Tuesday, December 25, 2007

Credit Card Defaults move to Forefront of Deflation Debate

Americans are falling behind on their credit card payments at an alarming rate, sending delinquencies and defaults surging by double-digit percentages in the last year and prompting warnings of worse to come.

The value of credit card accounts at least 30 days late jumped 26 percent to $17.3 billion in October from a year earlier at 17 large credit card trusts examined by the AP. That represented more than 4 percent of the total outstanding principal balances owed to the trusts on credit cards that were issued by banks such as Bank of America and Capital One and for retailers like Home Depot and Wal-Mart.

At the same time, defaults - when lenders essentially give up hope of ever being repaid and write off the debt - rose 18 percent to almost $961 million in October, according to filings made by the trusts with the Securities and Exchange Commission.

Among the trusts examined, Bank of America Corp. had the highest delinquency volume, with overdue accounts valued at $5 billion. Bank of America defaults in October were almost 200 percent higher than in October 2006.

The Current Picture

* Residential foreclosures are enormous
* Commercial real estate is heading south
* Credit card delinquencies are rising sharply
* REOs will dramatically increase once the wave of Alt-A and pay option ARMs  hits
* Ambac and/or MBIA are in serious trouble with funding
* Ambac and MBIA put municipal bond ratings in jeopardy

The current picture is not pretty nor is there anything remotely inflationary with it. It took a while, but now credit cards can be added to the growing list of problems. Rather than a single domino triggering a collapse, perhaps there is simply a sudden out of the blue implosion caused by too much debt with no possible way to service it.

The Global Economy’s Inevitable Hard Landing

In recent weeks, the global liquidity and credit crunch that started last August has become more severe. This is easy to show: in the United States, the euro zone, and the United Kingdom, spreads between Libor interest rates (at which banks lend to each other) and central bank interest rates – as well as government bonds – are extremely high, and have grown since the crisis began. This signals risk aversion and mistrust of counterparties.

To be sure, major central banks have injected dozens of billions of dollars of liquidity into the commercial banking sector, and the US Federal Reserve, the Bank of England, and the Bank of Canada have lowered their interest rates. But worsening financial conditions prove that this policy response has failed miserably.

So it is no surprise that central banks have become increasingly desperate in the face of the most severe crisis since the advent of financial globalization. The recent announcement of coordinated liquidity injections by the Fed and four other major central banks is, to be blunt, too little too late.

These measures will fail to reduce interbank spreads significantly, because monetary policy cannot address the core problems underlying the crisis. The issue is not just illiquidity – financial institutions with short-term liabilities and longer-term illiquid assets. Many more economic agents face serious credit and solvency problems, including millions of households in the US, UK, and the Eurozone with excessive mortgages, hundreds of bankrupt sub-prime mortgage lenders, a growing number of distressed homebuilders, many highly leveraged and distressed financial institutions, and, increasingly, corporate-sector firms.

At the same time, monetary injections cannot resolve the generalized uncertainty of a financial system in which globalization and securitization have led to a lack of transparency that has undermined trust and confidence. When you mistrust your financial counterparties, you won’t want to lend to them, no matter how much money you have.

The US is now headed towards recession, regardless of what the Fed does. The build-up of real and financial problems – the worst US housing recession ever, oil at $90 a barrel or above, a severe credit crunch, falling investment by the corporate sector, and savings-less and debt-burdened consumers buffeted by multiple negative shocks – make a recession unavoidable. Other economies will also be pulled down as the US contagion spreads.

...[T]he actions recently announced by the Fed and other central banks are misdirected. Today’s financial markets are dominated by non-bank institutions – investment banks, money market funds, hedge funds, mortgage lenders that do not accept deposits, so-called “structured investment vehicles,” and even states and local government investment funds – that have no direct or indirect access to the liquidity support of central banks. All these non-bank institutions are now potentially at risk of a liquidity run.

So the risk of something equivalent to a bank run for non-bank financial institutions, owing to their short-term liabilities and longer-term and illiquid assets, is rising – as recent runs on some banks (Northern Rock), money market funds, state investment funds, distressed hedge funds suggests. There is little chance that banks will re-lend to these non-banks the funds they borrowed from central banks, given these banks’ own severe liquidity problems and mistrust of non-bank counterparties.

Major policy, regulatory, and supervisory reforms will be required to clean up the current mess and create a sounder global financial system. Monetary policy alone cannot resolve the consequences of inaction by regulators and supervisors amid the credit excesses of the last few years. So a US hard landing and global slowdown is unavoidable. Much greater and more rapid reduction of official interest rates may at best affect how long and protracted the downturn will be.

Monday, December 24, 2007

Crisis may make 1929 look a 'walk in the park'

Glance at the more or less healthy stock markets in New York, London, and Frankfurt, and you might never know that this debate is raging. Hopes that Middle Eastern and Asian wealth funds will plug every hole lifts spirits.

Glance at the debt markets and you hear a different tale. Not a single junk bond has been issued in Europe since August. Every attempt failed.

Europe's corporate bond issuance fell 66pc in the third quarter to $396bn (BIS data). Emerging market bonds plummeted 75pc.

"The kind of upheaval observed in the international money markets over the past few months has never been witnessed in history," says Thomas Jordan, a Swiss central bank governor.

"The sub-prime mortgage crisis hit a vital nerve of the international financial system," he says.

Saturday, December 22, 2007

Big Fund to Prop Up Securities Is Scrapped

Some of the country’s biggest banks have pulled the plug on a plan backed by the Treasury Department to rescue troubled investment vehicles that were leveled by the subprime mortgage crisis.

The decision came Friday after it became clear that neither the banks nor the structured investment vehicles were willing to create a giant fund to bail out the SIVs.

The reversal is a setback for Treasury Secretary Henry M. Paulson Jr., who had urged the banks to create the so-called super SIV to keep the crisis in housing-related debt from worsening.

A separate proposal by the Bush administration to modify home loans for troubled borrowers has also met with skepticism.

Friday, December 21, 2007

Train Wreck Imminent

We learned yesterday that the British government's guarantee to bail out Northern Rock’s creditors is worth a staggering £100 billion. That's £5,000 [$10,000] per British household. This week the European Central Bank made $500 billion available through money market operations. And only last week $110bn of new money was created by central bank loans with artificially low rates and reduced-quality security. This is money creation on an epic scale.

Why is this happening now? Here's my theory: 31st December is a major day on the financial calendar. If you take a sample of bonds you'll find that a disproportionate number of them are due for interest and/or redemption on 31st December. Redeeming bonds is very cash intensive, and cash is not freely available in the banking system right now.

So it seems likely that some frantic finance directors will be working long hours to find the cash that will enable them to avoid a default next week.

If that's right the festive season could see the announcement of some nasty shocks.

Leading Economic Indicators Fall Again

For the third time in four months, and 4th time in 6 months, the leading economic indicators fell signaling a slow down in the economy, if not an outright recession.

In each of the past two months, the LEI fell sharply. The greater than forecast 0.4% decline comes on top of a 0.5% drop in October.

Kasriel: 65% Chance of Recession

Northern Trust's Director of Economic Research Dr. Paul Kasriel's model is putting the odds of recession at 65.5%: Probing the Probabilities of a 2008 Recession

Subprime Daily Briefing, Dec 21

Severe recession in 2008-2009. The economy sinks under the weight of high oil prices, the liquidity crisis, and the loss of home equity. With unemployment rising, the default rate on mortgages keeps climbing. The economy experiences its worst recession in over 25 years. Probability: 25 percent.

Thursday, December 20, 2007

Fitch Places 173,022 Issues on Rating Watch Negative

Press Release: Fitch Places 173,022 MBIA-Insured Issues on Rating Watch Negative

Concurrent with its related rating announcement earlier today on MBIA Inc. (MBIA) and its financial guaranty subsidiaries, Fitch Ratings has placed 173,022 bond issues (172,860 municipal, 162 non-municipal) insured by MBIA on Rating Watch Negative.

Only 173,022 issues. Ho-hum.

BofA: Attitudes Changing Towards Default

Within the next couple of years, probably somewhere between 10 million and 20 million U.S. homeowners will owe more on their homes, than their homes are worth. (See Homeowners With Negative Equity)

One of the greatest fears for lenders (and investors in mortgage backed securities) is that it will become socially acceptable for upside down middle class Americans to walk away from their homes.

