from lawmakers on the Senate Permanent Subcommittee on Investigations were largely parallel with Goldman's previous denials of any wrongdoing in the 2007 deal called Abacus 2007-AC1.

But internal documents disclosed during the daylong hearing might weaken several arguments that Goldman has been using since the suit was filed earlier this month, according to some legal experts. For example, Goldman has said that investors in such transactions created by the firm were "sophisticated," a word Mr. Tourre repeated in his testimony. During the hearing, though, Sen. Susan Collins (R., Maine) referred to an email sent by Mr. Tourre that discussed a list of buyers for a potential mortgage-related investment that "should include fewer sophisticated hedge funds." "This sounds like a deliberate attempt to sell your products to less-sophisticated clients," she said. Mr. Tourre responded that the comment reflected his view of hedge funds, which "have a tendency to argue … very, very much about prices."

Michael Perino, a law professor at St. John's University who studies securities litigation, said such emails could help the SEC if the case goes to trial, adding, "Is the jury going to believe these post hoc explanations for 'what we meant' in these internal memos?" During the hearing, another Goldman email was used against Mr. Tourre, when he repeated Goldman's previous statements that a firm called ACA Management LLC had "sole authority" to select the securities portfolio in the deal, with hedge-fund Paulson & Co. merely suggesting securities to the advisory firm.

Sen. Carl Levin (D., Mich.) noted an email Mr. Tourre wrote to a superior, in which the trader said ACA and Paulson had "selected" the securities used in the deal. "I could have been more accurate," Mr. Tourre responded. The SEC alleges that Goldman failed to tell investors of the role of Paulson in choosing mortgage securities underlying the Abacus deal. Paulson hasn't been charged in the case. The SEC also alleges ACA was misled into believing Paulson wanted the deal to perform well. Mr. Tourre said Tuesday he told ACA that Paulson was betting against the deal. Mr. Tourre's comment was consistent with testimony provided to the SEC by a former Paulson executive who said he had told ACA of Paulson's intention, according to people familiar with the matter.

One of Mr. Tourre's answers on Tuesday could weaken a key Goldman response to the SEC claims—that Goldman had no incentive to structure the deal so it would fail. Goldman has said it was an investor in the deal and lost $90 million when the deal lost value. But Mr. Tourre told the senators that Goldman tried early on to sell its investment, and couldn't find a buyer. New documents that surfaced in Tuesday's hearing appeared to bolster the government's case, at least to a degree. An early January calendar entry for an ACA executive, Laura Schwartz, reads: "Canceled: Meet with Paulson, potential equity investor."

Later that evening, Ms. Schwartz wrote an email to a Goldman employee [Gail Kreitman] concerning a Paulson meeting, saying that "it didn't help that we didn't know exactly how they want to participate in the space. Can you give us some feedback?" Another email from April shows Ms. Schwartz referring to Paulson's equity position. The email concerning Abacus 2007-AC1 reads, "We did price $192 million in total of Class A1 and A2 today to settle April 26th. Paulson took down a proportionate amount of equity (0-10% tranche). Goldman does expect to issue more over the next 2 weeks as well." Still, there are suggestions that ACA was actively involved in the vetting. Another email to Ms. Schwartz from a Paulson executive, Paolo Pellegrini, thanks her for "your direct personal involvement in selecting the deal's portfolio of reference obligations."

SEC Probes Hedge Funds' 'Side Pocket' Arrangements
by Jenny Strasburg

Federal regulators are examining whether hedge-fund managers abused tools known as "side pockets" that helped prevent clients from withdrawing billions of dollars of assets during the financial crisis.
The issue is one of several investigative priorities recently set by a newly organized Securities and Exchange Commission enforcement unit focused on ferreting out misbehavior by private-equity funds, hedge funds and other asset managers.

The group, run by co-chiefs Rob Kaplan and Bruce Karpati, held its first full staff meeting this week. Some 60 attorneys are assigned to the unit across nine offices, said people familiar with the matter. The unit is delving into a number of issues surrounding hedge funds and asset managers, including whether the funds are assigning fair values to assets and accurately disclosing information about investment strategies, assets and performance to investors.

Side pockets aren't a new tool for hedge funds, but they grew more common and more controversial in 2008. At the time, funds were inundated with withdrawal requests amid market losses. Many fund managers barred clients from exiting from their investments. Side pockets can protect investors by confining new or long-held investments until markets improve, potentially limiting losses. But during the crisis, clients complained managers weren't disclosing reasons for creating side pockets, nor disclosing which assets were being stashed there.

Some funds being probed by the SEC might have misvalued assets in side pockets while continuing to charge fees based on the inflated values, said one person close to the matter. Some investors say they were effectively held hostage by the side-pocket arrangements while continuing to pay fees on holdings. The SEC's enforcement division has two investigations into the use of side pockets it hopes to bring to the commission for approval within the next six months, said the people familiar with the matter.

