Friday, November 30, 2007

Some Details of the E-Trade Deal with Citadel

The mortgage business caused another casualty, this time E-Trade. Text in bold is my emphasis. Once again many of these firms have value, so the chances of them failing is limited. From Market Watch:

The subprime crisis claimed a new scalp Thursday as E-Trade Chief Executive Mitch Caplan said he was stepping down as part of a deal that has private equity firm Citadel injecting $2.55 billion into the troubled firm.

Under the deal, Citdel will end up with about a 20% stake in E-Trade after acquiring its $3 billion asset backed securities portfolio for $800 million and making other investments. The deal gives Citadel a nearly 20% stake in E-Trade and a seat on the board.

Lilien told MarketWatch in an interview Thursday that the deal provides some immediate benefits for the firm. "It gets the asset-backed securities portfolio off the balance sheet. That was the biggest source of issues for E-Trade," he said.

He added that it also injects capital, strengthens the balance sheet and allows E-Trade to boost reserves and raise capital.

"With the capital infusion and removal of the problem ABS portfolio, E-Trade has essentially bolstered its balance sheet & near-term capital position. We believe that answering near-term fears that E-Trade could not meet regulatory capital requirements is a positive," Sandler O'Neill analyst Rich Repetto said in a research report Thursday morning.

Under the terms, Chicago-based Citadel acquired E-Trade's $3 billion of asset-backed securities for about $800 million, or about 27 cents on the dollar.

That leaves E-Trade with a $2.2 billion writedown on that portfolio, analysts cautioned, but Lilien said getting rid of the portfolio was the best option.

"The way we look at it is, it is a package deal; we got cash, and in turn for that, Citadel took the asset backed problem from us," he said. "Citadel is in a position to hold those securities. This was a great transaction for them, because it's what they do, it was a good deal for us because it's not what we do."


He said the firm had several options for the asset-backed portfolio, but determined taking a loss on disposal was the best, because it couldn't afford to hold them on the balance sheet and take quarterly write-downs indefinitely.

Trying to sell them off over time also was not a pleasant option, Lilien said. "I would say absolutely this is a good thing to do. Having that on our balance sheet was too much of a burden. It was bad for customer confidence beginning to hurt us.

"The $2.2 billion effective loss on the ABS is an excessive cost to the company, and indicates just how weak the secondary market for these securities actually is," BMO Capital markets said in a research note Thursday. "While the risk on those securities has been removed, E*Trade still effectively absorbed a 73% writedown on that portion of the portfolio. The company retains the risk on its remaining loan and mortgage-backed securities portfolio," they added. . . . .

. . . . The deal, "gets the problem in the rearview mirror, it gets us back on a more sure footing, Lilien said. "It has made the franchise healthier and stronger, makes one more attractive. What's good for the franchise has got to make us look better to others," Lilien said.

Discussions About Freezing the Teaser Rates for Certain ARMS are in Progress

Discussions are underway to temporarily freeze the teaser rates on ARMs for a a certain class of borrower. The purpose of these discussions is to reduce the number of foreclosures in 2008. This will have some effect on shoring up the housing market. But, just look at the housing inventory overhanging the market, that still has to be dealt with. A couple of comments are in order:


1. Is this going to go the way of M-LEC where everyone discusses it but nothing happens?

2. What about the person that can pay the adjusted payment, is this going to penalize a person that can pay his bills?

3. The housing market in the US is collapsing. Allow it to collapse, it is not the end of the world. If we meddle in the markets it will either make it worse, or make the effects last longer, or both.

4. Is this being done to cut the losses at the banks?

However with all that said, what are the value of these comments if things are much worse than anyone is letting on? I would say if things are much worse than we think, the comments go by the way side except #2.

Text in bold is my emphasis. Text in italics is the original article. From the WSJ:

An accord could reassure investors and strapped homeowners, both of whom are anxious as interest rates on more than two million adjustable mortgages are scheduled to jump over the next two years. It could also give a boost to the Bush administration, which is facing criticism for inaction amid the recent housing turmoil.

The plan is being negotiated between regulators including the Treasury Department and a coalition of mortgage-related companies including Citigroup Inc., Wells Fargo & Co., Washington Mutual Inc. and Countrywide Financial Corp. People familiar with the talks say the individual members have agreed to follow any agreement reached by the coalition, which is called the Hope Now Alliance. (Really, if the bank does not go along how do you think their next bank exam by the OCC, the Fed, FDIC, or whomever examines them will go.)

Details of the plan, which could be announced as early as next week, are still being worked out. In general, the government and the coalition have largely agreed to extend the lower introductory rate on home loans for certain borrowers who will have trouble making payments once their mortgages increase.

