Wednesday, October 31, 2007

UBS – It Is Halloween and It Is Time For A Scary Story

I am not picking on UBS, but at least they are forth right in their comments of the bank and the credit markets going forward. The point is that there are still losses in future quarters that will have to be taken. Text in bold is my emphasis. The first portion of the post is from a WSJ article:

UBS AG's fourth-quarter warning stoked increasing anxiety that the pain from the credit-market turmoil that started this summer might last longer than investors had hoped.

But Switzerland's UBS warned yesterday of more potential losses ahead on U.S. mortgage-backed securities. The bank reaffirmed an estimate of a pretax third-quarter loss in the range of 600 million to 800 million Swiss francs ($515 million to $687 million). The bank, which has already announced a write-down of four billion Swiss francs in the third quarter, said the fourth quarter started well, but it may see further write-downs amid a new wave of downgrades on mortgage securities.

"UBS is not assuming that the quarter will continue as positively as it has begun, or that the current difficulties will be resolved in the short term," the bank said.

"There had been a feeling...that we'd seen the worst, and that the third quarter was going to be an opportunity for banks to basically clean out their balance sheets," said Simon Adamson, an analyst at credit-research firm CreditSights in London. But in the past week or two, there has been "a resurgence" of "nervousness and volatility, and concerns have resurfaced about the subprime market," Mr. Adamson says.

Much of the optimism was driven by hopes that credit markets would rebound once investors managed to separate good securities from bad. Instead, mounting losses on subprime loans and persistent waves of downgrades have begun to affect even the most highly rated securities, many of which are sitting on banks' books. A section of the ABX index that tracks the value of Aa-rated bonds backed by subprime mortgages was trading at only 50 cents on the dollar yesterday, down from roughly 65 cents on the dollar Oct. 19.

The second art is also from the WSJ and are comments made about the credit markets for mortgage backed securities:

As defaults and downgrades on mortgage-backed securities mount, banks, insurers and specialized funds around the globe are facing a problem: Some $60 billion in what were supposed to be perfectly safe investments are precipitating a new round of losses.

At issue are the so-called super-senior portions (or tranches) of collateralized debt obligations, investments that divide pools of securities into slices with different levels of risk and return. The tranches reaped the highest possible credit ratings because they were designed to be the last to suffer any losses.

But as the outlook for the U.S. housing market has deteriorated and defaults on mortgage loans have kept rising, chances have risen that losses on many CDOs -- those containing pools of lower-rated mortgage-backed bonds -- could reach all the way up to the super-senior tranches. As a result, billions of dollars in investments could be rendered worthless.

UBS AG Chief Executive Marcel Rohner shed light yesterday on the scale of the problem, calling a recent wave of ratings downgrades on mortgage-backed CDOs a "very serious second dislocation" that could prove painful for banks.

In October alone, ratings firms Moody's, Fitch Ratings and Standard & Poor's have downgraded or put on watch for downgrade more than $100 billion in CDOs and the mortgage securities they contain. Among the hardest hit have been so-called mezzanine CDOs, which consist entirely of lower-rated bonds backed by subprime-mortgage loans.

In a glimpse of how much banks have at stake, Mr. Rohner said UBS holds more than $20 billion of super-senior tranches, some two-thirds of which are part of mezzanine CDOs. They're among the reasons UBS, which yesterday reported a third-quarter loss of 830 million Swiss francs ($712.8 million), has warned that its investment bank is likely to face further losses in the current quarter. Nonetheless, UBS said the bank, boosted by its wealth-management business, should be profitable in the fourth quarter.

The potential for losses, analysts say, goes beyond the Zurich-based bank. Michael Hampden-Turner, a credit strategist at Citigroup Inc. in London, estimates that a total of some $60 billion in super-senior tranches of mezzanine CDOs are outstanding, mainly on the books of banks and specialized funds known as structured investment vehicles, or SIVs. Merrill Lynch & Co., for example, said losses on super-senior tranches accounted for most of the $8.4 billion third-quarter write-down involving CDOs and mortgage securities that it announced last week.

CDOs that own lower-rated mortgage-backed bonds are "one area that the market is particularly concerned about," said Mr. Hampden-Turner. Some ratings firms and analysts, he said, are forecasting scenarios in which the super-senior tranches would be rendered worthless.

Super-senior tranches were the biggest part of most mortgage CDOs that were underwritten by Wall Street in recent years. In many cases, they comprised 60% to 80% of the dollar value of each CDO, according to analysts.

Home Prices Continue to Slide

The following from the WSJ discusses the continuing slide in the price of homes. Text in bold is my emphasis.

Home prices continue to fall in most major U.S. metropolitan areas, according to the latest update of the S&P/Case-Shiller home price indexes.

Prices of single-family homes in 20 major U.S. metro areas in August were down an average of 4.4% from a year earlier, Standard & Poor's,
reported yesterday. Prices in those metro areas fell an average of 0.8% from July to August, the fastest monthly decline in the seven-year history of the 20-city index.

Prices as measured by this index have been down from a year earlier for eight straight months. "The fall in home prices is showing no real signs of a slowdown or turnaround," said Robert J. Shiller, co-creator of the index and chief economist for MacroMarkets LLC.

The Case-Shiller indexes track multiple sales of the same homes in an attempt to screen out price differences caused by shifts in the size and type of houses being sold. Some housing economists consider these indexes the best gauge of national and metro real-estate values.

The biggest declines are in the Rust Belt and in the former boom towns near the coasts. In the Tampa, Fla., area, prices were down about 10% from a year earlier. Prices continued to rise, though at a more modest rate, in parts of the Pacific Northwest and the South.

Eight of the 20 metro areas recorded their largest-ever year-over-year declines in August. Prices were up in five metro areas, led by Seattle with a 5.7% increase and Charlotte, N.C., with 5.6%.

What Is Wrong With This Picture?

The Fed cut the Fed Funds rate by 25 bps (basis points) to 4.5% this afternoon as expected. It also cut the discount rate by 25 bps to 5%. See the following from CNN.Money:

The Federal Reserve lowered the target for a critical short-term interest rate by a quarter of a point Wednesday, citing continued concerns about weakness in the housing market.

But the Fed indicated that it is also worried about inflation, a sign that the central bank may be reluctant to cut rates again at its next meeting in December. . . . .

. . . . "Housing will continue to be a drag," said Thomas di Galoma, head of U.S. Treasury trading with Jefferies & Co.

"If the Fed sees weaker housing data, they probably will drop rates another quarter point later this year. In the back of everyone's mind, people are wondering how will banks and brokers come out of this. Those fears are not going away overnight," di Galoma added.

So far so good. Right?

As you might expect oil is up to an all time high of $96/barrel, gold is up to $796/oz., and the dollar hits an all time low against the euro of $1.45/euro. All this basically says the dollar is becoming worth less as time goes on.

So why is the stock market up?

By the end of the day the DJIA is up 137 points (+1.00%), the S&P 500 is up 18.36 points (+1.20%) and NASDAQ is up 42.41 points (+1.51%).

$100/barrel For Oil Is Not a Stopping Point

The excerpts below from an article in the WSJ summarizes the supply issues for crude oil. Assuming no severe economic downturn that would reduce the demand for oil, supply will continue to be the primary constraint in the market. This coupled with a falling dollar basically means that prices in excess of $100/barrel will be in the norm in the near future. People have done all sorts of predictions about what "Peak Oil" looks like, well this is what if looks like. Text in bold is my emphasis.

Several leading oil experts, gathered here yesterday for an annual energy conference, sketched a near-term future in which mounting global demand and shrinking supplies push oil prices well past the $100-a-barrel mark.

Consuming countries, they argued, will simply have to deal with the fact that new pockets of oil are getting far harder and more expensive to tap. That, combined with years of underinvestment by the industry, has led to a tapering off of new oil supplies that will continue for years, despite rising energy demand in Asia, the Middle East and some industrialized countries.

Prices have jumped nearly 40% since early summer, the oil ministers of Qatar and the United Arab Emirates said, because of the slumping dollar, widespread Wall Street speculation and bottlenecks in the refining process.

The debate over what is driving the surge in oil prices is sure to get more spirited if prices continue to soar and oil executives, consumers and politicians seek to assign blame. But the feuding theories at this year's Oil & Money conference also show how hard it is to pinpoint a cause.

Sadad I. Al-Husseini, an oil consultant and former executive at Aramco, Saudi Arabia's national oil company, gave a particularly chilling assessment of the world's oil outlook. The major oil-producing nations, he said, are inflating their oil reserves by as much as 300 billion barrels. These amount to hypothetical reserves that are "not delineated, not accessible and not available for production."