If every upside down homeowner resorted to "jingle mail" (mailing the keys to the lender), the losses for the lenders could be staggering. Assuming a 15% total price decline, and a 50% average loss per mortgage, the losses for lenders and investors would be about $1 trillion. Assuming a 30% price decline, the losses would be over $2 trillion.

Not every upside down homeowner will use jingle mail, but if prices drop 30%, the losses for the lenders and investors might well be over $1 trillion (far in excess of the $70 to $80 billion in losses reported so far).

It is now time to downgrade the monoliners

The shocking and surprising revelation by MBIA – one the leading monoliners, i.e. bond insurers – that it has guaranteed $8.1 billion of collateralized debt obligations repackaging other CDOs and securities linked to subprime mortgages (i.e. it is holding the very risky CDOs of CDOs) – is the last drop in this monoliners’ farce: it is time for the credit rating agencies to downgrade most of these monoliners from their AAA rating status.

The forest issues is simple: a business – the monoliners’ insurance of securities and holding of risky ABS securities – that is fundamentally based on having a AAA rating is a business that does not deserve a AAA rating in the first place: it is clear to all that if a monoliner were to lose its AAA rating the essence of its business model would fail and such monoliner would have to close shop.

Add to this mess the fact that monoliners collectively insure $3,300bn of principal and interest (less than 30% of it ABS) with only a $22bn capital base. Of course a downgrade of monoliners will have a severe knock-on effect of potential downgrade on muni and other bond markets; analysts have estimated that such downgrades could cause losses writedowns of about $200bn. But these risks cannot be an excuse for not admitting that the monoliners don’t deserve an AAA rating. As long as monoliners were only in the muni bonds insurance business one could have made the argument that a prudent monoliner did deserve an AAA rating; but now that monoliners have vastly expanded in the ABS world of insuring toxic RMBSs, CDO, CDOs of CDOs and in some cases even holding these assets on their portfolios such an AAA rating does not make any sense.

Charting the Housing Bubble

A chart that may help clarify some of the things I have been/will be saying about housing.

This chart shows the ratio of housing prices from OFHEO to the “owners’ implicit rent” from the BLS. Both are index numbers, 1982 = 1. This is more or less equivalent to the price-earnings ratio for stocks.

The red line shows the ratio for the United States as a whole. The blue line shows the ratio for the Los Angeles metropolitan area.

What the chart shows is that this decade we’ve had a national housing bubble that is somewhat bigger than the bubble in LA in the late 1980s — a bubble that was followed by a 20% drop in nominal home prices, and a 30% fall in real prices. In LA itself, and in a number of other metropolitan areas, the bubble has been on a scale completely unprecedented in modern experience.

Wednesday, December 19, 2007

Financial Day of Reckoning Approaches

Standard & Poor's cut its ratings on ACA Financial Guaranty Corp to junk as part of actions on six bond insurers on Wednesday.

S&P cut ACA's rating to "CCC," or eight levels below investment grade, from "A," the sixth-highest investment-grade rating. It also said it may cut Financial Guaranty Insurance Co's 'AAA' rating.

Banks Study Bailing Out Struggling Bond Insurer
Officials from Merrill Lynch (MER), Bear Stearns (BSC) and other major banks are in talks to bail out a struggling bond insurance company that has guaranteed $26 billion in mortgage securities, according to two people briefed on the situation, because the insurer’s woes could force the banks to take on billions in losses they had insured against.

The insurer, ACA Capital Holdings, which lost $1 billion in the most recent quarter, has been warned by Standard & Poor’s that its financial guarantor subsidiary may soon lose its crucial A rating.

My Comment: Not only did it lose its A rating, the rating dropped all the way to CCC

If it did, the banks that insured securities with the ACA Financial Guaranty Corporation would have to take back billions in losses from the insurer under the terms of the credit protection they bought from the company.

The troubles at ACA could also serve as the first real test for credit default swaps, the tradable insurance contracts used by investors to protect, or hedge, against default on bonds. In June, the value of bonds underlying credit default swaps rose to $42.6 trillion, up from just $6.4 trillion at the end of 2004, according to the Bank for International Settlements.

My Comment: The entire US economy is $14 trillion or so in contrast to $42.6 trillion in credit default swaps. The entire Derivatives Trade Soars To Record $681 Trillion.

"The hedge is only as good as the counterparty, or the other party, to the hedge,," said Joseph R. Mason, a finance professor at Drexel University and the Wharton School of the University of Pennsylvania. “This is part and parcel of the financial innovation that has grown very rapidly in recent years.”

My Comment: There is absolutely no way all the hedges can be paid. Look at the number of derivatives and swaps above as proof.

Investment banks, hedge funds and insurance companies often use credit default swaps to bet on or against bonds without trading the underlying securities. Warren E. Buffett and other critics have described the contracts as financial time bombs, because they say that traders often misprice risk of default and do not set aside enough reserves to cover claims. They also note that investors have become complacent about the risks in recent years because default rates fell to historically low levels.

My Comment: Those time bombs are now going off.

Banks that insured securities with ACA have another reason to keep the company afloat — if it fails they may have to restate earnings they have already booked as a result of their dealings with the company.

My Comment: Those earnings were a mirage. That mirage made the S&P 500 look cheap. The S&P 500 was not and is not cheap because much of the earnings were a mirage based on hopelessly unsound financial engineering.

Mr. Egan and other analysts also note that ACA more than doubled its credit default business in the last 12 months; it had contracts outstanding on $70 billion in bonds on Sept. 30, up from $30 billion a year ago. The timely use of credit default swaps this summer helped large investment banks like Goldman Sachs and Lehman Brothers avoid huge losses on mortgage securities as others had billions in losses. But Jim Keegan, a senior vice president and portfolio manager at American Century Investments, questions whether the firms that sold protection will be able to pay up when losses materialize.

It’s a zero-sum game,” he said, noting that the gains at the investment banks buying the protection have to eventually result in losses for the firms they hedged with. “If you put trades on that worked so well that you bankrupt your counterparty, you will not collect on those trades.”

My Comment: It is obvious here that the emperor has no clothes. There is going to be a global collapse in derivatives as soon as a key counterparty defaults. ACA is one such domino. It remains to be seen if it is THE domino or not.

Last week, the New York Stock Exchange delisted ACA Capital after its stock price had collapsed and the company declined to offer a plan to bring itself back into compliance with listing standards. The stock was trading at about 40 cents over the counter on Tuesday; it traded as high as $15 in the summer.

My Comment: ACA capital was delisted last week, but S&P kept its credit rating at A up until today. Actions speak louder than words. It is clear the rating agencies are hopelessly and purposely behind the curve.

One look at ACA should be enough to tell anyone that the reaffirmations by the ratings agencies of Ambac (ABK), MBIA (MBI) and others are completely suspect at best, and purposeful manipulation at worst. For more on Ambac and MBIA please see Ambac Blows It ... Again.

Here is something I am going to keep repeating until it sinks in: It's Time To Break Up The Credit Rating Cartel.

Any talk of a bailout of ACA is fantasy. Banks are so capital impaired that a bailout is not possible. If by some sleight of hand shell game they manage to pull it off, they will most likely have to do it again with MBIA and/or Ambac. With that in mind I see MBIA hit a new 52 week low today.

Neither Ambac nor MBIA deserves the AAA ratings they have. However, the ratings agencies do not want to downgrade MBIA and Ambac because it would trigger the re-rating and possible forced sale of $2.5 trillion in municipal bonds.

However, the market will eventually force a downgrade those companies whether anyone likes it or not. Indeed, Professor Depew is reporting Ambac, MBIA: Prognosis Negative in today's dose of Five Things.

The financial day of reckoning approaches.

Japanese banks wary of U.S. subprime M-LEC rescue plan

Sumitomo Mitsui Banking Corp. President Masayuki Oku implied that his institution won't be participating in the U.S. subprime rescue fund as requested by its U.S. backers, according to published reports.

Oku said his bank is taking a cautious approach toward the request to contribute to the so-called superfund," implying that SMBC's participation is unlikely at this point, according to a report in the Nikkei business daily.

"We must consider this matter extremely carefully," he said at a regular news conference for the Japanese Bankers Association, which he heads. In Japan, use of such phrases often indicates that no action will be forthcoming.
Japanese bankers are far from novices when it comes to subprime loans and credit crunches.