How hedge funds value assets under management has been a controversial issue. Many funds trade in loans, real estate and securities that aren't easily priced and don't frequently change hands among investors. The difficulty in valuing those assets raises questions about whether hedge funds inflate their values to boost returns and fees. But suspicions of wrongdoing have been more common than cases proving them. In investigating the issue, Messrs. Kaplan and Karpati have focused on outside parties, including third-party administrators and auditors, people close to the matter said.

Investigations also are likely to focus on offshore funds' directors—in place to help managers govern their funds, including by looking out for fund clients' interests—and questions about whether directors shirked responsibilities related to valuations and investor disclosure. Managers of offshore hedge funds, which for tax purposes are located in places such as the Cayman Islands and Bermuda, commonly hire directors who in some cases may hold similar positions with hundreds of hedge funds. Some investors who turned to offshore directors during the crisis found the directors referred the investors to offshore lawyers, a response many found frustrating.

Other priorities for the new enforcement unit include evaluating how honest managers are when they say they have their own wealth invested in their funds, said a person close to the matter. One continuing SEC hedge-fund investigation that touches on asset valuations, client redemptions and side-pocketing of holdings is focused on New York-based Ram Capital Resources LLC, people familiar with the matter say. The SEC has in recent months sent subpoenas to investors in the firm's Truk Opportunity and Shelter Island Opportunity funds asking for emails between Ram and investors, fund marketing materials, and investor letters from Ram, says a person familiar with the probe. Ram's performance declined when the value of loans its funds made to companies declined, the person says.

The Ram investigation is in addition to the two side-pocket cases SEC attorneys hope to bring to the commission in the next six months, a person close to the matter says. The side-pocket issues don't show signs of going away. As funds restabilize and clients again consider writing new checks to increase hedge-fund investments, managers aren't moving away from side pockets.

Instead, many are inserting new language into their fund documents to make sure they have even more flexibility to freeze holdings, said Chris Addy, chief executive of Montreal-based Castle Hall Alternatives, which assesses investment risks for hedge-fund clients. "Managers now have more latitude to use side pockets as part of their armory," said Mr. Addy. That is somewhat surprising considering "the painful experience of the past 12 to 18 months," he said.

'Out of thin air'
by Alistair Barr

The securities at the crux of the Securities and Exchange Commission's case against Goldman Sachs Group Inc. inflated the credit bubble, leaving even more losses when it popped, structured-finance experts and investors said in the wake of the recent civil-fraud charge against the investment bank. Some called for the synthetic collateralized debt obligations -- which are baskets of derivatives known as credit-default swaps -- to be banned.

"Derivatives and synthetic securities have been used to create imaginary value out of thin air," George Soros, chairman of $27 billion hedge-fund firm Soros Fund Management, wrote in a column posted on his Web site last week. "More triple-A CDOs were created than there were underlying triple-A assets. This was done on a large scale in spite of the fact that all of the parties involved were sophisticated investors," he added. "The process went on for years, and culminated in a crash that caused wealth destruction amounting to trillions of dollars. It cannot be allowed to continue."

"Synthetic CDOs should be abolished," Janet Tavakoli, a structured-finance specialist who wrote a book about CDOs in 2003, said in a recent interview. "They're too complex and provide no real benefit. They only existed to game the system or hide losses." The SEC alleged that Goldman Sachs (NYSE:GS) didn't tell investors in a synthetic CDO called Abacus 2007-AC1 that hedge-fund firm Paulson & Co. helped structure the deal, and also was betting against it. Goldman and Paulson have denied wrongdoing.
'The process went on for years, and culminated in a crash that caused wealth destruction amounting to trillions of dollars. It cannot be allowed to continue.'
George Soros

Because they weren't based on real assets, such investments were tricky to value. When the housing market collapsed, the existence of such hard-to-value securities in the financial system caused havoc as counterparties struggled to find out who had lost money. Fabrice Tourre, the Goldman banker named in the SEC's case, described such problems in a January 2007 email, just as the subprime-mortgage meltdown was gaining steam.

"I'm trading a product which a month ago was worth $100 and which today is worth $93 and which on average is losing 25 cents a day," Tourre wrote, according to recent Goldman disclosures. "When I think that I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invent telling yourself: 'Well, what if we created a 'thing', which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?') it sickens the heart to see it shot down in mid-flight," Tourre added in the email.