A lot of production in the Middle East is from mature reservoirs, and the giant fields of the Persian Gulf region, he said, are 41% depleted.

Global oil and gas capacity is constrained by mature reservoirs and is facing a "15-year production plateau," Mr. Husseini said. He predicted that supply shortages will continue to add $12 to the price of oil for every million barrels a day in additional demand. Global demand, now at some 85 million barrels a day, was on average 10 million barrels a day lower in 1999.

Nobuo Tanaka, the new executive director of the Paris-based International Energy Agency, which is funded by the world's leading industrialized consumer nations, said he sees little likelihood the world's spare capacity for oil production will increase notably in the near future, partly because so many oil-rich countries continue to shun outside investors.

"The IEA says that despite the high oil price, market tightness will increase from 2009, because new capacity additions won't keep up with reduced capacity from existing fields," he said.

IEA analysts insist that a sufficient resource base exists to supply demand through 2030, but Mr. Tanaka said he isn't confident there will be enough investment, skilled workers and technology to actually get to that oil "in a timely manner."

Andrew Gould, the chairman and chief executive of Schlumberger Ltd., an oil-services company, expressed similar concerns, noting that 70% of the oil fields that now quench world demand are more than 30 years old. The growth in global demand since 2003, he said, has been roughly the equivalent of the daily output from two of the world's larger suppliers: the North Sea and Mexico.

"Our industry simply cannot cope with these kinds of increases," Mr. Gould told the assembly. OPEC countries supply about 40% of world production. But that slice is expected to increase in coming years as output decreases in non-OPEC countries such as Mexico and Russia. Saudi Arabia, the world's largest single supplier, is looking to increase production substantially into the next decade.

But with oil prices now flirting with $100 a barrel, OPEC officials have been aggressive in batting aside talk that they are to blame. "The market is increasingly driven by forces beyond OPEC's control, by geopolitical events and the growing influence of financial investors," said Mohammed bin Dhaen al-Hamli, the United Arab Emirates' oil minister, who also serves as OPEC's president.

Mr. Hamli said prices still are "far below" the all-time inflation-adjusted high of $101 a barrel, set in the spring of 1980 after the 1979 Iranian revolution shocked oil markets.

Both ministers said the cartel won't formally consider whether to increase supplies to the world market during a heads-of-state meeting in Saudi Arabia next month. The group agreed last month to add about 500,000 barrels a day to world production, effective Nov. 1.

A top official at the Energy Department disputed OPEC's claim that supply isn't an immediate challenge. "We think the market still needs more barrels, as we look toward the next year or so," said Guy Caruso, an administrator at the department's Energy Information Administration.
"The problem is we don't have cushions," in terms of spare production capacity and spare crude stocks, he said. "We have relatively low and declining inventories and a refining sector that's finding it hard to get the crude it needs."

Tuesday, October 30, 2007

Consumer Confidence Falls to Lowest Level in Two Years

The news does not seem to be getting better. From Market Watch:

Consumers are less upbeat about the U.S. job market, with an index tracking the level of their confidence sliding to its lowest level since October 2005, shortly after Hurricane Katrina hammered the Gulf Coast, economic data showed Tuesday.

The Conference Board's consumer confidence index fell to 95.6 in October from a revised 99.5 in September, the private research organization reported.

"This was the third straight hefty fall, and it seems to suggest that the relative strength of the stock market is no longer enough to offset the impact of the housing disaster," wrote Ian Shepherdson, chief U.S. economist with High Frequency Economics.

"Further weakening in business conditions has, yet again, tempered consumers' assessment of current-day conditions and may very well be a prelude to lackluster job growth in the months ahead," said Lynn Franco, economist for the Conference Board.

The percent of consumers with plans to buy a home within the next six months decreased from 3.0% in September to 2.7% in October -- the lowest rate since November 2004, according to the Conference Board. The percent with plans to buy a major appliance in coming months fell from 29.8% to 25.9% -- the lowest level since October 2005.

"This is really reflective of the downturn in housing," Franco said.

Cutbacks in major appliance purchases are "a sure sign of consumer strain and should be taken seriously," wrote Tony Crescenzi, chief bond market strategist for Miller Tabak & Co.

"This report is very negative in what is says about the U.S. economy," he wrote. "The figures are not recession-like," but they are indicative of a trend that could become difficult to arrest.

Also, consumers are growing more pessimistic about the short-term future and their "rather bleak outlook suggests a less-than-stellar" end of the year, Franco noted.
Will We Escape A Recession?

The excerpts below are from an article in Market Watch, that discusses why we may not escape a recession. A question that I have is: is there really a big difference between the economy growing at 1.5% or a -1.5%? I don't think so and we are probably headed for one of those places. Also as the economy slows many forecasters were predicting an economic slowdown in the Q3 - Q4 time frame. It appears that this may have to be rolled back 3 to 6 months. Text in bold is my emphasis.

. . . . many economists are skeptical. . . . . they are seriously concerned that the economy soon could slip into a recession. Economists are advising investors to ignore all festivities planned after the third-quarter gross domestic product report is released on Wednesday morning

It is the growth in the next two quarters where the rubber meets the road. Analysts expect growth in the fourth quarter to slow to around a 1.5% rate, less than half of the third quarter. They call the January-March quarter of 2008 "the dangerous quarter" for a sharp slowdown.

If these worries prove correct, any amount of further Federal Reserve rate cuts expected this week and over the next few months likely won't stop a sharp downturn, but would just soften the blow.

Federal Reserve vice-chairman Donald Kohn seemed to hint at the Fed's powerlessness when he said in a recent speech that the Fed's half-point rate cut in September "will not be able to avert all of the weakness in the economy that may be in train for the next several months."

In addition, the most recent Fed Beige Book report, which is a collection of anecdotal report of the central bank's business contacts, gave off a gloomy glow. And the minutes of the Fed's Sept, 18 meeting reported the Fed staff had trimmed its forecast for growth in the fourth quarter and 2008.

Douglas Holtz-Eakin, former chief of the Congressional Budget Office and now an expert on the U.S. economy at the Peterson Institute for International Economics, said his gut tells him the economy might be weaker at the moment than the economic indicators show.

The key factor, he said, is that business confidence appears to be weakening sharply. The current economic situation reminds him of the slow recovery in 2002. As the economy exited a recession then, the fundamentals improved but job growth remained weak. It turned out the hidden factor was that businesses stayed in a sour mood even though the recession was over.

The fact that business confidence is now at the same low level as 2002 "gives me reason to be more nervous than I otherwise would be," Holtz-Eakin said.

Robert Brusca, chief economist at Fact and Opinion Economics, said he also sensed "there is something going on out there that isn't good...I am concerned about the economy. It is looking pretty weak to me."

One reason the recession fears haven't gained more prominence is that economists are generally loathe to forecast serious downturns.

Carl Tannenbaum, chief economist at La Salle Bank in Chicago, who used to compile economists' surveys from the National Association of Business Economics, said he doesn't recall ever seeing a formal forecast of a recession.

What generally happens in a recession is that the economy starts to slow down, and then growth just falls sharply. None of the complex econometric models in use can forecast this break.

"Most of the models are continuous, where the economy strengthens a bit or softens a bit. It is quite difficult to deal with what could be a step-change, where you get some tipping point where everyone decides it is time to cut back on hiring and capital spending. When that happens, pretty soon everything snowballs into a major slowdown," said Nigel Gault, economist at Global Insight.

In recent months, consumer confidence has dropped, job growth is weak, and the unemployment rate has started to rise.

But, at the moment, economists will go no further than saying the odds of a recession are one-in-three.

But the housing sector, credit crunch and the price of oil price above $90 has economists watching closely.

"There is a feeling out there that there is more bad news to come," said Gault.

Tannenbaum of La Salle Bank said he is beginning to pick up signs that commercial real estate is leveling off. He said this is a good coincident indicator of job growth as new workers need space.

At the same time, almost everyone agrees the housing market will continue to weaken, and home prices may fall sharply.

Tannenbaum says greater job growth is needed to keep out of danger: "If we continue to create 100,000 jobs a month, I think we can work our way through it. But if we get a negative payroll report that is a true negative, that is the kind of chain reaction that could end the expansion," he said.

One factor arguing strongly against a recession is the stock market, which seems optimistic about the longer-term outlook, even as the bond market is priced for bad news.

Another wild-card is the Christmas shopping season, which could always turn out to be better than the current gloomy forecasts.