Many subprime loans carry a low "teaser" interest rate for the first two or three years, then reset to a higher rate for the remainder of the term, which is typically 30 years in total. In a typical case, the rate would rise to around 9.5% to 11% from 7% or 8%. That would boost an average borrower's payment by several hundred dollars a month.


Exactly which borrowers will qualify for the freeze and how long the freeze would last are yet to be determined. Under one scenario, the freeze could run as long as seven years. The parties are developing standard criteria that would determine eligibility. The criteria should be finalized by the end of year.

Mortgage servicers -- the companies that collect loan payments -- are a key part of the coalition, because they are the companies that deal directly with borrowers. Often the servicer is different from the company that originally made the loan. Citigroup and Countrywide are among the nation's biggest mortgage servicers. The mortgage servicers in the coalition represent 84% of the overall subprime market. The coalition also includes lenders, investors and mortgage counselors.

The Bush administration has been looking for ways to stem the fallout from the mortgage crisis. Treasury Secretary Henry Paulson and Housing and Urban Development Secretary Alphonso Jackson helped assemble the coalition so that government officials could have a single counterpart with which to discuss terms of a plan. (How bad could the mortgage crisis be if President Bush has to get involved. I would say pretty bad.)

While the government can't force the industry to modify loans, Mr. Paulson and other administration officials have been using moral suasion to push for workouts, telling the companies it is in their interest to avoid foreclosure since most parties can lose money when that happens. A similar plan to freeze interest rates temporarily was recently announced by California Gov. Arnold Schwarzenegger and four major loan servicers, including Countrywide.
Among the holdouts have been investors, who typically hold securities backed by mortgages. If interest rates are frozen, they would lose the potential benefit of higher payments. But investors have cautiously moved toward cooperation, likely on the grounds that it's better to get some interest than none at all.


At a meeting at the Treasury Department yesterday, coalition members told Mr. Paulson and other regulators that they are on track to announce the new industry guidelines by year's end, according to a senior Treasury official. Among those attending were representatives of Wells Fargo, Washington Mutual, Citigroup and the American Securitization Forum, a group whose members issue, buy and rate securities backed by bundles of mortgages.

"There has been a convergence of thought on this," said William Ruberry, spokesman for the Office of Thrift Supervision, which is also involved in the discussions.

A spokeswoman for the American Securitization Forum, which earlier resisted a broad approach to changing loan terms, said: "We support loan modifications in appropriate circumstances and are working to establish systematic procedures to facilitate their delivery."

Treasury officials say financial institutions are likely to set criteria that divide subprime borrowers into three groups: those who can continue to make their payments even if rates rise, those who can't afford their mortgages even if rates stay steady, and those who could keep their homes if the maturity date of their mortgages were extended or the interest rates remained at the teaser rates. Only the third group would be eligible for help.

The creditors are likely to look at whether the borrowers have equity in their homes, despite falling house prices, and whether their incomes are holding steady.

Mr. Paulson, who is philosophically opposed to federal meddling in markets, at first rejected a sweeping approach to loan modifications when the idea was floated by Federal Deposit Insurance Corp. Chairwoman Sheila Bair. But he shifted his position recently. He told The Wall Street Journal last week that it would be impossible to "process the number of workouts and modifications that are going to be necessary doing it just sort of one-off."

(Hmmm! The FDIC suggested this. They usually don't take the lead on this sort of issue unless there is a problem at the banks.)

As a drumbeat of bad news about housing has continued -- including news of fewer home sales, falling prices and higher foreclosures -- the Bush administration has come under pressure to be seen as actively addressing the problem.

Officials in Washington have been cautious about steps that would be seen as rescuing borrowers, lenders and investors from the consequences of their own bad decisions. That is why few are suggesting direct support for borrowers who can't afford their loans. Mr. Paulson has decided his best option is to prod the markets to sort matters out themselves, as long as companies bear in mind the public interest in keeping people in their homes. "There's not some silver-bullet piece of legislation out there," a senior Treasury official said.

"If I ever saw a role for government, it is...to bring the private sector together when innovation has really outrun our ability to deal with it," Mr. Paulson said. He is expected to talk about the administration's approach to the housing crisis at a conference Monday.

Interest rates are set to reset next year on $362 billion worth of adjustable-rate subprime mortgages, according to Banc of America Securities. An additional $85 billion in such mortgages is resetting during the current quarter. The estimates include loans packaged into securities and held in bank portfolios.