Synthetic CDOs sat at the end of a long chain of boom-time transactions that began with the origination of mortgages and other loans. These assets were packaged up by investment banks and sold as asset-based securities, including residential mortgage-backed securities, or RMBS. CDOs were created by taking pieces of RMBS and other securities, packaging them up again and reselling them. Demand for such investments was so strong during the credit boom that there weren't enough underlying assets to build new ones. So Wall Street came up with a way of creating CDOs that didn't need actual assets.

The result was synthetic CDOs. These are formed by writing credit-default swaps on bits of RMBS and other asset-backed securities. (These swaps pay out in the event of default.) Once enough of these derivatives contracts were written, investment banks bundled them up into new CDOs and sold them. More than $110 billion worth of synthetic CDOs were sold in 2006 and 2007, according to Thomson Reuters data. Royal Bank of Scotland, Morgan Stanley and BNP Paribas were the leading underwriters of synthetic CDOs in 2006. The year after, Barclays Capital, Goldman and Merrill Lynch, now part of Bank of America Corp., were the top underwriters, Thomson Reuters data show.

The beauty of these products was that they could be churned out without creating underlying assets. "You don't have to wait for bonds to come to market; you can create your own exposure -- and that flexibility is in both the long and the short side," said Joseph Mason, an expert on financial crises at Louisiana State University. "Synthetic CDOs added information to the markets and the information they added was that there was a bubble."

Broader problem
The SEC's suit against Goldman highlights a broader problem with structured finance - the business of packaging assets and selling or securitizing them, according to Sylvain Raynes, an expert in the field and co-founder of R&R Consulting. "Structured finance is nothing," he said in an interview. "It's always been nothing. We were always on the edge of the abyss and what kept us from going over the edge was Moody's."

Raynes, who used to work at Moody's Investors Service (NYSE:MCO) and co-authored a book on structured finance, said the rating agency put AAA ratings on many parts of CDOs, giving investors the confidence they needed to buy the products. "You needed a third party to analyze the structures," he added. "That's what provided the value for these deals."

In the case of Goldman's Abacus 2007-AC1 CDO, the firm got a third party called ACA Management to have the final say on what assets went into the deal. Without ACA's involvement the deal would have been difficult to sell because investors were getting worried about the mortgage market, the SEC alleged in its complaint against Goldman. The SEC claims Goldman misled ACA into thinking that Paulson & Co. was going to be a long investor in the deal, when in fact the hedge fund firm was betting against the deal. Goldman denies it misled ACA. ACA has declined to comment about this.

In court
Other CDO deals have also ended up in court. HSH Nordbank, a German lender, sued UBS AG in February 2008 after losing roughly $500 million on a CDO called North Street 2002-4 that was arranged, underwritten and managed by the Swiss banking giant. North Street 2002-4 was a hybrid CDO, which means some of the deal included real assets while the other bits were synthetic. HSH alleged that UBS made $120 million the day the CDO deal closed. The Swiss bank pulled this off by deliberately picking securities that had already lost value but hadn't been downgraded by rating agencies yet -- a strategy known as ratings arbitrage, the suit claims.

Later on, UBS replaced relatively stable assets with riskier collateral then bet against those credits. That effectively transferred default risk from its own balance sheet to the North Street CDO, HSH claimed. UBS has said that it stuck closely to all its contractual obligations in the deal and that HSH was sophisticated enough to understand potential risks.

Rabobank sued Merrill Lynch in 2009 after suffering $45 million in losses from an investment in a hybrid CDO called Norma. "Norma was never intended by Merrill Lynch to be a secure investment vehicle for Rabobank or anyone else," the suit alleged. "Rather, Merrill Lynch created Norma as a dumping ground for many millions of dollars of subprime securities (including tens of millions of dollars of other Merrill Lynch-structured CDOs backed by subprime mortgage securities) that Merrill Lynch knew were already impaired and wanted to get off its own books." Merrill has said that Rabobank was aware of the risks and should have done its own homework on the assets in the CDO, rather than relying on the investment bank.

Milken Faults Companies Failing to Cut Debt as Markets Recover
by Gabrielle Coppola

Companies failing to exploit the recovery in bond and equity markets to pay down debt are making a mistake, according to Michael Milken, the junk-bond billionaire turned philanthropist.
Near-zero interest rates in the U.S. and Europe have fueled demand for high-risk securities, providing companies with an opportunity to cut debt incurred during the excesses of the credit boom, Milken told an audience at the Milken Global Institute conference yesterday in Beverly Hills, California.

Companies sold $98.9 billion of high-yield bonds in the U.S. this year, on pace to beat the record $162.7 billion issued in 2009 after government measures unlocked credit markets frozen by Lehman Brothers Holdings Inc.’s collapse. The extra yield investors demand to own junk bonds instead of Treasuries fell to 5.51 percentage points yesterday from a peak of 21.82 percentage points in December 2008, according to Bank of America Merrill Lynch’s U.S. High-Yield Master II index. The average junk bond traded at 99.5 cents on the dollar from a low of 54.9 cents on Dec. 15, 2008, Merrill data show.