The Japanese financial world underwent its own real-estate-centered crisis after the property bubble burst in 1989. Japan's banks were unable to raise funds in the short-term money markets and were forced to cut lending to corporate clients.

Japanese companies weren't able to borrow from banks or raise funds in the capital markets, and the economy entered what is now known as "The Lost Decade" of stop-and-go sluggish growth and contraction, until a banking-sector cleanup began in earnest in 2002.

Major U.S. banks reportedly asked Japan's three megabanks, Sumitomo Mitsui Financial Group (JP:8316: news, chart, profile) , Mitsubishi UFJ Financial Group (JP:8306:
to each set up a credit line of $5 billion, or roughly 550 billion yen, as part of the master liquidity-enhancement conduit, or M-LEC.

The Credit Crunch

Morgan Stanley Post Loss on 4Q Writedown

Morgan Stanley, the No. 2 U.S. investment bank, reported a $9.4 billion writedown on Wednesday from bad bets on mortgage-related debt, leading it to take a $5 billion infusion from an arm of the Chinese government.

The writedown, nearly triple what Morgan Stanley warned of in November, pushed the investment house to the first quarterly loss in its 73-year history. Chairman and Chief Executive John Mack accepted blame for the fiscal fourth-quarter loss, and said he would forgo his annual bonus.

Tuesday, December 18, 2007

The Conscience of a Liberal

Authors @ Google Talk on December 14, 2007
Paul Krugman is a professor of economics and international affairs at Princeton University, and the author or editor of 20 books and more than 200 professional journal articles. In recognition of his work, he has received the John Bates Clark Medal from the American Economic Association, an award given every two years to the top economist under the age of 40. The Economist said he is "the most celebrated economist of his generation."

1. Banks have an solvency issue not a liquidity issue
2. Krugman expects the housing market to continue to decline
3. There is a 50% chance of recession in 2008 as measured by the NBER
4. The dollar will continue to decline
5. The current housing crisis is like the S&L crisis of the early 1990s
6. He fully expects to see "debt deflation" as the economy moves into 2008 and beyond

See also "After the Money's Gone" NYT December 14, 2007

Fed Shrugged as Subprime Crisis Spread

Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford. But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of “best practices” and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading. John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act.

As housing prices soared in what became a speculative bubble, Fed officials took comfort that foreclosure rates on subprime mortgages remained relatively low. But neither the Fed nor any other regulatory agency in Washington examined what might happen if housing prices flattened out or declined. Had officials bothered to look, frightening clues of the coming crisis were available. The Center for Responsible Lending, a nonprofit group based in North Carolina, analyzed records from across the country and found that default rates on subprime loans soared to 20 percent in cities where home prices stopped rising or started to fall.

Subprime loans carry high interest rates, sometimes as high as 12 percent, and were designed for people with weak credit records. Unlike traditional banks and thrifts, which traditionally financed their loans with deposits, most subprime lenders are financed by investors on Wall Street who buy packages of loans called mortgage-backed securities. Starting from a virtual standstill 10 years ago, subprime lenders became by far the fastest-growing segment of mortgage lending before they collapsed. They made $540 billion in mortgages by 2004 and $625 billion at their peak in 2006 — about one-quarter of all new mortgages.

Home ownership, which had hovered around 64 percent for years, climbed to almost 70 percent by 2005. The biggest gains were among blacks and Hispanics, groups that had suffered discrimination for decades. Borrowers were being qualified for loans based on low initial teaser rates, rather than the much higher rates they would have to pay after a year or two. Many of the loans came with big fees that were hidden in the overall interest rate. And many had prepayment penalties that effectively blocked people from getting cheaper loans for two years or longer.

Why are the most risky loan products sold to the least sophisticated borrowers?” Mr. Gramlich asked in a speech he prepared last August for the Fed’s symposium in Jackson Hole, Wyo. “The question answers itself — the least sophisticated borrowers are probably duped into taking these products.”

The drop in lending standards became unmistakable in 2004, as lenders approved a flood of shaky new products: “stated-income” loans, which do not require borrowers to document their incomes; “piggyback” loans, which allow people to buy a home without making a down payment; and “option ARMs,” which allowed people to make less than the minimum payment but added the unpaid amount to their total mortgage. But the regulators found themselves hopelessly behind the fast-changing practices of lenders and did not impose new standards on option arms until September 2006 and subprime until June 2007 when 30 subprime lenders had already gone out of business.

Fed Board Recommends Tighter Curbs on Subprime Loans

The Federal Reserve Board voted unanimously to propose new restrictions on subprime mortgages, including a ban on low-documentation loans and limits on penalties for borrowers who prepay their debts.

The Fed governors voted in favor of tightening restrictions on so-called pre-payment penalties, requiring the escrow of taxes and insurance, and banning loans made without verification of income or assets. New rules would make lenders responsible for determining whether their customers can afford a loan after the initial interest rate resets.

The Board approved prohibiting lenders from paying brokers fees [e.g. rebates for higher interest rate loans] in excess of what the borrower agreed the broker should receive. The proposal bars coercion of appraisers, and defines seven advertising practices as misleading or deceptive.

SIV liquidity problems: The next wave looms

Funding problems for the structured investment vehicles at the heart of this year’s liquidity troubles are far from over, despite the move by a number of banks to step in to support their vehicles, reports the FT’s Paul Davies on Tuesday.

January will bring the start of a second wave of liquidity problems for SIVs as the vast majority of medium-term funding starts to come due for repayment, according to a report from Dresdner Kleinwort analysts to be published on Wednesday.

SIVs rely on cheap, short-term debt to fund investments in longer-term, higher-yielding securities. This cheap debt has come from both the very short-term commercial paper markets and from the slightly longer maturity, medium-term note (MTN) markets. CP funding has long dried up and much of what was sold has matured.

So far, SIVs have primarily felt the impact of collapsed CP issuance, Domenico Picone at DrK told the FT. Outstanding MTN for the 30 SIVs currently stands at $181bn, which will be the next liquidity challenge they face, he added.

This represents almost 65 per cent of the value of the SIV sector in mid-October, and it is likely that SIVs have shrunk a great deal more since then.

According to the DrK analysts’ calculations, two-thirds of all MTN funding for SIVs comes due for repayment by the end of next September. Almost $40bn is to be repaid from January to March alone.

This second liquidity squeeze will affect some SIVs more than others.

Sigma Finance, run by Gordian Knot, accounts for 22.5 per cent of all outstanding MTNs issued by SIVs, says Davies. It must repay about $22.5bn by the end of September and another $2.5bn in the final quarter.

Another heavy borrower in the MTN market is HSBC’s Cullinan Finance, which must repay $19bn by the end of September. DrK has to repay $13.4bn over the coming nine months and Citigroup $29.1bn.

Central Banks Are Getting Desperate in Dealing with the Liquidity Crunch and Resorting Again to Stealth Reductions in Policy Rates

Central banks are now becoming even more creative in dealing with the liquidity crunch and starting to do the kind of stealth policy rate reductions that they performed last August and September. The ECB just announced a special liquidity operation that will allow financial institutions to borrow for two weeks unlimited amounts at a rate of 4.21% (close to its policy rate of 4%); the two-week euro Libor had been 4.9% before the announcement. So the ECB is providing a temporary monetary policy easing of 70bps for a two week period.

The operation is highly unusual and heterodox; and while getting creative in dealing with liquidity crunches may be appropriate this action signals some desperation on the part of the ECB. The problem is that the ECB is the only G7 central bank – apart from the BoJ – that has not reduced at all its policy rate.

And since most financial and other private contracts are indexed to Libor, an average Libor that is about 100bps above policy rates it is equivalent to the ECB having raised its policy rate by 100bps in the last few months. So not only the ECB has not reduced its policy rate in spite of major signals and risks of economic slowdown in the Eurozone ...it has effectively increased its policy rate by 100bps as Libor – rather than the policy rate – is the relevant cost of capital for the financial system.

9am EST Update: Today's monster monetary injection by the ECB ended up being even larger than expected, amounting to 348.6 billion euros (or about $501 billion). The two-week Euribor fell a record 50bps to 4.45%. But in spite of this massive intervention it is still 45bps above the 4% policy rate of the ECB; so even with this unprecedented intervention the ability of the ECB to unclog the money markets has been only partially successful. Thus, while a massive injection of liquidity of $500 billion partially reduced the crunch at a short term maturity of two weeks - the one that covers the year end "turn" it has done little to nothing to deal with the liquidity crunch at a 3 month horizon.