So the key is whether the economy gets through the October -March period unscathed.
Before You Jump, Understand The Real Cost of the Losses at Merrill Lynch

In reading the comments on this blog and others many are very adamant that companies like Merrill Lynch or Citigroup (or whatever) should pay totally for the mistakes they made in the credit markets. So if they fail “so be it”. Just realize that these are very large firms that employ a lot of people. Forget the few executives that made a series of profit driven decisions without properly weighing the risk. There are a lot of people that get up every day, go to work, do a good job, support a family, etc. What do you do with those people? It is easy to make quick judgments, but in many cases the human cost of the decisions come at a very high price. Don't get me wrong, I am not condoning what many of these firms did, but one needs to look at the total cost of their failure. Besides where were the regulators, the board of directors, the risk department, auditors, and shareholders when all this was occurring? No group in their right mind pushes for big profits today when they realize that they could lose it all six months from now. How come no one is talking about these people?

Text in bold is my emphasis. From Bloomberg:

The real damage to shareholders came with Merrill's $8.4 billion writedown. It is the biggest in the history of Wall Street and wiped out four quarters of growth in shareholders' equity, according to Merrill's published figures. The charge, mostly for collateralized debt obligations and subprime mortgages, left the New York-based company with $38.8 billion of assets minus liabilities.

Losing ``20 percent of shareholders' equity in one fell swoop is a serious blow,'' said Robert Willens, the accounting analyst at Lehman Brothers Holdings Inc. in New York. ``It might take them two to three years to earn that capital back.''

``What they lost is likely to be more than they made in the last two years in CDOs,'' Hintz said. ``You can't put it all down to CDOs, but it's not a bad estimate.''

Merrill estimates it had $38.8 billion of shareholders' equity at the end of September, down from $42.2 billion in June.

The firm still has $15.2 billion of CDOs, less than half the amount it held at the end of June. Merrill may have to write down another $4 billion in the fourth quarter, said Meredith Whitney, a New York-based analyst at CIBC World Markets, in a note to clients last week.
The Purpose of the VULTURE in the Housing Market

This is a great article from CNN.Money about the vulture in the mortgage securities market. Please realize that the same thing is happening in the housing market. If one is interested in buying a house today the bidding should start at 50 cents on the dollar and if the seller is not willing to at least counter, then the buyer should move on to the next house. It is a "New Market", the old rules do not apply. Text in bold is my emphasis.

Since the subprime crisis erupted earlier this year, vulture investors looking for bargains have been circling battered securities backed by mortgages.

While opportunistic investors may be reviled by some, their presence is often an indication that a beaten down market has reached a bottom. The longer they stay away, the more likely it is that turmoil will roil the market.

"[Distressed debt investors] are a good thing for the market - they're a new force for providing liquidity," said Mark Adelson, an independent mortgage securities analyst.

For sure, vulture investors are getting ready to strike. Fundraising in the first nine months of the year hit a record $6.6 billion, according to London-based Private Equity Intelligence.

The research firm doesn't break down how much of that total is directed at risky mortgage-related debt, but several high-profile investors are eyeing the sector. The market chattered last month about a new $2 billion fund by Pacific Investment Management Co. Distressed debt investor TCW Group and hedge-fund firm Marathon Asset Management also have been said to be making moves in the sector.

The mortgage meltdown has sent many investors fleeing from risky mortgage bets like subprime-backed securities and collateralized debt obligations, which are pools of bonds sold off in slices of varying credit risk. It has also brought out vulture investors who, as their name suggests, smell an opportunity.

These investors face the difficult task of determining when prices for the distressed securities have hit a bottom. Until they're sure they're getting a bargain, they're likely to hold back on investing their money.

"It's not that no one's going to want to touch [subprime securities]. The question is at what price," said Adelson, who used to head structured finance research at Nomura Securities.

But the securities are hard to value, and no one knows if things are going to get worse. Merrill Lynch said last week that it took a $7.9 billion loss on mortgage-related assets in the third quarter. That was about $3.4 billion higher than the writedown the bank had projected a little more than two weeks earlier.

Furthermore, a recently created "superfund" designed to buy bonds and other debt backed by home loans could deter distressed investors from entering the market.

Some critics, including former Federal Reserve chairman Alan Greenspan, have warned that the fund could do more harm than good by propping up prices.

"If you intervene in the system, the vultures stay away," Greenspan said in a recent interview with Emerging Markets Magazine. "The vultures sometimes are very useful."

That some players are starting to sniff around the mortgage sector is a good sign that the market may be starting to stabilize.

Still, the murky economic outlook has left some experts anticipating a further drop off in prices of mortgage-backed securities. And there are signs the housing woes could get worse. For example, analysts are bracing for a massive wave of mortgages to reset to higher interest rates and trigger another wave of delinquencies.

The uncertainty leaves distressed debt investors with the tricky task of "catching a falling knife," said Daniel Alpert, a partner at New York-based boutique investment bank Westwood Capital, which specializes in mortgage and related securities.

"You could argue this is a good time to go in," Alpert said. "But my view is that a good portion of the market thinks the knife hasn't even started to plummet yet."

This last comment are my sentiments about the market. If you have money now is a good time to stand around on the sidelines with your hands in your pockets

Monday, October 29, 2007


In case you did not notice everyone is now able to comment, a google password is no longer required. So please feel free to comment as often as you like. I am trying to encourage commenting because I don't know everything; other people have very good points of view and I like to hear them; and I enjoy a good, well-reasoned discussion.

3 basic rules for commenting:

1. No swearing.

2. No calling other commenters names.

3. No advertising or promoting products, services, stocks, etc.

I do have editorial control of the comment page and I do delete comments. So far, it has always been someone trying to sell something.
SIVs 101

I posted this over the weekend and it did not get many hits (people have other things to do on weekends besides reading various business/economics/finance blogs - how about that). This is a very nice and quick intro to SIVs in slide format.
Some Opinions About SIVs or Should I Say SIVilis?

No, I did not originate the word SIVilis, but it is kind of funny. The article below from CNN.Money gives another point of view about the big bank bail-out fund (MLEC). Did you notice that as time passes we get closer to the truth about what is actually happening. This is playing out just right, it is about time people see what “high finance” is really like. After a while it actually makes sense. The cost of a large bank failing is so costly and so destructive, that it make sense to bail them out, although morally it grates on everyone’s nerves. Welcome to the world of 10,000 shades of gray. Text in bold is my emphasis.

This may sound silly, but let me ask you a question. Let's say that I maxed out my credit at Citigroup to speculate on a house whose market price is now less than what I paid. Citi wants its money, but instead I say, "Sorry, the house is selling for less than its true value. As soon as it sells for what it should, I'll send you a check." What do you think Citi's reaction would be? How about "Sir, where should I send the repo man?"

Well, folks, Citigroup seems to have put itself in just such a fix by borrowing lots of money to buy assets that have dropped in market value. But instead of summoning the repo (as in repossession) man, some of the world's biggest hitters are trying to set up a huge fund to buy time for Citi and some other institutions with similar problems.

The idea is to set up a $100 billion "master liquidity enhancement conduit"
(MLEC) to take some of the $80 billion of suspect securities off Citi's hands so that it doesn't have to sell them in the current market. Other institutions have about $300 billion worth. (This conduit is being called a superfund, to the delight of those of us who live in New Jersey, for whom the term evokes images of toxic industrial waste. But I digress.)

The problem here, as you probably know, involves seven of Citi's "structured investment vehicles," known as SIVs. They borrowed short-term money to buy long-term assets, such as mortgage-backed securities, that have fallen in market value.

Regulators and various big institutions are trying to stabilize things to avoid what we can call SIVilis. That's a financially transmitted disease that could infect the world's financial markets, leading to cascading failures and other consequences too dire to even think about. In my mind the regulators should have been pushing safe sex so Citi does not get SIVilis.

Citi won't talk to us about SIVs. The only player who would go on the record is Treasury Secretary Hank Paulson, whose department is in charge of maintaining orderly financial markets.

The problem, Paulson told FORTUNE, is not merely "the repricing of risk" but also analyzing the immensely complicated securities the SIVs own. "What you're dealing with here is complexity," he told us, and the proposed master conduit would pool not only money but analytical information as well. An interesting concept.

Paulson wouldn't discuss Citigroup or provide details about how bad SIVilis is. But he gets points for coming out and talking.

Citi clearly screwed up with its SIVs. When a financial institution borrows short term to buy long-term assets, it's supposed to have a plan for when its bet goes bad - rather than just whining about "disorderly markets."

Citi now says it has put together enough borrowings to carry its SIVs through year-end, which may be why Paulson told us the problem "isn't urgent."