"Defaults were exaggerated, the risks were exaggerated," Milken said of the recovery in high-yield bonds. "Those risks existed in mortgage-backed securities, but they didn’t exist in industrial companies, and that’s what the market is saying." The debt has returned 4.8 percent this year, following a record 58 percent return in 2009, Merrill data show. High-yield, or junk, bonds are ranked lower than Baa3 by Moody’s Investors Service and below BBB- by Standard & Poor’s.

Milken, 63, pioneered the junk-bond market in the 1970s as the high-yield bond chief at Drexel Burnham Lambert Inc. He was indicted on 98 counts of racketeering and securities fraud in 1989, ultimately serving about two years after a plea bargain and sentence reduction. For the past decade he has focused on philanthropy and running the research institute he founded, which seeks ways to generate capital for people around the world.

ECB in stark warning on sovereign debt crisis
by Ralph Atkins

A top European Central Bank policymaker has intensified warnings of a "full-blown sovereign debt crisis" unless governments take ambitious steps to bring public finances under control, saying the UK, US and Japan faced an even greater challenge than the eurozone. The comments by Jürgen Stark, ECB executive board member – which echoed similar warnings by the International Monetary Fund – highlighted the spreading concerns sparked by the escalating crisis over Greece’s public debt. However, he played down the idea of the ECB offering Greece a lifeline in an extreme scenario by buying its government bonds. Speaking at a conference in Berlin, Mr Stark said fiscal concerns had become a "major concern" in the eurozone. But bringing public debt ratios back to safer levels appeared "even harder for the UK, the US and Japan. Given their high budget deficits and the high and rising debt levels, they must undertake very strong consolidation efforts to manage a reversal."

For the three years from 2009 to 2011, the public sector deficit was expected to exceed 6 per cent of gross domestic product in the eurozone, but more than 10 per cent in the US and UK, he said. Mr Stark warned that high government deficits would fuel fears about inflation, drive up interest rates and severely limit governments’ room for manoeuvre in future crises. "The onus is now on governments to ensure that the crisis that initially affected the financial sector, and subsequently the real economy, does not lead to a full-blown sovereign debt crisis. Averting it will require very ambitious and credible fiscal consolidation efforts." His speech came as Jean-Claude Trichet, ECB president, arrived in Berlin to try to persuade German parliamentarians to back the joint eurozone/IMF rescue programme for Greece. Mr Trichet has urged eurozone politicians to "live up to their responsibilities" and argues that eurozone members share "a common destiny".

But Mr Stark appeared to rule out one option floated by economists – of the ECB itself buying Greek government bonds. This was not an issued being "discussed at present", he told journalists in Berlin. In his speech, Mr Stark also pointed out how, even at the height of the post-Lehman Brothers economic crisis, the ECB had not made outright purchases of assets of government bonds – unlike other central banks. Meanwhile, Mr Stark argued that the eurozone private sector was not facing credit constraints. Instead, the decline in borrowing reflected the weakness of economic activity. The ECB’s latest bank lending survey, released on Wednesday, showed an unexpected weakening in demand for loans by companies in the first three months of this year – showing that a recovery in lending that started early in 2009 had gone into reverse. The results could add to worries about the fragility of the eurozone’s economic recovery.

Goldman Sachs adds to its ranks of lobbyists
by Tomoeh Murakami Tse

Until a few years ago, Goldman Sachs operated a sleepy lobby shop in the nation's capital. But now, faced with fraud charges, investigations, a firestorm of criticism and a regulatory overhaul bill that could seriously damage its profitability, the venerable Wall Street firm is assembling a team of veteran lobbyists, well-connected former Hill staffers and top public relations strategists to confront what is arguably the most traumatic moment in its 140-year history.

Over the past two years, as it emerged from the financial crisis with a reinforced image as Wall Street's top bank but also the No. 1 target of public ire, Goldman has built up a 12-person government affairs office in Washington to help the firm get its message to legislators and regulators. The team has gotten down in the trenches with the other large banks, meeting multiple times in recent months with members of key House and Senate committees working on the regulatory overhaul. Earlier this month, for example, Goldman sent executives from New York to Washington, where they accompanied the firm's lobbyists to a meeting with the staff of Sen. Blanche Lincoln (D-Ark.), chairman of the Senate Agricultural Committee and author of a proposal that would force banks to spin off their lucrative derivatives-trading desks.

Goldman's former lobbyists, as well as Congressional staffers and industry lobbyists who have dealt with the firm, say the company's government relations staff had traditionally maintained a low-key presence inside the Beltway and elsewhere, focusing on building goodwill and long-term relationships. Over the years, it has hosted training sessions at its New York headquarters for regulators and government officials, including managers at the Securities and Exchange Commission and those coming up the ranks in foreign regimes.