Monday, December 17, 2007

A Little Acid Test for Fed Liquidity

If investors think the Fed buying up a few billion of Treasury and agency debt means a hill of beans, they might do well to remember that the U.S. government is running up annual deficits in the hundreds of billions. In fact, the U.S. Treasury will float tens of billions of new debt in December alone (most of which will be sopped up by foreigners, who have increased their holdings of Treasuries by well over $200 billion in the past year). This will be mixed in with refinancings.

Last week, for example, the Treasury auctioned $21 billion in 3-month bills and $20 billion in 6-month bills. In doing so, the Treasury offset every bit of the Federal Reserve's actions this week, even if it turns out that the $40 billion “term auction facility” represents new liquidity and not just rollovers. Why aren't investors just as interested in that? When the Fed does open market operations, all it's doing is buying up (temporarily or permanently) a tiny fraction of U.S. Treasury debt and replacing it with currency and bank reserves. But every time the Federal government issues more debt to finance its deficits, the new issuance cancels out any beneficial increase in liquidity the Fed could possibly provide.

So it's difficult to understand why investors would get all excited about the Fed temporarily buying up a few billion in government securities, when we've got a Federal government that's simultaneously and permanently issuing and then constantly rolling over many, many times that amount. It‘s an escape into dreamland to believe that Fed actions have any chance at all of providing more “liquidity” when the Federal government's deficits suck up in a matter of weeks every bit of liquidity that the Fed has provided in a year. These Fed actions are nothing but marginal tinkering around the edges of the global financial system, and investors are starting to catch on.

The Crisis of 2007: The Same Old Story, Only the Players Have Changed

A well known tradition in monetary economics which goes back to the nineteenth century and in the twentieth century was fostered by Wesley Mitchell ( 1913), Irving Fisher (1933), Hyman Minsky (1957) Charles Kindleberger (1978) and others. It tells the tale of a business cycle upswing driven by what Fisher called a displacement (an exogenous event that provides new profitable opportunities for investment) leading to an investment boom financed by bank money (and accommodative monetary policy) and by new credit instruments --financial innovation. The boom leads to a state of euphoria where investors have difficulty distinguishing sound from unsound prospects and where fraud can be rampant. It also can lead to a bubble characterized by asset prices rising independently from their fundamentals. The boom inevitably leads to a state of overindebtedness, when agents have insufficient cash flow to service their liabilities. In such a situation a crisis can be triggered by errors in judgement by debtors and creditors in an environment changing from monetary ease to monetary tightening. The crisis can lead to fire sales of assets, declining net worths, bankruptcies, bank failures and an ensuing recession. A key dynamic in the crisis stressed by Mishkin ( 1997) is information asymmetry ,manifest in the spread between risky and safe securities, the consequences of which( adverse selection and moral hazard) are ignored in the boom and come into play with a vengeance in the bust. (Michael D. Bordo, Rutgers University and NBER Remarks prepared for the Federal Reserve Bank of Chicago and International
Monetary Fund conference; Globalization and Systemic Risk.
Chicago, Illinois September 28, 2007)

Sunday, December 16, 2007

A Citi That Gets No Sleep

On Friday, Moody's Investors Service downgraded Citigroup's long-term ratings, saying it expects continued losses related to mortgages and other complex securities. The action came a day after Citigroup resolved longstanding questions about troubled off-balance-sheet vehicles it sponsors.

The danger is that every time Mr. Pandit fixes one problem, the bank's balance sheet could spring another leak. Citigroup could quickly find itself in a capital squeeze; additional losses eat into capital even as downgrades of its assets force the bank to set aside more money to meet regulatory requirements.

This pressure could push Mr. Pandit to cut the bank's generous dividend. The $2.16-a-share annual payout costs the bank $10.8 billion a year, money which could go a long way towards shoring up capital. Citigroup's stock Friday fell 31 cents, or 1%, to $30.70, just above its five-year low. The shares yield slightly less than 7%.

CIBC analyst Meredith Whitney estimates the bank will need to raise $30 billion and will have little choice but to cut the dividend -- and do even more. She and other analysts expect Citigroup will have to raise additional capital from investors beyond the $7.5 billion in convertible bonds it recently sold to Abu Dhabi's investment arm and sell assets.

Sean Jones, the Moody's analyst who follows Citigroup, said he expects the bank to face write-downs on its collateralized-debt-obligation assets that exceed the $8 billion to $11 billion loss the bank already has forecast on this debt for the fourth quarter.

That could also spell trouble in terms of the $49 billion in SIV assets Citigroup is bringing onto its books, should those get downgraded. A change in the SIV assets' risk weighting "could translate into yet another capital challenge," Ms Whitney's report said.

Subprime Crisis Claims California: Arnold to Declare Fiscal Emergency

The inevitable has happened, and, as tipped here previously, California governor Schwarzenegger has conceded that the state budget deficit is ballooning to record levels. From forecasting breakeven, as of last August, the state is now saying that it is looking at a whopping $14-billion shortfall in 2008, up from the $10-billion forecast of a scant few months ago.

How big is that deficit? It is the size of the California prison system budget plus the cost of running the sprawling University of California schools. Turns out that a stalling economy, plus collapsing real estate are a pretty serious whack on the state's financial head.

Wait Till Next Year

Although many people consider a two-quarter downturn of gross domestic product to be a recession, the designation of recessions is done by the business-cycle dating committee of my organization, the National Bureau of Economic Research. The bureau defines a recession as a significant decline in economic activity spread across the economy and lasting more than a few months. In judging whether the economy is in recession, the committee looks at monthly data on real income, employment, industrial production, and wholesale and retail sales.

Because monthly data for December won’t be available until next year, we cannot be sure whether the economy has turned down. The measure of personal income for October suggests that the economy may have peaked and begun to decline, but the data for employment and industrial production in November and for sales in October show continued growth.

My judgment is that when we look back at December with the data released in 2008 we will conclude that the economy is not in recession now.

There is no doubt, however, that the economy is slowing. There is a substantial risk of a recession in 2008. Whether that occurs will depend on a variety of forces, including monetary policy and a possible fiscal stimulus.

— Martin Feldstein, a professor of economics at Harvard and the president of the National Bureau of Economic Research.

Bet the House on It

The economy faces a vicious downward spiral of foreclosures, declining property values and mounting losses on mortgage-backed securities and related financial assets.

The resetting of interest rates on more than 2 million subprime loans will prompt a large number of foreclosures, perhaps a million a year in both 2008 and 2009. These huge waves of foreclosures will depress the price of residential real estate still further. Plummeting real estate values and escalating foreclosures will cause further losses on mortgage-related securities and will further burden American consumers already dealing with higher energy prices and substantial debt.

Given the dampening effects of these developments on both consumption and investment spending, it is increasingly likely that the economy will slip into recession next year.

Laura Tyson, a professor of business and public policy at the University of California, Berkeley, and the chairwoman of the Council of Economic Advisers from 1993 to 1995.

You Can Almost Hear It Pop

The American economy is slipping into its second post-bubble recession in seven years. Just as the bursting of the dot-com bubble led to a downturn in 2001 and ’02, the simultaneous popping of the housing and credit bubbles is doing the same right now.

Home prices are likely to fall for the nation as a whole in 2008, the first such occurrence since 1933. And access to home equity credit lines and mortgage refinancing — the means by which consumers have borrowed against their homes — is likely to be impaired by the aftershocks of the subprime crisis.

There is hope that young consumers from rapidly growing developing economies can fill the void left by weakness in American consumers. Don’t count on it. American consumers spent close to $9.5 trillion over the last year. Chinese consumers spent around $1 trillion and Indians spent $650 billion. It is almost mathematically impossible for China and India to offset a pullback in American consumption.

America’s central bank has mismanaged the biggest risk of our times. Ever since the equity bubble began forming in the late 1990s, the Federal Reserve has been ignoring, if not condoning, excesses in asset markets. That negligence has allowed the United States to lurch from bubble to bubble.