Borrowers whose loans are resetting are likely to have a tougher time sidestepping the rising payments by refinancing or selling their homes. Lending standards have tightened and many borrowers can't qualify for refinancing. And falling home prices mean that many borrowers have little or no equity in their homes. Some owe more than their homes are worth.

Top Treasury officials fear that unless creditors agree to relax the terms on many of those mortgages, borrowers will default at a higher pace. About 6.6% of subprime mortgages were in foreclosure as of August, the most recent data available, according to First American LoanPerformance.

Panic Groups Florida Government Investment Pool

Another outcome of the mortgage crisis is that supposedly “safe” money market accounts such as the one in Florida for local government entities and school districts invested in SIVs that were recently downgraded. Now the state of Florida has been forced to freeze the assets of the money market account until it figure out how to handle withdrawals. I can hear the investment officers saying right now, “We never thought that would happen.” Text in bold is my emphasis. From CNNMoney:

Florida officials suspended withdrawals from a state-operated investment pool Thursday, abruptly halting a run by local governments spooked over the downgrade of its mortgage-related holdings.

The State Board of Administration, chaired by Gov. Charlie Crist, acted during an emergency meeting after local governments had taken out nearly $10 billion, or 40 percent of the pool's assets, in the past two weeks. That included $3.5 billion Thursday morning.

The investment pool is similar to a private money-market fund. Cities, counties, school districts and other local entities invest money on a short-term basis in the fund and withdraw cash when needed to make payrolls and pay other operating costs.

The suspension will remain in effect at least until Tuesday, when the board will meet again to consider proposals for shoring up and restoring confidence in the pool.

The pool had nearly $25 billion in assets when the run began after about $900 million in asset-backed commercial paper had been downgraded below purchase credit rating guidelines.

"Participants are scared to death," said Coleman Stipanovich, the board's executive director. "If we don't do something quickly, we're not going to have an investment pool."

Stipanovich blamed the run on a news report that characterized the downgrading as a default, which he disputed. At least one local government - Leon County - withdrew its money before the article was published after learning about the downgrade.

"No matter what's motivating it, whether it's factual or not factual, it's almost irrelevant at this point," Crist said. Wayne Blanton, executive director of the Florida School Boards Association, said districts have other assets and lines of credit they can use until Tuesday.

"We can make payroll, but the fact is the purpose of that system is to help us move our money in and out and at any given time - 24 hours a day," Blanton said. "Right now they have frozen that ability."

Crist and the other board members, Chief Financial Officer Alex Sink and Attorney General Bill McCollum, were worried that without suspending withdrawals, the pool would run out of money because the downgraded assets would have to be sold at a loss. That would leave the last local governments in the pool with nothing.

McCollum participated by telephone from Utah, where he is attending a meeting of the National Association of Attorneys General.

Stipanovich proposed using the state's $137 billion pension fund to secure the downgraded paper, but board members were cool to that idea. They voted, instead, to seek advice from outside financial experts before considering the proposal again Tuesday.

"It's something that, speaking for myself, I'm not excited about," Sink said.

Crist agreed. He said he didn't want to do anything to harm the pension plan and state and local government employees who depend upon it.

Stipanovich said there would be little risk to the pension plan because the downgraded paper is backed by highly rated mortgages that continue to return millions of dollars in premiums and interest to investors.

Their market value, though, has plummeted because investors are shunning all mortgage-related securities due to losses on subprime mortgages.

Even if they do default, the pension fund would receive the mortgages as collateral and they would continue to pay off, Stipanovich said. He said they also should regain their market value although that could take years.

That's no problem for the pension fund, which invests for the long term, but it is for the local government pool because it needs to keep its assets liquid.

Is the Long-Awaited Consumer Slowdown Beginning? Part III – Dept. of Commerce Data Shows a Slow October

Consumer spending slowed in October and is expected to be slow for the remainder of the quarter. Text in bold is my emphasis. From Bloomberg.

Consumer spending in the U.S. rose less than forecast in October and incomes increased at the slowest pace in six months, adding to concern the economy will bog down.

The 0.2 percent increase in purchases followed a 0.3 percent gain in September, the Commerce Department said today in Washington. Incomes also rose 0.2 percent, half the pace anticipated by economists surveyed by Bloomberg News.

The figures reinforce concern that, as Federal Reserve Chairman Ben S. Bernanke suggested in a speech yesterday, consumers will pare spending amid higher gasoline prices, the housing slump and reduced access to credit.

``Consumer spending is off to a pretty weak start for the fourth quarter,'' said Peter Kretzmer, a senior economist at Bank of America Corp. in New York. ``This helps confirm what is built into the market by now -- that the Fed is likely to move on interest rates next month.''