As head of its government affairs office in Washington, Goldman has installed Michael Paese, a former top aide on the House Financial Services Committee to Chairman Barney Frank (D-Mass.) and more recently an industry lobbyist. (Frank has barred Paese from lobbying his panel for two years, longer than what ethics rules require.) Paese reports to Faryar Shirzad, a top adviser to President George W. Bush on economic affairs. On their team are Eric Edwards, a former staff director of a House Financial Services subcommittee; Joyce Brayboy, a former chief of staff for Rep. Melvin Watt (D-N.C.); Joe Wall, aide to former vice president Dick Cheney on legislative matters; Kenneth Connolly, formerly with the Senate's environment and public works committee; and Michael Thompson, who worked for Sen. Mike Enzi (R-Wyo.).

The bank also has in place an external roster of high-powered lobbyists, including Richard Gephardt, the former Democratic House majority leader; his former aide Stephen Elmendorf, now of Elmendorf Strategies; Kenneth Duberstein, who served as Ronald Reagan's chief of staff; Harold Ford Sr., a former representative from Tennessee; and Richard Roberts, a former SEC commissioner who has also served as the top aide to Richard Shelby, the ranking Republican on the Senate banking committee.

Perhaps more telling of the urgency of Goldman's efforts are recent additions who technically aren't lobbyists but have deep ties to Washington. This month, the firm hired high-powered public relations professional Mark Fabiani, whose clients are often large corporations in crisis mode. Dubbed the "Master of Disaster" for his handling of the Whitewater scandal during the Clinton administration, Fabiani is advising Goldman on a number of fronts, including public image strategy. Stephen Labaton, a veteran former regulatory reporter for the New York Times, has also been brought on as full-time consultant.

Rounding out the team is Gregory Craig, President Obama's former White House counsel and now a partner in the Washington office of the law firm Skadden Arps, who will be working on litigation advice and related matters. Together, the team is plowing forward with a more aggressive lobbying and public relations campaign, one aimed at making sure that when the history books are written, Goldman's side of the story is told. One focus will be the Financial Crisis Inquiry Commission, the independent group set up by Congress which is putting together a massive report on the causes of the financial collapse.

Goldman has also increased its political spending. The firm's lobbying expenditure was $1.15 million for the first three quarters of this year, up 72 percent from the same period last year. While other major banks have increased their spending, Goldman's increase was the sharpest. Goldman's team will have its work cut out for them. With the SEC charges looming -- charges that the firm has vehemently denied -- Goldman has become "radioactive," in the words of one prominent financial industry lobbyist.

Lincoln said this week that she will donate to charity the $7,500 she received from Goldman's political action committee during the current election cycle. Rep. Mark Kirk (R-Ill.), who is running for Senate, also said he will return contributions from Goldman. "They can't conduct business as usual," said Steve Fraser, author of "Wall Street: America's Dream Palace." "I don't think any more secretaries of Treasury are about to come out of Goldman for quite some time. Democrats, even Republicans, will have to be crazy to name some ex-CEO as his next head of Treasury or the Fed."

Greek debt crisis spreading 'like Ebola' and Europe must act now, OECD warns

The Greek debt crisis is spreading "like Ebola" and Europe must act now to protect the stability the financial markets, according to the Organisation for Economic Co-operation and Development. "It’s not a question of the danger of contagion; contagion has already happened," OECD secretary general Angel Gurria said. "This is like Ebola. When you realise you have it you have to cut your leg off in order to survive," he added, saying the crisis is "threatening the stability of the financial system".

Alistair Darling, the Chancellor, called for Eurozone countries to "urgently" agree a bail-out for Greece or risk a further decline in stock market confidence. Mr Darling said it was "absolutely essential" that Greece's problems were sorted out "quickly, effectively and decisively", following a torrid 24 hours for world markets. Asked on LBC Radio about the drop in the FTSE on Tuesday, the Chancellor said stock markets rise and fall but added: "That's my argument about the situation in Greece – we have got to make sure that it gets sorted out. "But the primary responsibilities are for the other members of the euro group. They know that they have got to sort it out. They have promised money, and what I would say is they need to make that money available as soon as possible." He added: "If we can sort out the problems in Greece quickly, then that will make people more confident."