If Citi's only problem is that it can't liquidate its SIVs without a profit hit, too bad. If Citi's very existence is at risk, I don't think we dare let it fail, because that would drag down institutions throughout the world. But if the bank needs help, its shareholders should have to pay. Bigtime.

Step one would be to eliminate its common stock dividend, currently more than $10 billion a year. Step two would be to force Citi to raise the capital it needs by selling new stock at a price well below its recent $42 a share. That would force holders to either ante up or have their Citi stake diluted. That just might inflict enough pain on shareholders that someone other than underlings would pay for Citi's SIV sloppiness.

In any event, if we believe in markets, Citi should have to take its chances. We small fry take chances when we borrow, and we pay the price if we're wrong. Big fish should have to do the same.

Sunday, October 28, 2007

Joint Economic Committee (of Congress) Discusses the Sub-Prime Problems

Below is the Executive Summary for the Joint Economic Committee (JEC) report on the subprime crisis. This reports is 32 pages long with lots of graphs, charts, tables, and maps. This report does not pull any punches, although the report admits that it uses a mid-level forecast for housing deterioration and if the forecast is too optimistic then the situation will be worse. A must read.

As the losses caused by the subprime lending crisis continue to work their way through the financial markets, there is a growing awareness among policymakers and financial market regulators that we need to prevent the continuing foreclosure wave from affecting the broader economy. A significant increase in lax (and often predatory) subprime lending during a period of rapid housing price appreciation put risky adjustable rate mortgages in the hands of vulnerable borrowers who are now facing substantial payment shocks and risk foreclosure when their loans reset this year and next.

Part I of this report shows that unless action is taken, subprime foreclosure rates are likely to increase as housing prices flatten or decline, and the effects of the subprime crisis are likely to extend beyond the housing market to the broader economy. The decline in housing wealth will negatively affect consumer spending, and the forced sale of large numbers of homes is likely to negatively impact the prices of other homes.

Part II of this report shows that, unless action is taken, the number and cost of subprime foreclosures will rise significantly. For the entire 2007 through 2009 period, if housing prices continue to decline, we estimate that subprime foreclosures alone will total approximately 2 million.

Part II also includes forward looking, state-level estimates of subprime foreclosures and associated property losses and property tax losses, covering the second half of 2007 through 2009. For that shorter period, and assuming only moderate housing price declines, we estimate that:

• Approximately $71 billion in housing wealth will be directly destroyed through the
process of foreclosures.
• More than $32 billion in housing wealth will be indirectly destroyed by the spillover effect of foreclosures, which reduce the value of neighboring properties.
• States and local governments will lose more than $917 million in property tax revenue as a result of the destruction of housing wealth caused by subprime foreclosures.

Part III of the report highlights the underlying causes of the subprime crisis and explains how incentive structures in the subprime market work against the interests of borrowers and have had much to do with the dimensions of this crisis.

Finally, in Part IV, policy options aimed at reducing foreclosures and preventing the crisis from reoccurring in the future are offered.
Head of Merrill Lynch Resigns

The excerpts below from a fairly long article in the WSJ, speaks for itself. However, I am very curious as to what we are not seeing. Text in bold is my emphasis.

Chief Executive Stan O'Neal has decided to leave the firm, according to a person familiar with the matter. . . . .

. . . . Directors have grown increasingly frustrated since Merrill announced $5 billion in write-downs three weeks ago. In the past week, the size of the hit grew by more than $3 billion, and Merrill reported a $2.24 billion net loss for the third quarter. Analysts say several billion dollars in additional write-downs may be in store. . . . .

. . . . The latest board meeting came after news that Mr. O'Neal had approached Wachovia Chief Executive G. Kennedy Thompson in the past week about whether the Charlotte, N.C., bank would be interested in a combination with Merrill. Mr. O'Neal didn't consult with the board before making the phone call. Mr. Thompson, who has said he is focused on integrating two recent acquisitions, said the timing wasn't right for a deal, people familiar with the matter said.

What Does It Feel Like When You Are At The Top Of Niagara Falls and You Look Down?

I have been in banking (or near) banking for almost three decades and I just don’t see any of this ending well. Text in bold is my emphasis. From the NY Times:

THE props holding up the values of risky mortgage securities finally started to give way last week. And that means the $30 billion in losses and write-downs taken by big brokerage firms in the third quarter are not likely to be the last.

Even as developments in the credit markets went from bad to worse this year, investors for the most part have remained upbeat about the values of the mortgage securities they held. One reason that they could keep their heads in the sand was that these complex securities are hard to value in good times, impossible during periods of stress.

Executives of companies with big stakes in mortgages also accentuated the power of positive investor thinking. Emerging periodically from their corner offices, these executives opined that in spite of rocketing delinquencies, most loans continued to perform well. Rating agencies, fending off complaints that they had been slow to downgrade, maintained that they would adjust their ratings only after they saw actual loan failures. Government officials trotted out regularly to contend that upheaval in the mortgage market was a minor scrape.

After last week, however, it was no longer plausible to deny that mortgage loans, and the complex securities derived from them, had crashed — and caused a lot of damage in the process.

First to face the music was Merrill Lynch
, which stunned investors Wednesday with an $8.4 billion write-down, $7.9 billion of which was for mortgage-related assets. The write-down was $3.4 billion more than it had warned investors about just three weeks before.

Until that moment, investors had been willing to trust companies claiming to have limited exposure to the credit mess. But Merrill’s third-quarter results made clear that such confidence must now be earned, not presumed.

In a pained, hour-long conference call, Merrill’s top executives said that almost $8 billion of the firm’s capital had been vaporized in the third quarter because it had underestimated the degree to which its holdings of collateralized debt obligations, or C.D.O.’s, had tanked. C.D.O.’s are pools made up, for the most part, of mortgage securities divvied up into tranches of differing risk levels.

The executives on Merrill’s dismal conference call conceded that even after they decided to value their C.D.O. holdings more conservatively — resulting in losses — much of their methodology was based on “quantitative evaluation.” (For the rest of us, that means that Merrill was in the unfortunate position of still having to guesstimate its exposure to losses.)

ANALYSTS quickly responded by forecasting an additional $4 billion in write-downs on Merrill’s portfolio. Marking positions to model — a favorite reality dodge on Wall Street — just doesn’t cut it anymore.

To be sure, Merrill was especially overexposed in C.D.O.’s, choosing as it did to go into the business relatively late but in a very big, very voracious way. Other banks and brokerage firms are not likely to have as much junk on their books.

Nevertheless, Merrill’s decision to write down its holdings as it did gives a clear signal to other banks and brokerage firms that valuing similar assets at lofty levels is no longer acceptable or credible.

Then, on Friday, Moody’s Investors Service began downgrading C.D.O.’s. Despite the subprime turmoil, some of these securities had continued to carry high ratings — until Friday. Moody's
cut or placed on review for possible downgrade securities from dozens of C.D.O.’s, some rated as high as AAA. The C.D.O.’s that may be subject to a downgrade hold subprime mortgage loans worth $33 billion, and there are probably more to come.

Moody’s move was not a surprise. It warned several weeks ago that C.D.O.’s were finally coming under its microscope. But Moody’s downgrade is notable because many investors holding C.D.O.’s — like insurance companies — have to sell them when their ratings fall significantly.
With the C.D.O. market stopped dead in its tracks, it is not clear who will be willing to buy and at what price. But it’s a good bet that these forced sales aren’t going to add buoyancy to the market. A better bet may be to expect Wall Street to recognize further losses.

“We’ll definitely see a lot more write-downs,” said Josh Rosner, an expert on asset-backed securities at Graham-Fisher, an independent research firm in New York. “I think that the exposures that we are seeing and the announcement out of Merrill are the leading edge, not the end.”

ONE reason that Mr. Rosner expects more losses from banks and brokerage firms relates to the calendar. So far, the write-downs that banks and brokerage firms have taken have come during periods when managements were preparing their financial statements but hadn’t submitted them to outside auditors for a more thorough vetting.

Intense auditor scrutiny comes once a year, and that is the period we are in now — fiscal years at many big brokerage firms, Morgan Stanley
, Leham Brothers and Bear Stearns, for example, end in November.

“When it comes time for the auditors to attest, they are going to be very conservative,” Mr. Rosner said. That means write-downs will have to reflect the reality in the market, not some rosy scenario.

Way back in 2003, Warren Buffet
defined derivatives — like those exploding on a balance sheet near you — as financial weapons of mass destruction.

“The derivatives genie is now well out of the bottle,” he wrote, “and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear.”