After adjusting for inflation, which are the figures used in calculating economic growth, purchases were little changed, the Commerce figures showed today.


Spending cooled as inflation has picked up. Prices rose 2.9 percent since October 2006, compared with a 2.4 percent increase in the year to September.

The report's price gauge tied to spending patterns and excluding food and energy costs, the Fed's preferred measure, rose 0.2 percent in October for a second month. It was up 1.9 percent from October 2006, matching the September increase which was revised higher.

Bernanke said in a speech yesterday that ``uncertainty surrounding the outlook'' is ``even greater than usual,'' requiring the Fed to be ``exceptionally alert and flexible.''

Federal funds futures show traders see a 100 percent chance of a reduction in the benchmark rate next month, with a 30 percent probability of a half-point move.

Inflation-adjusted spending on durable goods, such as autos, furniture and other long-lasting items, dropped 0.6 percent, the biggest decline since June. Purchases of non- durable goods fell 0.1 and spending on services, which includes utilities and accounts for almost 60 percent of all outlays, increased 0.1 percent.

The Fed said economic growth slowed in seven of 12 U.S. regions from October through mid-November, with retailers ``slightly pessimistic'' about year-end holiday sales, according to their regional survey issued this week.

Reports on retail spending ``were downbeat in general,'' according to the report known as the Beige Book. Most Fed banks reported that retailers expect sales growth ``to be modest at best in the upcoming holiday season,'' the central bank said.

Meeting of Home Builders States that 2008 is Going to be Tough

The excerpts below from a Bloomberg article summarize a recent meeting of home builders. This gist of the meeting is that 2008 will be another tough year and 2009 is uncertain. In addition, the industry has already lost some builders and 2008 could be the year that some well known builders are lost. The saving grace in all of this is at least the home builders are not pumping out all the optimistic baloney about a turn around next quarter. First thing you have to do in a crisis is admit that you have a crisis. Then you can move on from there. Text in bold is my emphasis.

As the U.S. housing slump enters its third year, there is no sign of dawn in the darkness that is paralyzing home building, home buying and home lending.

Standard & Poor's 15-member Supercomposite Homebuilding Index tumbled 62 percent this year as of yesterday, the largest drop since the benchmark was started in 1995. The companies have lost about $35 billion of market value.

The outlook is bleak with new home sales projected to fall 13 percent in 2008, according to estimates from the National Association of Realtors in Chicago, even as interest rates drop.

Losses at Fannie Mae and Freddie Mac, the two biggest U.S. providers of mortgage financing, may restrict the availability of home loans, and chief executive officers at D.R. Horton Inc. and Centex Corp. expect another tough year.

``This looks like it's going to be the deepest correction of any housing correction since World War II, and the question really is, `What's the duration, how long will it be?''' Centex CEO Timothy Eller said at a JPMorgan Chase & Co. conference in Las Vegas on Nov. 27.

Total new home sales peaked in July 2005 and have declined for 19 of the last 28 months through October, according to Commerce Department data. Existing home sales peaked in September 2005. The median price for a new home dropped 13 percent in October, the most since 1970, and the annual sales rate for new homes in September was the lowest in almost 12 years.

Credit default swap spreads climbed last week by as much as 335 basis points for builders with investment-grade ratings and by an average 209 basis points for those with junk ratings, according to CreditSights Inc., a New York-based research firm. Credit default swaps are contracts to protect bondholders against default. An increase indicates worsening perceptions for credit quality.

``If we talked two weeks ago, I'd say there wasn't much more downside, but the market is acting like there's still a lot more to go,'' said James Wilson, an analyst who follows home builders at San Francisco-based JMP Securities LLC.

Beazer Homes USA Inc., the Atlanta-based homebuilder under investigation by the U.S. Securities and Exchange Commission, and Hovnanian are ``bankruptcy risks,'' Wilson said. Those companies have too much debt and are exposed to slumping housing markets in Florida and Michigan, Indiana and Ohio, he said.

Beazer CEO Ian McCarthy said at this week's conference in Las Vegas that 2008 ``is going to be another tough year.'' The company has a secured credit line of $500 million, he said.

``The company is really looking to make sure its balance sheet and its credit position is strong as we go through this tough time,'' McCarthy said. The company also has agreements ``with our bankers and with our secured credit lenders'' that will ``put us in good stead going forward.''
Many homebuilding executives at the conference said they expect the slump to last through 2008.

Next year ``is going to be worse than '07 for us and for the industry in general,'' said Donald Tomnitz, D.R. Horton's CEO.