The crisis in Greece sent stock markets and the euro reeling for a second day as fears grew that it would not be able pay its debts. A widespread stock market sell-off was triggered on Tuesday when ratings agency Standard & Poor's cut Greek debt to junk status, while a downgrade to Portugal reignited worries about a growing eurozone crisis. As the European Union said that it would hold an emergency summit on Greece, the Frankfurt stock market slid 1.93pc and Paris 2.16pc in midmorning trading. London's FTSE 100 fell 1pc, one day after suffering its biggest one-day loss since November. Lisbon tumbled 6pc and Madrid fell 3pc, while Athens was down 1.69pc after heavy recent losses. "Any hope that the Greek issue was finally coming under control took a huge blow yesterday with the country's sovereign debt being downgraded to junk," said Ben Potter, an analysts at IG Markets.

The debt crisis also unsettled Asian markets, with Tokyo dropping 2.6pc and Hong Kong 1.3pc. Wall Street shed 1.9pc overnight, with the Dow Jones index finishing under the symbolic 11,000-point level. "The downgrading of Portuguese and Greek debt has spooked investors, as there is a very real fear that other European countries could be downgraded too," said Owen Ireland, an analyst at ODL Securities. In the foreign exchange market on Wednesday, the European single currency hit a new one-year dollar low. The euro plunged to 1.3143 dollars – last seen in April 2009 – as traders fretted over a debt crisis that could spread to other nations such as Portugal, Spain, Italy and Ireland. In bond market trade on Wednesday, the yield on 10-year Greek sovereign bonds soared to 11.076pc, the highest 10-year level ever recorded in the eurozone, after 9.73pc on Tuesday.

"The S&P downgrades to Portugal and Greece brought a fresh bout of fears to equity and credit markets alike, with concerns over contagion effects continuing to rise," said Deidre Ryan, an analysis at Goodbody's stockbrokers. "Along with the spike in peripheral euro-area bond yields, the euro also continues to weaken, falling below the $1.32 level to its lowest level in a year." Debt-laden Greece has appealed for emergency loans totalling €45bn from the European Union and the International Monetary Fund. The funds would be made available on condition that Greece implemented tough austerity measures, currently the subject of talks with the EU and the IMF. In response the latest news, the European Union has called an emergency summit on Greece, with eurozone leaders set to meet next month.

EU President Herman Van Rompuy said leaders from the 16 nations using the single currency would meet in Brussels "by around May 10" to try to agree how to set up a massive rescue operation. Speaking in Tokyo, Mr Van Rompuy said there was "no question" of Greece defaulting. Across in Athens on Wednesday, strikes and protests erupted as its crisis-hit economy reeled from another scathing downgrade of its debt and the stock exchange took emergency measures to deter speculators. Amid a growing recession, a general strike has been called for May 5 against austerity cuts that the government is enforcing to slash the rampant public deficit and debt worth nearly €300bn. Oil prices also sank on Wednesday, shaken by the Greek crisis and the strong US currency, which makes dollar-priced crude more expensive for foreign buyers.

ECB may have to turn to 'nuclear option' to prevent Southern European debt collapse
by Ambrose Evans-Pritchard

The European Central Bank may soon have to invoke emergency powers to prevent the disintegration of southern European bond markets, with ominous signs of investor flight from Spain and Italy. Greece’s fortunes were dealt yet another blow as Standard & Poor’s slashed its credit rating to junk status - BB+ - the first time that has happened to a euro member since the single currency was created, pushing yields on 10-year Greek bonds up to a record 9.73pc. The credit-rating agency also cut Portugal’s sovereign debt ratings by two notches to A-, as the swirling storm hit the country with full-force. "We have gone past the point of no return," said Jacques Cailloux, chief Europe economist at the Royal Bank of Scotland."There is a complete loss of confidence. The bond markets are in disintegration and it is getting worse every day. "The ECB has been side-lined in the Greek crisis so far but do you allow a bond crash in your region if you are the lender-of-last resort? They may have to act as contagion spreads to larger countries such as Italy. We started to see the first glimpse of that today."

Mr Cailloux said the ECB should resort to its "nuclear option" of intervening directly in the markets to purchase government bonds. This is prohibited in normal times under the EU Treaties but the bank can buy a wide range of assets under its "structural operations" mandate in times of systemic crisis, theoretically in unlimited quantities. Mr Cailloux added: "This feels like the banking crisis in late 2008 post-Lehman, though it has not yet spread to other asset classes. The ECB will have to act it if does." Yields on 10-year Portuguese bonds spiked 48 basis points to 5.67pc, replicating the pattern seen as the Greek crisis started. Portugal’s public debt will be just 84pc of GDP by the end of this year, far lower than that of Greece, at 124pc. However, its private debt is much higher and data from the IMF shows that its external debt position is worse. Interest payments on foreign debt will be 8pc of GDP this year. Portugal’s net international investment position is minus 100pc of GDP, the worst in the eurozone.