Fixated on the narrow “core inflation” rate, which excludes the necessities of food and energy, the Fed has ignored new and powerful linkages that have developed between economic activity and increasingly risky financial markets.

Over time, America’s bubbles have gotten bigger, as have the segments of the real economy they have infected. The Fed needs to rethink its reckless, bubble-prone policy. Once the current crisis subsides, the economy will require the tight money of higher interest rates — the only hope America has for breaking the lethal chain of endless asset bubbles. Stephen S. Roach, the Chairman of Morgan Stanley Asia.

Saturday, December 15, 2007

California is another country

Commenter Jim M. points to Housing Tracker as a source for data on house price to income ratios. Here is a list of the top cities in terms of median house price relative to median income.

1. Los Angeles, Ca. 10.5
2. San Francisco, Ca. 9.8
3. NY, NY. 9.4
4. Orange County, Ca. 9.2
5. San Jose, Ca. 9.2
6. San Diego, Ca. 8.8
7. Miami, Fl. 8.5
8. Riverside, Ca. 6.7
9. Boston, Ma. 5.4
10. Sarasota, Fl. 5.4

California has five of the top six. Outside of California, New York City, and Miami, most housing markets may not be far from equilibrium. Remember that my ceiling for a price/income ratio is six, while others peg it at four. But the median price/income ratio might be higher than the ceiling, because median income includes a lot of renters.

Overall, it looks as if prices may have to fall almost 50 percent in the top 7 markets, but in many other markets they don't have to fall at all.

What Bankers Fear

Make no mistake: The central bankers' announcement Wednesday of a new coordinated effort to pump cash into the global financial system is a sign of their nervousness. The global credit squeeze that began last summer still hasn't run its course, and the central bankers fear that the stressed financial system could pull the world economy into a deep recession.

Thus the bankers' decision to shower the system with money, through a new system of auctions that will allow banks to borrow more cheaply than they can through the commercial interbank market. What's unusual is that five leading central banks agreed to act as a joint rescue committee.

The aim isn't so much to prevent a downturn -- the bankers aren't sure that's possible, or even desirable -- as to mitigate its effects. Fed officials have decided that they need to let the adjustment happen in financial markets, with prices of mortgage-backed securities and other assets falling to levels that will allow the markets to clear.

What scares the central bankers now is the evaporation of trust from the system. Banks don't believe each other's numbers; since nobody knows the real value of some of the mortgage-backed securities everyone is holding, they assume the worst. They start hoarding cash as a buffer against their own losses and because they're nervous about lending to anyone else.

"The basic problem is that banks don't trust each other. They can't get financing, so they don't lend, and this can cause spillover into the larger economy," explains Ted Truman, a senior fellow at the Peterson Institute in Washington and the Fed's former top international economist.

"If someone would take me out of all my positions, long and short, I'd do it," he said. This is the financial market equivalent of saying you want to start over. Six months into the credit crunch, that's the way many exhausted players are feeling. The markets will have to sink a good deal more, alas, before the vultures arrive to carry off the debris and the process of rebuilding can start.

Things That Go Bump in the Night

From 1990 until the spring of this year, we saw the development of what Paul McCulley calls the shadow banking system. Non-depository institutions and funds created massive amounts of new money based on leverage. The Fed has lost control of the money supply, because the banks it regulates no longer are the primary movers of debt creation. Investment banks, hedge funds, SIVs, and a score of new investment vehicles have been created to finance a vast array of "stuff." Corporate loans are syndicated by banks but are then sold to non-banks (CLOs and hedge funds), who leverage the loans up beyond what a bank could do.

All that credit exploded the largest measure of the money supply (M-3, over which the Fed has no control - none - zip - nada) and lowered the risk premium for all sorts of investments and encouraged yet even more leverage in order to keep up portfolio returns.

But that changed this year and in particular in August. We are now seeing a de-leveraging that is unprecedented in the modern era. This is increasing risk premiums (which I think is good), but it is also deflating the total money supply. We are seeing two bubbles, the housing market and the credit markets, deflate before our eyes.

Why monetary policy easing is warranted even in the current insolvency crisis

Starting in 2001 the Fed cut rates from 6.5% all the way to 1% by 2003; in spite of that the bust of the tech bubble continued: the Nasdaq fell all the way from a level of 5000 to about 1200; other stock indexes in the US and abroad sharply fell; thousands of internet companies that were mostly “vaporware” – i.e. with little revenues, let alone earnings – went belly up and bankrupt. Thus that aggressive monetary easing did not succeed in bailing out investors.

Similarly today home prices that rose in a bubble like fashion by almost 100% in real terms between 1997 and 2006 will fall by at least 20% - if not more – regardless of what the Fed does; given the biggest glut in new and existing homes in US history and the biggest housing recession ever no amount of Fed easing will prevent this collapse in home prices. And the broader financial losses – that will be close to 1,000 billion dollars once you add sub-prime, near prime, prime, auto loans, credit cards, student loans, commercial real estate, leveraged loans and lending to the distressed parts of the corporate sector – will be massive regardless of what the Fed does. And once the unavoidable hard landing becomes clear to market participants the current delusional hope of the stock market investors that the Fed can prevent such hard landing will fizzle out and stock price will sharply fall as well. In a recession there is no room to hide: in a typical US recession – with or without Fed easing – the S&P 500 falls by an average of 28% in nominal terms and almost as much in real terms.

When bubbles go bust the Fed can only minimize the collateral damage to the economy and reduce modestly the severity of the losses; it cannot prevent massive losses and sharp falls in asset prices from occurring as the experience with the S&L boom and bust in the late 1980s and the tech boom and bust in the late 1990s suggests.

Thus, the way to deal with the risk of new asset bubble is not to renounce monetary policy easing that is necessary to reduce the real economy collateral damage of a bursting bubble [i.e. depth & duration]; it is rather using the appropriate supervision and regulation of the financial system to ensure that a new bubble does not emerge from that monetary policy easing. It is still appropriate and legitimate use of monetary policy easing interest rates when an asset bubble bursts when both monetary and regulatory policies have been used to control a bubble when such a bubble is emerging; so a symmetric approach of monetary/regulatory policy [both up & down the cycle] to bubbles – rather than the asymmetric approach advocated by Bernanke/Greenspan/Kohn – is the appropriate way to minimize the risk of moral hazard and to avoid turning the Fed into a serial bubble blower.

Friday, December 14, 2007

After the Money’s Gone

In past financial crises — the stock market crash of 1987, the aftermath of Russia’s default in 1998 — the Fed has been able to wave its magic wand and make market turmoil disappear. But this time the magic isn’t working.

Why not? Because the problem with the markets isn’t just a lack of liquidity — there’s also a fundamental problem of solvency.

Suppose that there’s a nasty rumor about the First Bank of Pottersville: people say that the bank made a huge loan to the president’s brother-in-law, who squandered the money on a failed business venture. Even if the rumor is false, it can break the bank. If everyone, believing that the bank is about to go bust, demands their money out at the same time, the bank would have to raise cash by selling off assets at fire-sale prices — and it may indeed go bust even though it didn’t really make that bum loan.

And because loss of confidence can be a self-fulfilling prophecy, even depositors who don’t believe the rumor would join in the bank run, trying to get their money out while they can.

But the Fed can come to the rescue. If the rumor is false, the bank has enough assets to cover its debts; all it lacks is liquidity — the ability to raise cash on short notice. And the Fed can solve that problem by giving the bank a temporary loan, tiding it over until things calm down.

Matters are very different, however, if the rumor is true: the bank really did make a big bad loan. Then the problem isn’t how to restore confidence; it’s how to deal with the fact that the bank is really, truly insolvent, that is, busted.

In August, the Fed tried again to do what it did in 1998, and at first it seemed to work. But then the crisis of confidence came back, worse than ever. And the reason is that this time the financial system — both banks and, probably even more important, nonbank financial institutions — made a lot of loans that are likely to go very, very bad.

First, we had an enormous housing bubble in the middle of this decade. To restore a historically normal ratio of housing prices to rents or incomes, average home prices would have to fall about 30 percent from their current levels.

Second, there was a tremendous amount of borrowing into the bubble, as new home buyers purchased houses with little or no money down, and as people who already owned houses refinanced their mortgages as a way of converting rising home prices into cash.

As home prices come back down to earth, many of these borrowers will find themselves with negative equity — owing more than their houses are worth. Negative equity, in turn, often leads to foreclosures and big losses for lenders.