Last week, Merrill Lynch shareholders got a taste of that toxicity. Others will soon have their turn.

A Review of the Banking Industry – Is a Credit Crunch On The Way?

The excerpts below from an article at MSN.Money gives a very good summary of the current state of the banking industry and why a credit crunch may be on its way. Text in bold is my emphasis.

The horrors let loose among mortgage borrowers and lenders by falling housing prices have begun to sink their fangs into the market for auto loans and credit cards, too. We're inching dangerously close to the point where consumers run for the hills -- taking their wallets and prospects for economic growth in the United States with them.

The damage came from two directions: mortgage delinquencies and assets backed by mortgages. At Citigroup, for example, delinquencies soared in September. The percentage of first mortgages more than 90 days past due climbed that month to 2.09% from 1.29% a year earlier, and second-mortgage delinquency rates doubled from earlier in 2007. And losses from Citigroup's investments backed by mortgages climbed to $1.56 billion for the quarter. That was well above the $1.3 billion loss the company had pre-announced just weeks earlier.

The damage was similar at other big banks:

Washington Mutual reported a net loss of $222 million from selling mortgage loans that it didn't want to hold in its own portfolio. That was a big switch from the $192 million gain on sale in the second quarter. Nonperforming mortgage assets increased to 1.65% at the end of the quarter, up from 1.29% at the end of the second quarter.

At Bank of America, the quarter saw a $527 million loss from structured debt products including mortgages and a doubling in nonperforming assets to $3.4 billion.

Wachovia reported a $587 million increase in non-performing residential real-estate loans and a $127 million increase in residential mortgage foreclosures.

At Wells Fargo, net credit losses rose to $892 million from $663 million in the third quarter of 2006.

Altogether, U.S. banks raised their reserves against loan losses by $6 billion in the third quarter from reserve levels at the end of the second quarter of 2007.

That's bad news for bank stocks, certainly. Every dollar that goes into reserves is a dollar less that can be lent out to make money. And the levels of reserves don't look likely to fall in the near future. Washington Mutual, for example, told Wall Street analysts that it expects that charge-offs in its mortgage portfolio will increase by 20% to 40% in the fourth quarter.

But the really scary news for the general economy is that the banks' problems aren't limited to mortgages and the housing market. They're starting to see rising delinquencies and charge-offs in their portfolios of auto loans and credit card debt.

Wells Fargo, for example, said that charge-offs on its credit card portfolio rose to $176 million from $161 million in the second quarter. At Washington Mutual, managed credit card delinquencies climbed to 5.73% of the bank's portfolio from 5.11% in the second quarter.

A "credit crunch" means that banks cut back on lending because of past losses. But now credit card companies are "crunching" customers -- raising fees, cutting limits and more -- and that could hurt spending, says MSN Money’s Jim Jubak.

But the most stunning news -- and the most troubling indicator that credit problems aren't limited to the mortgage market anymore -- came from the credit card companies. Because these lenders have neither direct nor indirect exposure to the mortgage market, the trends here are an indicator of what's happening with consumer credit outside mortgages. And the news in the third quarter wasn't good.

For example, American Express in its Oct. 22 third-quarter earnings report, put aside an additional $196 million in the third quarter, a 44% jump from the end of the second quarter, for loan losses in its credit card portfolio. The company's total provision for loan losses climbed 25% in the quarter to $982 million. Outstanding loans climbed 23% for the quarter, trailing both the percentage increases in credit card and total loan-loss provision.

At Capital One Financial, credit card charge-offs climbed to 4.13% and delinquencies to 4.46% in the third quarter. The company increased its loan-loss provision in its auto-loan business by 34% from the second quarter. Total loan-loss provision climbed 32% from the third quarter of 2006 and 28% from the second quarter of 2007.

There are other explanations for some of these numbers. Capital One Financial recently moved to add an indirect channel for making auto loans, which has led to a jump in delinquent loans. During its conference call, Capital One Financial called this move a mistake and announced that it was moving the auto-loan business back to a direct-lending model.

Rising industrywide delinquency and default rates are, to some degree, a return to normal after atypical lows following the rush to bankruptcy caused by a change in bankruptcy laws that took effect in October 2005, which cleared a lot of bad debt out of lenders' portfolios.

But taken together, with evidence of rising delinquency and default rates coming from so many different lenders operating so many different business models in so many different markets, the possibility that we're seeing the troubles that borrowers are facing with their mortgages spill over into problems with credit cards and auto loans is disquieting.

These problems could indeed slow the economy in 2008 more than investors now believe is likely.

The biggest danger, though, doesn't come from the consumers running behind on their credit cards and their auto loans. With delinquency rates still below 5% at a credit card company like Capital One, reduced spending by consumers with credit problems probably isn't enough to tank the economy.

It's the folks in good shape that the economy has got to watch out for. If consumers who are in good shape decide to cut back on spending in order to reduce their credit card balances, that would take a considerable amount of spending out of the economy. There is some evidence that this has started to happen. Repayment rates are running about 1 percentage point above their long-term average, according to And credit card utilization rates -- the amount of available credit that consumers actually use -- are near 15-year lows.

The banks aren't helping the situation. Certainly, you understand why a bank that's been burned by higher-than-expected mortgage default rates would think first about cutting back on mortgage lending. It's too little, too late, but the impulse is almost irresistible. In the mortgage market, lenders have lowered the amount they'll let consumers borrow against their homes, done away with teaser rates and no-income-verification loans and raised the credit scores they require to approve a loan. The result is a credit crunch where people who want to borrow today can't -- even though they meet the lending standards in effect just yesterday -- because lenders have stopped lending.

Something similar may be brewing in the credit card market. Through the first six months of 2007, direct-mail offers to consumers with the best credit have dropped by 13%, according to Mintel International. (On the other hand, offers to consumers who are in danger of defaulting on their home loans have actually climbed by 41% in the same period.)

At the same time as they're sending out fewer card offers to the best prospects, banks have been increasing the rates they charge on cards:

Regular monthly interest rates are going up.
Penalty interest rates are going up -- to as much as 34% in some states -- for cardholders who make even one late payment.
More cards are adding a universal penalty clause where missing a payment on one card you hold can trigger a rate increase on all your other cards.
Late fees have zoomed and so have over-limit fees.
Grace periods that allow you to pay before interest charges kick in are getting shorter.
It's harder to get a credit card company to raise a credit limit on an existing card, and new card offers come with lower initial credit limits.

A "credit crunch" means that banks cut back on lending because of past losses. But now credit card companies are "crunching" customers -- raising fees, cutting limits and more -- and that could hurt spending, says MSN Money’s Jim Jubak.

Most of those changes, in my opinion, are simply attempts by banks and other credit card issuers to pull in more revenue from cardholders to offset the squeeze on their profits that results from putting more money into loan-loss reserves. They don't intend to create a credit crunch. But by lowering credit limits and by making it more expensive and more aggravating to use a credit card, the result is still the same. We're witnessing the very early stages of a classic credit crunch in the credit card market.

It's too early to tell if the crunch will get crunchy enough to take a percentage point or two out of the 1.9% growth rate projected for the U.S. economy in 2008. But in this part of the debt market -- as in so many others from mortgages to buyout loans -- the trend is clearly toward less available and more expensive credit. That's never a recipe for faster economic growth.

Saturday, October 27, 2007

The Strategic Petroleum Reserve – A Review

Do you remember the Strategic Petroleum Reserve (SPR), that reserve of crude oil formed during the Carter administration? There is a lot of talk recently about the SPR, but ultimately it just isn’t that big. Text in bold is my emphasis. From the WSJ:

Lawmakers and oil analysts want to know why the Bush administration, at a time of sky-high oil prices, insists on pumping 50,000 barrels a day of some of the world's most desirable crude into salt caverns in Texas and Louisiana.

The question centers on the country's huge Strategic Petroleum Reserve, which now holds 694 million barrels, or enough to replace 69 days of U.S. crude imports. Critics of the Energy Department argue the administration could ease concerns over lofty prices simply by not pumping additional oil into the reserve and putting the extra barrels on the market instead.

Filling the reserve is the latest wrinkle in a larger debate over its role. Should the U.S. turn to the petroleum stash to calm oil markets, as governments often increase spending when the economy slows? Or should it be used only in times of true crisis, like another war in the Middle East or a massive hurricane like Katrina?

Energy Department officials say it makes sense to keep filling the reserve at the current rate. They say that Bush administration has no intention of changing course, whether to send signals to the market or otherwise.