The interest rate on a €9.5bn (£8.2bn) issue of Italian notes jumped to 0.814pc, up from 0.568pc in March. The bid-to-cover ratio was wafer-thin, falling to 1.02. Italy has the world’s third biggest debt in absolute terms. The issue of the ECB buying bonds is a political minefield. Any such action would inevitably be viewed in Germany as a form of printing money to bail out Club Med debtors, and the start of a slippery slope towards in an "inflation union". But the ECB may no longer have any choice. There is a growing view that nothing short of a monetary blitz — or "shock and awe" on the bonds markets — can halt the spiral under way. The markets are already looking beyond the €40bn to €45bn joint rescue for Greece by the IMF and the EU, questioning whether some form of debt restructuring or managed default can be avoided over the next year or two, or even whether the rescue plan can work at all in a country trapped in debt deflation with no way out through devaluation.

Professor Willem Buiter, a former member of Britain’s Monetary Policy Committee and now global economist for Citigroup, said there may need to be a "voluntary restructuring" of debt. "It is quite likely that a haircut of, say, 20pc to 25pc will be imposed on creditors as parts of the deal," he said. The bond markets are already "pricing in" a default of some kind in Greece, where rates on 2-year debt spiked close to 15pc in panic trading yesterday. The European Commission and the International Monetary Fund both insist that restructuring is out of the question but investors have become cynical after months of EU rhetoric and foot-dragging by Berlin. The ECB cannot lightly risk a second sovereign crisis erupting, with dangers of a spillover into Spain.

The exposure of Spanish-based banks to Portuguese debt exceeds $80bn, according to the Bank for International Settlements. There were early signs of strain in the Spanish banking system yesterday. Banks were forced to pay a premium in the domestic "repo" market on fears of counterparty risk, although the Bank of Spain has so far won plaudits for ensuring that banks have large safety buffers. It is unclear why the markets are becoming skittish over Italian bonds. Public debt is 115pc of GDP but this is offset by very low household debt. Italian citizens are among the most frugal savers in the OECD club of rich states. Moreover, the government has weathered the financial crisis with a budget deficit in remarkable good health.

Britain risks Greek-style crisis, warns Vince Cable
Britain risks sliding into a Greek-style fiscal crisis unless the next government takes drastic action to cut borrowing, warned Vince Cable, the Liberal Democrat finance spokesman. Greece is currently in talks with the IMF and the European Union on getting a €45bn bail-out package to prevent a sovereign default, and a slashing of its debt to junk status has sent global financial markets into a tailspin. "The Greek position is much more serious but is a salutary warning that unless the next government gets seriously to grips with the deficit problems, as we're determined to do, we could have a serious problem," Mr Cable told Reuters Insider television. "It's worth reflecting that Greece and Britain have one thing in common: they have one-party governments that haven't carried the public with them, and that's one danger that I think we need to be mindful of going into this election."

However, Lord Mandelson, the Business Secretary, said comparing Britain’s fiscal and economic position to that of Greece was "frankly ridiculous". "The real difference is that we have an AAA rating, Greece has junk status," he told a news conference organized by his Labour Party in London today. "Britain is not Greece. We are very, very different economies." The global stock market sell-off continued for a second day in Europe, with markets in London, Germany and France falling between 1pc and 2pc. Portuguese stocks tumbled 6pc as jitters over the country's debts were heightened after a credit rating downgrade on Tuesday. Fears that a European debt crisis could dent a global recovery hit Asia markets earlier. On Tuesday, London's FTSE 100 tumbled 2.6pc, Germany's DAX 2.7pc, France's CAC 3.7pc and Dow Jones index 1.9pc.

The Greek regulator on Wednesday banned speculators from shorting the Athens market - trying to make money from betting shares will fall further. Lorraine Tan, director of equities research at Standard & Poor's in Singapore, said "The fear is that Greece and Portugal are just the appetisers. "The concern is it is going to spread and have an impact on the financial system and ultimately on the economy." As a further indication of investor jitters, the premium being demanded to hold Greek government bonds jumped to its highest since late 1996.

Distressed UK companies owe £55bn, new report warns
by Helia Ebrahimi

A staggering £55bn is owed by companies in financial distress threatening a tidal wave of defaults which could swamp healthy creditors, suppliers and service businesses, new research has found. More than 160,000 companies are experiencing "significant" or "critical" financial distress and between them owe in excess of £55bn, according to Begbies Traynor. In its latest Red Flag update, which highlights troubled businesses, the professional services group found a 14pc jump in the number of distressed companies. There were 161,601 red flagged companies in the first quarter of this year compared with the final quarter of 2009.
Although some of the increase was put down to a normal seasonal uplift at the start of a year, Begbies estimated half the rise was due to a more aggressive approach by trade creditors who were more willing to take court action against their debtors. Bad weather and soaring input costs were also factors. Among the worst hit sectors were property services, where problem companies jumped 42pc, construction companies which saw a 30pc increase, retail firms (up 19pc), and recruitment, which also saw a 19pc rise.