That translates into a lot of losses, and explains why liquidity has dried up. What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic, because there’s a lot of bad debt out there, and you don’t know how much of that bad debt is held by the guy who wants to borrow your money.

Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed.

See also Calculated Risk post today.

Reccession Odds: Greenspan 50%, Merrill 100%

Earlier on Thursday, CNBC reported that Greenspan raised his view of chances of a U.S. recession to 50%, from 30%:

"Greenspan said it's too soon to say whether a recession is coming, "but the odds are clearly rising."

The former Fed chair is downright chipper compared with some of the data crunchers over at Merrill Lynch: They look at the simple formula involving the Yield Curve and Corporate Spreads. This correctly forecast the 2001 and 1990-91 recessions.

Restoring Market Liquidity in a Financial Crisis

The auction facility and other measures we have taken to address market liquidity problems do not directly address the balance sheet or capital constraints facing financial institutions. Nor can they be expected directly to reduce the perceived risk in exposure to other financial counterparties. But by providing a more effective form of access to liquidity, these new measures can help reduce the uncertainty that gives institutions the incentive to secure liquidity in ways that might lead to a further deterioration on market conditions.

Thursday, December 13, 2007

Morgan Stanley issues full US recession alert

Morgan Stanley has issued a full recession alert for the US economy, warning of a sharp slowdown in business investment and a "perfect storm" for consumers as the housing slump spreads.

"Slipping sales and tightening credit are pushing companies into liquidation mode, especially in motor vehicles," it said. "Three-month dollar Libor spreads have jumped by 60 to 80 basis points over the last month. High yield spreads have widened even more significantly. The absolute cost of borrowing is higher than in June." "As delinquencies and defaults soar, lenders are tightening credit for commercial, credit card and auto lending, as well as for all mortgage borrowers," said the report, written by the bank's chief US economist Dick Berner. He said the foreclosure rate on residential mortgages had reached a 19-year high of 5.59pc in the third quarter while the glut of unsold properties would lead to a 40pc crash in housing construction.

"We think overall housing starts will run below one million units in each of the next two years -- a level not seen in the history of the modern data since 1959," he said.... Morgan Stanley is the first major Wall Street bank to warn that it is may now be too late to stop a recession, though most have shifted to an ultra-cautious stance in recent weeks.

The bank at first treated the August crunch as a "mid-cycle correction", much like the financial storm after Russia's default in 1998. But the collapse of the US commercial paper market has now continued for seventeen weeks, suggesting a "fundamental deleveraging of the banking system"...

Executive Confidence "Doom & Gloom"

WHAT holiday cheer? The latest quarterly poll of chief financial officers conducted by Duke University, Tilburg University and CFO magazine, a sister publication of The Economist, makes for grim reading. Of the 1,275 finance chiefs quizzed, those in Europe and America were more gloomy about their regional economies than ever before, with pessimists far outnumbering optimists. A third of companies in both regions, from a wide range of industries, said that they were directly affected by the recent credit-market turmoil. Optimism is relatively higher in Asia.

Wednesday, December 12, 2007

This is Not Good

Consider these two facts:

The biggest act of international economic cooperation since the Sept. 11 terrorist attacks is being put in place after demand for cash caused borrowing costs to rise. Banks and securities firms around the world have written down about $76 billion of assets this year after the market for mortgage-backed securities disintegrated.

The market for U.S. asset-backed commercial paper backed by assets such as mortgages and credit-card loans has shrunk for 17 straight weeks to $801 billion, falling 33 percent from its peak on Aug. 8, as structured investment vehicles continued winding down, according to data compiled by Bloomberg.

Those two pieces of information should scare the snot out of everyone.

Coordinated Central Banks Liquidity Injections: Too Little Too Late To Address the Fundamental Problems of the Financial System

Given the worsening of the global liquidity and credit crunch – with a variety of short term interbank Libor spreads relative to policy rates and relative to government bonds of same maturity being even higher recently than at the peak of the crisis in August – it is no surprise that central banks were really desperate to do something.

The announcement today of coordinated liquidity injections by FED, ECB, BoE, BoC, SNB is however too little too late and it will fail to resolve the liquidity and credit crunch for the same reasons why hundreds of billions of dollars of liquidity injections by these central banks – and some easing of policy rates by Fed, BoC and BoE – has totally and miserably failed to resolve this crunch in the last five months. What was announced today are band-aid palliative that will not address the core causes of this most severe liquidity and credit crunch.

There has some heated debate in recent weeks on whether the liquidity crunch is due to:

a) short-term year end liquidity needs (the “Turn”);

b) a more persistent liquidity risk premium;

c) a rise on counterparty risk and broader perceived credit problems of counterparties; i.e. serious problems of insolvency rather than illiquidity alone.

d) a more general increase in risk aversion due to severe credit problems and information asymmetries (risk aversion due to uncertainty about the size of the financial losses and uncertainty on who is holding the toxic waste of RMBS, CDOs and other ABS products);

e) the failure of the monetary transmission mechanism in a financial system where most financial institutions are now non-bank and thus do not have direct access to the central banks’ liquidity or lender of last resort support.

Steve Randy Waldman on the new Fed plan

I'm a bit more blase than that, but I did think it worth a blog post. The core innovation is that the Fed announces a quantity of funds to be auctioned, and the market sets the price. That is in contrast to the Fed targeting the Federal Funds rate; price-quantity equivalence results do not hold when credit rationing is present. It's like forcing a certain amount of discount window borrowing. This means that new funds will get to banks, and to banks with credit problems, it will be interesting to see at what price.

The skeptical Jim Lowe, over at Mark Thoma's, says:

The primary problem facing credit markets is not lack of liquidity but rather a combination of capital inadequacy and fears of credit/counterparty risk. I don't see how another liquidity injection addresses these problems.

In response, the Fed seems to be promising to "hold the bag" on the collateral offered by the soon-to-be borrowing banks. Could this be a collateral pledge disguised as a liquidity injection? Or is the main goal simply to reroute liquidity injections away from the main banks and toward the troubled cases?

TAF is a really, really big deal

I haven't time to write properly, I am caught between a million things. But when I woke up the the Federal Reserve's press release about the TAF, my jaw dropped. It was one of those moments when the world shook, everything was the same, but everything had changed. So, when I step into the blogosphere to read comments like "solid first step", I feel compelled to spew some first impressions.

I agree with several commentators (Felix Salmon, Calculated Risk) that the Bair/Paulson Plan, whatever it is, is not a bailout. But this, this is a bailout,. Nearly all government bailouts take the form of subsidized loans, extending credit at low rates to counterparties or against collateral for which the market would have demanded a high premium. That is precisely what the TAF will do. The Fed's press release claims, of course, that loans will only be available to "sound" banks, and that they will be "fully collateralized". But no one who can get the same deal from private markets will use this facility. The need for the program arises because private markets are skeptical about the soundness of counterparties and the quality of the assets they have to offer as collateral. The Fed hints at this when it mentions the "wide variety of collateral" that can be used to secure loans. You can bet that whatever it is private lenders are eschewing will be pledged as collateral to the Fed under TAF. The Fed is going to bear private risk that market refuses to. That is a bailout.

The Great Fed Bluff that Got Whacked Back

Folks, we must be mindfull of the fact that we're only in maybe year 2 of at least a 5 year residential mortgage cycle full of resets. Today was a roller coaster, huge. Markets opened high on upside due to the 'Fed Auction' surpise pump this morning, then reality set in by 4pm with only a minor gain, way down from yesterday's whipping. Here are two astute reader comments from Roubini's blog... a) "It seems absurd that the Fed would think a secret and anonymous auction of central bank funds could be useful in addressing a crisis of confidence arising from a lack of transparency and liquidity for unpriced, unmarketed synthetic assets and liabilities. The bids and winners will be secret, but everyone will know that whoever won was damn desperate - and that whoever didn't win will be tight and desperate too." b) "All you guys/gals have to do to see who will be at the auction is just go to Bankrate.com and look at the top offering rates for 3 month CD's and you will see that names like Countrywide and ETrade ore offering CD rates 100 bps above the current Fed funds rate and 85 bps above where they could borrow Fed Funds or do Repo's...there is you answer."