Megan Barnett, an Energy Department spokeswoman, said the input is "a minute amount compared to over 20 million barrels per day consumed in the U.S. and over 80 million barrels consumed globally every day." The extra oil, she said, "helps to provide an added layer of protection to Americans in the case of a severe supply disruption."

Of particular interest is the growing premium buyers are now paying for low-sulfur crude, the mainstay of what the Energy Department is now pumping into the reserve from suppliers in the Gulf of Mexico. The reserve now contains 276 million barrels of sweet crude, with the rest being the less-desirable heavy, sour variety. "Sweet" crude yields more premium refined products like gasoline.

"Sweet crude is the Ch√Ęteau Haut-Brion of oil," says Philip Verleger, an independent energy economist based in Colorado who is clamoring for the government to dip into the reserve.

Larry Goldstein, director of the Energy Policy Research Foundation in Washington, says the crimp in sweet-crude supplies "makes this an opportune time for the government to rethink its policy. This would be a tinkering with the market, not a tampering."

The government isn't paying cash for the oil. Instead, private producers supply the government with oil as part of a royalty-in-kind program to pay for the right to drill in U.S.-controlled offshore waters. About 1.5 million barrels a month of this royalty oil is now flowing into the reserve.

But skeptics argue it would be smarter for the Energy Department to sell the oil and buy up additional reserves when prices subside, as many expect they will next year. Senate Democrats, in their letter to Mr. Bodman, argue that Congress wants the department "to use a market-based approach to determining when to fill the SPR."

U.S. officials say they aren't continuing to fill the reserve with a particular contingency in mind. The U.S. decided to create a petroleum reserve system right after the 1973-74 Arab oil embargo, and began filling the first salt caverns in 1977. The Energy Department now describes the reserve as "a significant deterrent to oil import cutoffs and a key tool of foreign policy."

The reserve has been tapped in the past for emergencies. During the 1990-91 Gulf War, the government pulled 21 million barrels. President Bush opened the spigots in 2005, after Hurricane Katrina caused massive damage to oil facilities in the Gulf of Mexico in 2005, putting another 21 million barrels on the market. The reserve has also offered to swap or loan oil during limited supply disruptions.

But President Clinton in the late 1990s turned to the reserve to address less calamitous needs. Citgo Petroleum Corp., part of Petroleos de Venezuela, and the forerunner of ConocoPhillips together borrowed a million barrels from the reserve in June 2000 when an accident cut off supplies to two of their huge refineries in Louisiana. Twice that same year the administration tapped the reserve to offset surging heating-oil prices in the Northwest.

The Bush administration has been determined to boost the reserve, which stood at 544 million barrels in September 2001. The government expects to fill the reserve to its 723 million-barrel capacity by the end of next year.

At the same time, the Energy Department is moving ahead on plans to eventually expand the reserve to a billion barrels. President Bush in January called for an even greater expansion to 1.5 billion barrels, though it is unclear whether Congress would appropriate the massive sums needed to buy and store that much oil at current prices.

The Weekend’s Contemplation – Emerging Markets Can’t Pick Up the Slack

Over the last several months there have been a number of posts on whether or not the rest of the world would slide into a recession if the US slid into a recession. Some believe that if the US slides into a recession other economies will not because their economy is sufficiently strong to get along without us (the whole idea behind de-coupling). Others believe that the opposite, that economies outside the US, primarily emerging markets, lack the size to make up for the US. This article from Bloomberg supports the latter position. Text in bold is my emphasis.

China is among the world's fastest- growing economies. Shanghai and Shenzhen are home to its hottest stock market. Now many investors regard the evolving Asian behemoth as the antidote to a slowing U.S. economy, picking up the slack in global growth as the American consumer retreats.

They probably shouldn't. China's growth has been fueled by exports and investment, not consumers, whose share of the country's gross domestic product is declining. From almost 80 percent in the first half of the 1980s, Chinese household consumption fell to 46 percent of GDP by 2000 and shrank further to 36 percent in 2006.

``The average consumer in China isn't a credit-card-toting shopper roaming malls in search of fashionable jeans or a large- screen television,'' says Joseph Quinlan, New York-based chief market strategist at Bank of America Capital Management.

Instead, the Chinese are savers. The average household banks a quarter of its after-tax income. That's to compensate for reduced government outlays for health care, unemployment benefits and pensions; more costly housing; the loss of guaranteed lifetime employment; and rising school-related expenses in a country obsessed with education.

``While China's global presence in certain industries has grown in significance over the past decade, Chinese consumers are not ready to drive global demand,'' Quinlan says. ``The Chinese are in no position to fill a consumption vacuum left by the U.S.''

China is part, a big part, of a growing consensus that emerging-market countries, can not only break free of their traditional dependence on the American consumer but that their own expanding domestic demand can cushion the global impact of a slowing U.S. economy.

Proponents of this thesis that the meek shall inherit the Earth -- or, at the very least, help stabilize it -- include Goldman Sachs Group Inc., Merrill Lynch & Co. and Lehman Brothers Holdings Inc.

Strong growth in emerging markets ``could balance the drag effect from the world financial turmoil,'' Lehman told clients at the end of August. On Sept. 12, Goldman economists boldly proclaimed: ``Our view of global decoupling has become the consensus view.'' Emerging markets generally and the so-called BRICs -- Brazil, Russia, India and China -- specifically, are key to global decoupling, they said.

The four BRICs, which sport growth rates of 5.4 percent to 11.5 percent, may be the toast of the evolving economic order. But declaring them the new citadels of the world economy is a stretch and premature.

Although developing countries are projected to account for about three-quarters of global growth in 2007, their size is still too small to power the world economy. Take the four BRIC nations: Collectively their GDP amounted to $5.6 trillion at the end of 2006. That's 43 percent of U.S. GDP, 56 percent of the 13- nation euro area's and 130 percent of Japan's.

When it comes to stock markets, the gap is even wider. The aggregate free-float value of the Brazilian, Russian, Indian and Chinese stock markets is a mere 4.9 percent of world market value, according to Morgan Stanley Capital International. The four BRICs are 12 percent of the U.S. market value, 16 percent of Europe's and 56 percent of Japan's.

China's CSI 300 Index has more than tripled in the past 12 months. Still, the country's stock market represents just 1.9 percent of total world-market value compared with U.S. equities' global share of 42 percent.

Even though developing countries are trying to boost domestic demand, they remain dependent on exports, accounting for about 45 percent of the world's cross-border sale of goods, according to Merrill Lynch.

Furthermore, the Japanese and German economies -- respectively, the world's second- and third-biggest -- are slowing, adding to the woes of emerging-market exporters already thumped by weaker U.S. growth. Japanese GDP fell an annualized 1.2 percent in the second quarter, and there's a good chance the ruling Liberal Democratic Party, eager to remain in power, will backslide on promised fiscal changes.

Meanwhile, Germany suffers from sluggish consumption, a strong euro that threatens exports, and a credit crisis that will increase the cost of financing investment.

No doubt, developing countries have come a long way since the 1997-1998 Asian financial crisis and the Russian default in 1998. Back then, Asian countries were starved for cash; now emerging-market economies, led by Asia, account for 66 percent of global foreign-exchange reserves. Inflation is down. And many countries have adopted flexible currency regimes.

As a group, the countries' total external debt-to-GDP ratio has been falling since 2000. And the aggregate current-account surplus of 54 countries studied by Goldman Sachs rose to 4.7 percent of GDP in 2006. That compares with a deficit of 1.4 percent of GDP in 1995.

Nonetheless, ``there are still plenty of vulnerable economies in the emerging-market space,'' says Gray Newman, New York-based senior Latin America economist at Morgan Stanley. South Africa, Turkey, Hungary and the Czech Republic have run current-account deficits averaging more than 4 percent of GDP for three years, while Turkey, Poland, Hungary and India have posted fiscal deficits of 3 percent to 8 percent of GDP in the last three years.

What's more, ``before we ring in the decoupling era, it is worth recalling that it has not been tested with a U.S. economy in recession,'' Newman says.

Bottom line: ``The old saying, `If the U.S. sneezes, the rest of the world catches a cold,' remains relevant,'' said the International Monetary Fund in its April 2007 edition of the World Economic Outlook.

How much of a cold depends on how big the sneeze.
A Slide Show on SIVs and MLEC

Below is a link to a short slide show on the SIV business and the bank bail-out fund (MLEC). This is quick and very informative.