Despite a rebound in the economy and equity markets, the latest figures represented the second successive quarter where the number of problem companies increased. It marks a renewed rising trend after company financial problems had begun to ease last year – from 185,772 troubled businesses in the first quarter of 2009 - helped by massive Government and economic stimulus packages. Begbies said its experience of previous recessions showed the recovery phase of the economic cycle presented the greatest challenge to vulnerable SMEs and it warned the withdrawal of Government support needed to be handled carefully to ensure a soft landing.

Begbies defines companies with significant problems as those facing court action or with poor or out of date accounts, while critical refers to County Court Judgements totalling more than £5,000 or winding-up petitions.
Ric Traynor, executive chairman of Begbies Traynor, said while the economy appeared to be showing positive signs of recovery, the scale of company liabilities represented a serious risk to creditors.

'The pound makes Britain immune from the Greek crisis? Nothing could be further from the truth'
by Barry Norris

Fundamentalist view: Why the London stock market will feel the effects of Greece's inability to pay its debts. It is possible that Greece will run out of money in the next few weeks. On May 19 investors who lent the Greek government €8.5bn will demand repayment. At present the Greek government doesn't have the funds to meet this payment and doesn't want to take on new debt at higher interest rates it can't afford in order to pay back the old debt. It has therefore asked the IMF and the EU to lend it €45bn at better interest rates to tide it over. Like a bank manager being asked by a spendthrift customer for a bigger overdraft, the IMF and the EU are reluctant to just hand over the money without imposing terms. They want to be paid back some time. A loan – not a gift – is on offer.

The problem is that it is becoming increasingly obvious that Greece may not be able to afford to pay the debt back. It has a debt to GDP ratio of around 120pc, a budget deficit of over 13pc and interest costs as a percentage of GDP (at current market rates) are now nearly 10pc. Moreover, higher taxes and lower public spending mean that GDP is likely to shrink rather than grow. Unlike Britain, Greece, by virtue of its membership of the euro, does not have the option of devaluing its currency to regain competitiveness and stimulate growth. A gift – not another loan – is what Greece really needs. There are two candidates for the role of reluctant benefactor: the taxpayers of other eurozone states, notably Germany, or the banks and financial institutions that hold existing Greek government debt. None of the logical endgames in all of this will be palatable. Therefore it is unlikely that any of the participants are particularly motivated to bring forward the day of reckoning. This probably means that Greece will be granted the aid it has requested to keep it liquid while the longer-term question on solvency is put off.

It will be hoped that the situation is manageable in a way that will not lead to further contagion affecting other sovereign debt or a "second wave" credit crunch through investment losses on Greek assets. A muddle through is the most plausible outcome. A wider implication of the crisis for investors is that country-specific factors are likely to become a lot more important in terms of stock market performance. Investors will be more risk adverse in allocating capital to European countries such as Greece, Portugal, Ireland, Spain and indeed Britain, which are perceived to be of higher credit risk. Investors will therefore be more likely to allocate capital to countries such as Germany, Switzerland, Finland and Norway with good credit risk. Europe is not a homogeneous market.

There will be winners and losers from this process. A good fund manager will position his investments accordingly. Another likely outcome is a weaker euro against the US dollar, but not necessarily against sterling, partly as a result of political and economic uncertainty, partly because the US economy is recovering at a rapid pace. Having been asked by numerous investors over the past decade about the potentially negative effects of a strong euro on European companies, I am now inundated with questions about the potentially negative effects of a weak euro on European companies. The answer remains the same. Some companies will benefit; others will suffer. For many European companies a decade-long bull market in the euro has meant that they have had to raise productivity to remain competitive.

Currency is now a significant tailwind for numerous European stocks. In Britain, by virtue of the pound, we tend to think of ourselves as not being affected by the problems in Greece. Nothing could be further from the truth. When I meet investors in Spain they are as worried about investing in Britain as we are about investing in Spain. There are a lot of pots and kettles flying around. For a British-based investor, whatever the outcome of the General Election, but particularly in the event of a hung parliament, diversification out of sterling remains important.

Finally, it is worth considering the most obvious argument for all developed market equities. Cash yields almost nothing, as does government paper, which also has default risk. There is very little value left in the corporate bond market. Inflation is picking up anyway, eroding real returns. Emerging markets and commodities are highly dependent on momentum in Chinese infrastructure roll-out, which currently looks shaky. Property is unlikely to go up much as banks and individuals pay back debt. Having gone nowhere for a decade, developed market equities are, in my opinion, by far the least bad investment currently on offer.