Citigroup: Morgan Stanley's Top Short Idea for 2008

Morgan Stanley is out pitching Citi (NYSE:C) as their top short idea for 2008. Near-term, the announcement of Vikram Pandit as CEO as well as the Fed should be a plus for Citi. But looking to 2008, MSCO sees 3 reasons to be short: earnings are deteriorating, they expect new management to deliver a dividend cut, not a breakup, and they expect further hybrid issuance, diluting current shareholders. The firm does not believe the stock has bottomed out as it is trading above trough multiples: 18% above trough PEs, 24% above trough P/B and 48% above trough P/TB + Reserves.

The firm has lowered their 2008 EPS From $4.01 to $3.55 due to higher losses against loans, CDOs, and SIVs, and due to slower top line growth in the IB and thinner net interest margins given wide LIBOR. They have lowered the forecasted dividend from 54c/quarter to 30c/quarter in 2Q08. MSCO is lowering their price target to $28 based on trough PE levels of 8.0x.

The Roots of the Mortgage Crisis by Alan Greenspan

On Aug. 9, 2007, and the days immediately following, financial markets in much of the world seized up. Virtually overnight the seemingly insatiable desire for financial risk came to an abrupt halt as the price of risk unexpectedly surged. Interest rates on a wide range of asset classes, especially interbank lending, asset-backed commercial paper and junk bonds, rose sharply relative to riskless U.S. Treasury securities. Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction.

The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums.

In addition, there has been a pronounced fall in global real interest rates since the early 1990s, which, of necessity, indicated that global saving intentions chronically had exceeded intentions to invest. In the developing world, consumption evidently could not keep up with the surge of income and, as a consequence, the savings rate of the developed world soared from 24% of nominal GDP in 1999 to 33% in 2006, far outstripping its investment rate.

That weakened global investment has been the major determinant in the decline of global real long-term interest rates is also the conclusion of a recent (March 2007) Bank of Canada study.

Equity premiums and real-estate capitalization rates were inevitably arbitraged lower by the fall in global long-term interest rates. Asset prices accordingly moved dramatically higher. Not only did global share prices recover from the dot-com crash, they moved ever upward.

After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own. There was clearly little the world's central banks could do to temper this most recent surge in human euphoria, in some ways reminiscent of the Dutch Tulip craze of the 17th century and South Sea Bubble of the 18th century.

Arbitragable assets -- equities, bonds and real estate, and the financial assets engendered by their intermediation -- now swamp the resources of central banks. The market value of global long-term securities is approaching $100 trillion. Carry trade and foreign exchange markets have become huge.

In theory, central banks can expand their balance sheets without limit. In practice, they are constrained by the potential inflationary impact of their actions.

The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.

Fed Term Auction Facility (TAP) & F/X Swap Lines

Today, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank are announcing measures designed to address elevated pressures in short-term funding markets.

Actions taken by the Federal Reserve include the establishment of a temporary Term Auction Facility (approved by the Board of Governors of the Federal Reserve System) and the establishment of foreign exchange swap lines with the European Central Bank and the Swiss National Bank (approved by the Federal Open Market Committee).

Tuesday, December 11, 2007

The consensus is moving from the soft vs. hard landing debate towards how severe the hard landing will be

While a few months ago analysts were still heatedly debating whether the US would experience a soft landing or a hard landing (a recession) the center of the macro debate has now clearly shifted away from soft landing versus hard landing discussion to a recognition that a hard landing is the most likely scenario; thus, increasingly now the debate is on how deep and severe the forthcoming hard landing will be.

David Rosenberg of Merrill Lynch is now clearly predicting a recession for the US economy in 2008; Jan Hatzius at Goldman Sachs is not formally speaking of a certain recession in 2008 but most of his analysis is consistent with a high likelihood of a recession in 2008; Mark Zandi of Moody’s Economy.com is also very close to a hard landing view.

And in the academic camp some of the most senior economists in the profession – Bob Shiller, Marty Feldstein, Larry Summers, Paul Krugman – are all in various degrees in the hard landing camp or very concerned about a hard landing.

Freddie Expects 4th-Quarter Loss, Record Default Rate

Dec. 11 (Bloomberg) -- Freddie Mac, the second-largest source of money for U.S. home loans, said it doesn't expect a ``quick fix'' for a mortgage market buffeted by record defaults, and may have a second straight quarterly loss of about $2 billion.

Freddie Mac didn't get any help today from the Federal Reserve, whose quarter-point cut in its benchmark interest rate failed to reassure investors that a recession could be avoided. Freddie Mac shares, down 52 cents before the announcement, fell $3.73, or 11 percent, to $31.31 on the New York Stock Exchange.

The housing market ``will get tougher before it gets better,'' Chief Executive Officer Richard Syron told investors at a conference in New York sponsored by Goldman Sachs Group Inc. ``We are not promising a silver bullet, a short-term quick fix.''

Fourth-quarter results ``are not going to be effectively better than'' the third-quarter net loss of $2.02 billion, or $3.29 a share, Syron said. Freddie Mac expects a 3 percent to 3.5 percent default rate in its mortgages, the worst since 1991, and reiterated a forecast for $10 billion to $12 billion in credit losses, according to slides accompanying Syron's speech.

Falling home prices nationwide and rising foreclosures signal the housing slump that began in 2006 may extend into its third year, matching the slowdown 18 years ago that ended in the 1991 recession. Freddie Mac and larger rival Fannie Mae sold preferred stock and cut their dividends in the past three weeks in order to maintain enough capital to absorb potential losses.

The U.S. mortgage and housing markets are unlikely to fully recover until at least 2010, Fannie Mae Chief Executive Officer Daniel Mudd said today.

``The correction will begin to turn into recovery in late '09, when we start to see credit clear and liquidity restored,'' Mudd told investors at a conference sponsored by Goldman Sachs Group Inc. He cautioned that ``forecasting right now is fraught with peril.''

Derivative Trades Jump 27% to Record $681 Trillion

The Bank for International Settlements (BIS) is reporting Derivatives traded on exchanges surged 27 percent to a record $681 trillion in the third quarter. The amounts are based on the notional amount underlying the contracts.

* Interest-rate futures, contracts designed to speculate on or hedge against moves in borrowing rates, led the increase with a 31 percent increase to $594 trillion.
* Trading in stock index futures and options rose 19 percent to a record $81 trillion in the third quarter, as investors speculated on whether the credit-market losses would spread to the equity markets.
* Trading in currency futures and options increased 18 percent to $6.4 trillion, the BIS said.

A derivative is a financial obligation whose value is derived from interest rates, the outcome of specific events or the price of underlying assets such as debt, equities and commodities. Companies and investors use them to hedge against, or speculate on, price changes.

Derivatives include futures, which are agreements to buy or sell assets at a set date and price, and options, which are the right but not the obligation to do so.

Investors may have shifted some trading to exchanges from the over-the-counter market to reduce the risk of counterparties defaulting on deals, the BIS said.

Warren Buffet on Super Siv Idea (M-LEC)

Becky: All right, if you want to talk abotu something complicated, let's talk about that Super-SIV plan. Has anybody explained this to you in a way that actually makes sense. Do you think this is a good idea?

Buffett: Well, it's been explained to me. And, I don't think it accomplishes a whole lot. What it's designed to do is to get assets over in a place where people will buy the commercial paper against them. And they'll buy that if the banks are backing it. So, right now you have a whole bunch of funds, particularly money market funds, that have financed these SIVs and they financed them in many cases because of the bank that was sponsoring them. And the SIVs do not have the liquidity and they don't have the assets at market value to pay off the commercial paper. So, there's a freeze in the financing of them.

The super-SIV would solve that by having the banks, in effect, back up the commercial paper, the super-SIV. But it doesn't make the assets better. I mean, one fundamental proposition is that even though we were taught when we were young that a princess could kiss a toad and it would turn into a prince, it didn't really work out. (Laughs.)

You can't turn a financial toad into a prince by kissing it, or by securitizing it. Or by transferring its ownership to somebody else. If there are problems with an instrument, there are problems with an instrument. And soem of the SIVs own things where the market value is down significantly and if sold presently, they couldn;t pay off the commercial paper.

Becky: So that's the problem? It's not the market that's setting a price on it, we're setting an artificial price?

Buffett: The market is the market. Yeah, an artificial price is a price you don't like. (Laughs.)