Friday, October 26, 2007

According to Ambrose Evans-Pritchard The Sky Has Fallen

Ambrose Evans-Pritchard is one of my favorite authors. He writes well and has a great sense of humor, except recently it is not always evident. Truth be told, recently he seems a little panicked. Below is an article of his in the UK Telegraph that gives a good summary of the credit markets, actions of the central banks, housing market, etc. It is always nice to get a point of view from outside the US.

By the way, Ambrose thinks things are going “to hell in a hand basket” fairly soon. So sit back, relax, and read on to enjoy good writing and some interesting conclusions. Text in bold is my emphasis.

If you are a bear, you must accept that you will always be wrong in polite society, and you will continue to be wrong all the way down to the bottom of recession. That is the cross that bears must bear.

Over the last three months we have seen a rolling collapse of speculative debt and real estate across half the global economy, yet friends still come over to my desk at the Telegraph, with that maddening look of commiseration on their faces, and jab: “so when is the sky going to fall then, eh”?

Well, excuse me. The sky has fallen. The median price of US houses has crashed from a peak of $262,600 in March to $211,700 in September. This is an 18pc drop nationwide.

Yes, the year-on-year slide is still just 4.2pc, but that will soon change as the base effect catches up.

Merrill Lynch has just confessed to a $7.9bn write down on CDO subprime debt and assorted follies, nearly double what it suggested three weeks ago.

This is what happens when a bank values its CDO debt at “mark-to-market” rather than “mark-to-myth”, as some of Merrill’s rivals are still trying to do.

Merrill’s Q3 loss of $3.5bn has cut the group’s equity capital by a fifth. This has consequences. The bank’s lending multiples will have to shrink.

In Britain, we have had the first bank run since the City of Glasgow Bank collapsed in 1878. The Fed has cut the interest rates a half point and vastly increased the pool of eligible collateral for Discount operations. The European Central Bank has injected over €400bn of liquidity in the biggest intervention since the euro was created.

Japan is in recession. Housing starts fell 23.4pc in July and 43.4pc in August.

The US
dollar has fallen below parity with the Canadian Loonie for the first time since 1976, and to all-time lows on the global dollar index.

All it will take now for a full-fledged rout is a move by the Saudi and Gulf states to break their dollar pegs, which they may have to do to prevent imported US inflation causing havoc; or for the Asian banks stop buying US Treasuries – as Vietnam, Singapore, Korea, and Taiwan, have gingerly begun to do.

And for good measure, the Bank of England has just
warned in its Financial Stability Report that lenders are still in serious trouble, that there is a risk of commercial property crash, and that equities are “particularly vulnerable” to a downturn. It is said there may well be a repeat of the summer crisis, “potentially on an even larger scale.”

What more do you want?

It is true that stock markets have once again decoupled from the realities of the debt markets. But they did this in the early summer, when the Bear Stearns debacle was already well under way. They caught up famously in August.

Nobody I talk to in the City credit trenches believes for one moment that the crunch is safely over. Indeed, they think that we are edging back to extreme stress levels, and the longer it goes on, the worse the damage.

Yes, Blue Chip companies can borrow money, but most of them don’t need to do so because they have bloated cash reserves.

Once you go down the chain, the picture changes fast. The iTraxx Crossover index measuring spreads on mid to low-grade corporate debt has jumped 100 basis points or so in the last week to around 360. It costs companies 1.8pc more to borrow than it did in the halcyon days of the credit bubble in February, if they can borrow at all.

The ABX indexes measuring subprime debt – those infamous CDO packages of mortgages sliced and diced, and sold to German pension funds and Japanese insurers with a lot of lipstick -- are still falling to record lows.

As Goldman Sachs strategist Peter Berezin put it: “It’s the summer that won’t end,”

“We continue to learn that it pays to respect the sell-offs in ABX and housing-related credit. This has elements of the February and August sell-offs, where credit markets signalled problems,” he said.

From a par of 100, these indexes have fallen to (depending on the vintage):
AAA grade: 90
AA: 64
A 33
BBB 21

This means that the toxic BBB tier has lost almost four fifths of its value. Even the AA has lost a third.

Now, remember that the total stock of subprime and Alt-A (close kin) debt issued from early 2005 to early 2007 amounts to $2 trillion. Ben Bernanke’s estimate that losses would be $100bn looks wildly optimistic.

Not to labour the point, but three-month Euribor rates are still at 62 basis points over the ECB’s 4pc rate. This amounts to a de facto half point rise since the crunch for all those in the euro-zone with floating mortgage rates – 98pc of the total in Spain, the biggest property bubble of them all.

Asset-backed security (ABS) issuance peaked at €78bn in March, fell to €52bn in July, €9.8bn in August, €5.6bn in September, and €2.5bn in October. It has died. Banks no longer dare to hawk the stuff of fear of a humiliating rebuff.

As for asset-backed commercial paper in the US, it has contracted every week since August as the lenders refuse to roll over short-term loans. Roughly 25pc of the market has been closed down, cutting off almost $300bn of funding for SIVs.

These SIVs (structured investment vehicles) are `conduits’ – in City argot – that allow banks to juice profits by speculating off books on high-risk debt. They borrow short (three to six months) to invest long (five years of so), making money on the interest arbitrage. Until the game blows up, of course. By the way, if you are like me you had to look up the word argot (pronounced ar-go): it is basically the special vocabulary and idiom of a particular profession or social group.

Some $370bn still needs to be rolled over, and there lies the rub. The strong suspicion is that Hank Paulson’s $75bn SIV rescue for the big four US banks is intended to cover up the problem by feeding out losses slowly, rather than allowing firesales to cause a cascade.

As the Bank of England warned, the Super-Siv should not be used to prop up fictitious valuations.

“It stinks, as does the Treasury’s sponsorship of the scheme. It seems designed to prevent price discovery.”” says Bernard Connolly, global strategist for Banque AIG.

Connolly says it resembles the slippery practices at the start of the Bear Stearns debacle, when creditors quickly abandoned attempts to force CDO sales by the Bear Stearns hedge funds as soon as they realized that prices were collapsing – exposing the awful truth that hundreds of billions were falsely valued on books.

Nauseating though Paulson’s MLEV -- `Master Liquidity Enhancement Conduit’ – may be, it probably has to be done.

Connolly says the Fed-led pack of central banks have made such a mess of capitalism by blowing credit bubbles (with low rates in the late 1990s and 2003-2006) that they now have no alternative other than to relaunch the “Ponzi Scheme”, or risk depression.

This will have political consequences, of course. “The looming threat on the horizon, or just over it, is that the socialization of risk will be accompanied, in many countries, by the socialization of wealth,” he said.

Indeed. The investors now baying for bail-outs had better be careful what they wish for. Democracy will have its way of making them pay. One recalls the 98pc tax rate on dividends in Britain in the late 1970s. Haircut now, or haircut later.

In any case, the Paulson Super-Siv has failed to calm the horses. “This rescue has back-fired. The central banks don’t want anything to do with it. There is a fear that the big four US banks are trying to hide their debts,” said Hans Redeker, currency chief at BNP Paribas.

The DOW is down 500 points or so since peaking in early October, and it looks wobbly.
Even so, equities have not begun to reflect the reality that the 2006-2007 credit bubble has popped and cannot be easily reflated at a time of stubborn, lingering inflation. Spare me the mantra that the “fundamentals” are sound. Credit is the ultimate fundamental.

Woe betide Wall Street if the Fed fails to slash rates dramatically over the Winter, starting on October 31.

Woe betide the dollar if it does.

Home Ownership Rate Declines For The Fourth Consecutive Quarter

The excerpts below from a article is Bloomberg states that the percentage of people owning homes has declined from a high of 69.3% in 2004 to 68.1% in Q3 2007. The percentage of people owning homes 10 years ago was about 64%. This is also the longest decline since 1981. The article also contains additional comments about the housing market, none of which is rosy. Text in bold is my emphasis.

The proportion of households that own their residences fell to 68.1 percent in the July-September period from 68.3 percent in the prior three months, according to a report today from the Census Bureau in Washington. The rate has been declining from a peak in 2004, which culminated a decade of gains fueled by easier lending standards and rising home purchases by immigrants and younger households.

``Owning a home in this country has been a principal source of wealth creation for low- and moderate-income people,'' said Nicolas Retsinas, director of Harvard University's Joint Center for Housing Studies in Cambridge, Massachusetts. ``In the absence of home equity, families will inevitably spend less.''

Homeowners accumulate wealth faster than renters, with median net wealth for owners at $184,400 in 2004, compared with only $4,000 for renters, according to Federal Reserve figures.