Fed Funds Cut to 4.25%

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/4 percent.

Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.

Readings on core inflation have improved modestly this year, but elevated energy and commodity prices, among other factors, may put upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; and Kevin M. Warsh. Voting against was Eric S. Rosengren, who preferred to lower the target for the federal funds rate by 50 basis points at this meeting.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 4-3/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, and St. Louis.

Monday, December 10, 2007

Mild recession likely, Morgan Stanley says

The U.S. economy is likely to slip into a mild recession in 2008, said economists at Morgan Stanley, which is the first major Wall Street firm to predict a recession.

WaMu Write Down $1.6 Billion, cuts 3,150 jobs, & closes 190 home loan centers

Washington Mutual Inc., the largest U.S. savings and loan, will write down the value of its home lending unit by $1.6 billion in the fourth quarter and cut 3,150 jobs as losses in the mortgage market increase.

Washington Mutual also will cut its quarterly dividend to 15 cents a share from 56 cents and close 190 of 336 home loan centers, the Seattle-based bank said in a statement today. The company said provisions for loan losses in the quarter will be $1.5 billion to $1.6 billion, about twice as much as it previously expected.

Fitch Ratings downgraded the firm's rating to ``A-'' from ``A,'' citing ``worsening asset quality,'' and ``extremely challenging conditions in the U.S. residential mortgage market.'' Washington Mutual said it plans to raise $2.5 billion to shore up its capital by selling convertible stock.

Industry-wide mortgage originations will probably shrink 40 percent in 2008 to $1.5 trillion, down from about $2.4 trillion this year, Washington Mutual said in the statement. The firm plans to cease lending through its subprime mortgage channel.

Takeover or Break Up for Citigroup

As Citi struggles to break free from the grip of its writedowns, and with capital levels hovering dangerously low, a takeover by a smaller banking rival is a distinct possibility, warn CreditSights.

In a gutsy - and perhaps mercurial - call, analysts at CreditSights say a takeover from JPMorgan isn’t unlikely, given the outlook for Citi. Otherwise, there’s also the threat of a breakup. At the very least, it’s a sluggish, troubled end to the decade for the world’s biggest bank - with the dividend remaining under threat for years to come.

It will take Citi three years to recoup losses on CDO writedowns, according to the report, and problems may get much, much worse.

First and foremost, Citi is faced with further big capital hits from its seven ailing SIVs, between them with $66bn AUM. CreditSights think this will be the next test of strength for the bank. The M-LEC superfund-cum-stumbling block, then, is far more critical for Citi than previously given credit.

Secondly, CreditSights hint at further CDO writedowns in the offing. Indeed, with a definite sense that the super-senior CDO debt market is fast collapsing, Citi can expect more trouble. The bank has $45bn in super-senior CDO exposure.
All in all, it amounts to a serious - potentially crippling - lead weight strung around Citi’s neck.

The Citi board meets on Monday and Tuesday to discuss the appointment of a new CEO.

UBS to Sell Stakes After $10 Billion in Writedowns

UBS AG, Europe's largest bank by assets, said it will write down U.S. subprime investments by $10 billion and raise 13 billion francs ($11.5 billion) by selling stakes to investors in Singapore and the Middle East.

UBS expects a loss in the fourth quarter, and may have a loss for 2007, the Zurich-based company said in an e-mailed statement today.

Securities firms and banks had announced about $66 billion of losses and markdowns linked to the collapse of the U.S. subprime mortgage market this year. UBS reported its first loss in almost five years in the third quarter after the subprime contagion led to about $4.66 billion ijavascript:void(0)
Publish Postn markdowns on fixed-income securities and leveraged loans.

Bank of America Money Market Fund down 70% & closed

The Columbia Strategic Cash Portfolio fund for institutional investors that was worth $40 billion only a couple months currently has about $12 billion in assets, Charlotte-based bank said.

The loss is related to the subprime-mortgage crisis that has rippled across the globe, Bank of America spokesman Jon Goldstein said.

"The conditions have really weakened the performance across the industry, including this one," Goldstein said.

Goldstein denied a CNBC report that the fund had been frozen, saying that clients were being offered the option of cash redemptions or of switching their assets into other Columbia-managed funds.

Overbought in an Unfavorable Market Climate

Now, if the belief in “Fed liquidity injections” was not so clearly misguided, I could launch into detailed speculation about how much “stimulus” the Fed might provide, and how long that liquidity will take to “work itself through the pipeline.” But as I detailed last week, the Fed has only “injected” about $16 billion into the banking system since March, all of which has been drawn out of the banking system as currency. Suffice it to say that I see speculation about the Fed's "stimulative" impact as useless because it is based on the demonstrably false premise that the Fed is actually injecting meaningful “liquidity” in the first place. Despite investors' flight to the safety of Treasury securities, commercial lending rates are not responding either (though economic softness is providing downward pressure that moderates the competing upward pressure from rising default risk).

Also, as I've frequently emphasized, monetary policy is not, and cannot be independent of fiscal policy. All the Fed does is to determine whether government liabilities take the form of Treasury bonds sold to the public, or currency and reserves held by the public directly or indirectly through the banking system. Monetary policy determines the mix of government liabilities held by the public (and even then only at the margin). Fiscal policy determines the total quantity of those government liabilities, most which are absorbed these days not by the Fed but by foreigners (in an amount many, many times what the Fed absorbs). If you want to worry about some entity that could have enormous impact on U.S. economic activity, ignore the Fed and focus on the real “maestros:” foreign purchasers of U.S. Treasuries, particularly China and Japan.

In the continuing saga of repo rollovers masquerading as “liquidity injections,” the total amount of Fed repos outstanding declined to $45 billion last week, which may be somewhat thin given the holiday shopping season. Most of this predictably comes due again this week, so the FOMC will initiate at least $33 billion in new repos by Thursday (a $12 billion repo matures on Monday, with $13 billion to roll over on Wednesday, and $8 billion on Thursday) – more if it refinances the rolls on Monday and Wednesday with 1-3 day repos. This fairly stable $45 billion pool of “liquidity” provided by FOMC actions is useful in maintaining the similar quantity of “required reserves” in the U.S. banking system. It is helpful in accommodating the day-to-day demand for currency and reserves (monetary base), but has no material impact on the volume of bank lending, nor the solvency of the $12.7 trillion banking system or the mortgage market in general.

Again, the Federal Open Market Committee (FOMC) has “injected” only about $16 billion of “liquidity” into the U.S. banking system since March – all via short-term repos that are continually rolled over. Meanwhile, foreign investors (particularly China's central bank) have provided about $2 billion in fresh “liquidity” per day, mostly by purchasing U.S. securities (primarily Treasuries).

As I noted last week, “The market has now cleared the oversold condition that it established a week ago. Stocks aren't overbought here, but overbought conditions in unfavorable Market Climates tend to be rare. The steepest bear market losses tend to follow immediately on the heels of such overbought conditions.”

So we remain defensive here, both with regard to the stock market, and with regard to the economy as a whole. Possible enthusiasm about the Fed notwithstanding, an overbought condition in a negative Market Climate is rarely a prescription for strong returns at acceptable risk.

Sunday, December 9, 2007

Why the Fed Can't Solve the Liquidity, let alone, the Insolvency Crisis

You may have seen this chart before. Central banks can only affect the bottom two parts of the chart, high powered money and M3. M3 the Federal Reserve is growing as fast as it can in order to indirectly support the much larger problem of securitized debt and derivatives but risking a return of inflation pushing long term yields up and bond prices down.

These two phenomenal pockets of debt are supported by asset prices: when asset prices (which act as collateral) decline, the credit market contracts & liquidity gets sucked out of the system. So the purpose of pumping new money into the system is to keep nominal asset prices up to protect collateral values of the real problem of leverage in the system that the Fed cannot directly control. It takes more and more money & the creation of new debt to do this because people are having huge problems servicing the debt they already have.

So we have two huge forces fighting each other right now: central banks desperately attempting to re-flate (increasing the money supply & giving lenders fresh cash to create more debt) and the market grudgingly but purposefully attempting to deflate by paying back (which the bureaucrats are trying to help with) or more likely destroying (write-offs) that debt. We have extremely high volatility as these two forces fight it out.

Looking at the chart, which do you think will win? The Federal Reserve or the contracting credit market.