The ownership rate reached a record 69.3 percent of households in 2004, up from 64 percent a decade earlier. With home prices soaring, net household wealth nearly doubled to $51.8 trillion at the end of 2005 from $27.6 trillion in 1995, with real-estate accounting for 47 percent of the change, according to Federal Reserve data.

A September study by the Fed Bank of Atlanta found that as much as 70 percent of the increase in the aggregate homeownership rate over the decade was due to the introduction of new mortgage products, including second mortgages. Demographics, including the rapidly growing immigrant population, accounted for up to 31 percent of the increase, said the study.

Now, declining ownership rates mean fewer Americans will be able to tap housing equity to fund education, vacations and other spending. In the last year, the proportion of American households that own their homes dropped by 0.8 percentage point, the biggest year-over-year decline since 1981-82.

The U.S. entered a recession in July 1981 that lasted until November 1982, according to the National Bureau of Economic Research, which tracks business cycles.

The Census Bureau report also found that a record 17.9 million U.S. homes stood empty in the third quarter as lenders took possession of a growing number of properties in foreclosure. The figure is a 7.8 percent gain from a year ago, when 16.6 million properties were vacant, the Census Bureau said. About 2.07 million empty homes were for sale, compared with 1.94 million a year earlier, the report said.

``If homeownership declines significantly, the implications for new-home sales could be dramatic,'' said Hatzius. With further weakness in sales, ``the drag from new-home building on GDP growth will last longer than most people have in their forecasts, perhaps, if things go badly, into 2009.''

Housing starts, which track work begun on new homes, fell 48 percent to a 1.19 million annual pace in September from a three-decade peak of 2.29 million in January 2006. Sales of new homes declined 45 percent to an annual pace of 770,000 units in September from a peak of 1.389 million in July 2005.

With inventories of unsold homes piling up near record levels, housing prices will have to fall further, economists say.

Home prices in 20 U.S. metropolitan areas dropped 3.9 percent in July from a year earlier, the biggest such decline since record-keeping began in 2001, according to the S&P/Case- Shiller home-price index.

Goldman Sachs is forecasting a 15 percent decline in home prices from the peak to trough, Hatzius said.

Second mortgages, along with interest-only, payment-option and other unconventional mortgage products, have largely dried up this year as subprime defaults mounted and lenders such as American Home Mortgage Investment Corp. closed their doors. That makes it harder for people to refinance adjustable-rate loans before they reset at higher rates.

``So many mortgages with ARMS are resetting and most people can't make their payments,'' said Steve Hawkins, a real-estate agent at Re/Max Inc. in Alexandria, Virginia. ``And with the new criteria, they can't get loans'' to refinance their mortgages, he said.

The volume of mortgages issued this year will fall to the lowest since 2000, the Mortgage Bankers Association forecast on Oct. 17. Foreclosures doubled in September from a year earlier, RealtyTrac Inc. said Oct. 11.
There Will Not Be a Recession, But Here Are All Reasons Why There Could Be a Recession

This all sounds like double speak from Michael Boskin, but it is actually quite informative. But you do have to read between the lines. Text in bold is my emphasis. From Market Watch:

Despite severe problems in the housing market, a credit crunch and record-high oil prices, the U.S. economy will skirt a recession in the coming few quarters and get back on a solid growth path after that, economist Michael Boskin told real estate industry executives Thursday at the Urban Land Institute fall conference.

Boskin, a senior fellow at the Hoover Institution at Stanford University and former chairman of the Council of Economic Advisers under the first President Bush, told 6,700 members of ULI that the U.S. economy is clearly slowing, although GDP growth will stay positive.

However, there is a risk that something worse could transpire, especially if housing prices spiral downward, Boskin said.

"There are a lot of headwinds for the economy housing, autos, oil. And we don't have a lot of shock absorbers left," he said. "So anybody who doesn't have a Plan B (for their business) should get one." I assuming that everyone has a "Plan B".

Boskin said job growth, while not booming, remains on a steady pace and that unemployment near 4.5% means the U.S. economy remains near "something that resembles full employment." And he said that households have added significantly to their net worth in the last few years, not through payroll savings but through asset growth in housing and the stock market. The housing net worth is probably illiquid at this time.

"Savings look OK as long as asset values hold up. And unless there is a large download of asset values, household balance sheets are in good shape," he said.

The key trouble spot is home prices, which have been falling in many markets and are likely to show an overall national decline this year and next of 2% or so.

"But if home prices stabilize, most people will still have more home value than they did three or four years ago. Homeowners don't 'mark to market' immediately," he said, and so are unlikely to look upon small declines in home values as a problem for their overall financial position.

Boskin's longer-term outlook for the U.S. economy is "cautiously optimistic," he said, with the U.S. in as good a long-term position as economies in Japan, the rest of the Asian region and Latin America, and decidedly in better shape than Europe, which he said benefited from a "golden era" in global growth in the last three years but which has a pessimistic long-term outlook. What is the issue with Europe?

It Is 11 am. Do You Know Where Your Money Is? SIVs and Money Market Accounts

The excerpts below from an article in may not be the way to start your weekend. If you thought your money was safe in your money market account, maybe it is not. Apparently some money markets accounts hold SIVs. The complete article has companies (or funds) that have SIVs in their money market funds and some that do not. In my mind there is no excuse for a money market account holding SIVs. People are in money market accounts for the safety not the yield. Text in bold is my emphasis.

Money market funds are often the safest investments offered by fund companies, but several large money market funds own securities that were issued by structured investment vehicles (SIVs), the large, offshore funds that have recently made it into the headlines because the U.S. Treasury, along with Citibank, B of A, and JP Morgan Chase are working on a plan to shore up them up.

Typically, SIVs borrowed money by issuing short-term notes at a certain interest rate and then invested that money in longer-term securities that had higher interest rates, hoping to make money on the difference between interest rates. Many money market funds bought the notes that SIVs issued to raise the money to make their bet.

Securities regulations state that money market funds can only buy short-term, very safe securities. In particular, rule 2a-7, part of the Investment Company Act of 1940, says that money market funds can only hold securities that have "minimal credit risks."

The fact that the SIVs are in trouble suggests that SIV securities had more than "minimal credit risks." Of course, money market funds would have felt comfortable buying SIV securities because they had very high credit ratings, but the current SIV difficulties indicate that those top-notch ratings were in many cases undeserved.

The issue here is whether money market funds should ever have been invested in SIV paper at all. . . . . certain money market funds chose to eschew SIV securities, which dispenses with the excuse that SIV exposure is an industry-wide phenomenon. Not everyone was into it.

If a fund company was doing its job, it would have asked itself very seriously whether the SIV notes deserved to be in a money market fund. Specifically, they'd go about enquiring whether SIV securities met the requirement of rule 2a-7 -- that they didn't present anything more than the minimal credit risks.

The argument for the defense of money market funds holding SIV paper goes something like the following. The SIVs that issue the notes are highly rated, well managed and have high quality balance sheets. Recently, they have been hit, almost unfairly, by an extraordinary panic in the credit markets that has led to a drop in demand for the notes the SIVs issue to fund themselves. And once the markets get back to normal, especially with the help of the Treasury, the SIVs will be fine.

Why isn't this approach convincing? Remember the key test is whether the securities present minimal credit risk. In this case, we have to ask whether the SIVs were actually strong enough to deserve the AAA rating, which usually only applies to entities with tiny amounts of credit risk.

That rating on a SIV implies that the SIV has the strength to get through almost any crisis. The fact the SIVs stumbled so quickly shows that they weren't built with anywhere near enough capital or commitments of back-up funding.

Fund management companies should have looked beyond the rating and basically asked themselves: Does a SIV really have the same creditworthiness as U.S. Treasurys, also rated AAA? And they should also have noted how skewed the SIVs were to short-term funding, since that is a common mistake in investing.

The other defense argument is that the SIV notes are backed with assets, which means the holders won't take a big loss because they have a claim on those assets and the income they produce. This is true, and it is a source of comfort for any poor money market funds holding SIV paper that does go into a liquidation process.

But it'd be a stronger argument if the SIVs had actually made public what the assets are that back their paper. What if those assets were loans or securities that are themselves distressed or very hard to sell? If so, the holder of the SIV securities will end up getting back less than 100 cents on the dollar.

But if a money market fund were to recoup the value of its SIV securities by claiming the underlying assets, wouldn't that allow the fund company to say that the SIV securities had "minimal credit risks" after all? Are you crazy?

Money market funds are supposed to the safest fund investments of all. They're not supposed to get involved in liquidations. That sort of event is a nightmare for a money market fund. And indeed it will be a nightmare if it does turn out that fund management companies have failed to follow rule 2a-7.