At least three closely held companies filed for bankruptcy protection in the past month, including Fort Lauderdale, Florida-based Levitt and Sons LLC, the 1949 pioneer of planned suburbs with Levittown on New York's Long Island. Tousa Inc. of Hollywood, Florida, which has lost 99 percent of its stock market value this year, said this month it was considering filing for Chapter 11 bankruptcy protection.

The New York Stock Exchange suspended trading in Tousa on Nov. 19 because the average closing price was less than $1 for 30 straight trading days. Tousa last traded at 8 cents, down from a seven-year high of $30 in August 2005.

A housing rebound is unlikely, as about 1 million adjustable loans made to subprime borrowers, those with weak or incomplete credit histories, are scheduled to reset at a higher rate in 2008, according to RealtyTrac.

That may put many homeowners at risk of foreclosure and lower the value of neighboring houses, said Rick Sharga, vice president of marketing at RealtyTrac. About 1.3 million subprime mortgages will be in foreclosure by September 2009, including actions already under way, according to estimates from New York- based analysts at Credit Suisse Group.

``There is just no quick fix, including further rate cuts, to stabilize the current weakness in the housing market,'' said CreditSights analysts Frank Lee and Sarah Rowin in a Nov. 23 report to clients.

Builders must contend with a glut of existing homes on the market. There's an almost 11-month supply of unsold existing homes, the highest in more than eight years, according to data from the National Association of Realtors.

The decline in the market for existing homes is lagging ``far behind'' the new home market, and resale prices have only started to erode, said Citigroup Inc. analyst Stephen Kim in a Nov. 23 report.

``We have never before seen how a belated dropoff in existing home prices will affect already discounted prices for new homes, but it is difficult to be optimistic here,'' Kim wrote.

Thursday, November 29, 2007

Petrodollar Recycling in the Current Period

Petrodollar recycling, what oil exporters do with all that money, has been a problem from time to time. In the beginning the large oil exporters were not always sure what to do with their windfalls. But over time they figured it out. Also over time a lot more of us is going to be owned by someone else. Text in bold is my emphasis. From the WSJ:

With so many economic threats facing the U.S., consider for a moment an old worry: the fear that oil-producing nations wouldn't be able to "recycle" all the money they were collecting, to the detriment of the global economy.

Angst about "petrodollar recycling" made headlines in the 1970s. It's a worry that seems quaint today as the Abu Dhabi Investment Authority trades the proceeds of roughly 75 million barrels of oil -- about a week's worth of U.S. oil imports -- for a 4.9% stake in Citigroup.

Still, three decades ago there was genuine concern that the Organization of Petroleum Exporting Countries wouldn't know what to do with the windfall from the first oil shock. And there was fear that oil-importing countries, especially in the developing world, might try to compensate for their growing oil-induced trade deficits by reducing other imports.

The International Monetary Fund set up special "oil facilities" to lend to oil-thirsty developing nations that were running up huge trade gaps. U.S. Treasury Secretary William Simon lobbied oil producers to deposit petrodollars in U.S. banks and discouraged them from direct investment in U.S. companies -- amid talk Iran might buy a stake in ailing airline Pan Am, which is now defunct.

OPEC, it turned out, went on a buying binge. The money it did save, before oil prices fell, went into government securities or bank deposits. Commercial banks, in turn, increased lending to Latin America and other developing countries to bankers' later regret. With that prominent exception, though, "Recycling was carried out quite successfully in 1974-78," retired Federal Reserve economist Robert Solomon wrote in a monetary history of the period. "The problem turned out to be manageable after all."

Now oil prices are up, and money again is flowing from consumers in the U.S., Europe, Japan, China and India to producers who are -- as Edwin Truman of the Peterson Institute for International Economics puts it -- "taking wealth out of the ground and putting it above ground." Even if oil falls back to $70 a barrel, oil producers have nearly $2 billion to invest every day. So why so little worry about recycling petrodollars?

For starters, the global economy of the early 2000s has been far healthier than the stagflationary 1970s. The world has largely weaned itself off rigid foreign-exchange regimes, though not entirely, a problem for Middle Eastern countries whose dollar-linked currencies are sinking with the U.S. dollar when fundamentals suggest they should be rising. Global financial markets are far bigger than they were then.

The prospect of huge trade deficits doesn't seem as unsettling as it once did, perhaps because the U.S. has managed to maintain a large and (until recently) growing trade gap longer than doomsayers thought possible. And the biggest emerging markets are far more robust than they were 30 years ago. Indeed, China is running a huge trade surplus despite its hefty oil imports. And the IMF projects that, within a few years, funds managed by the investment arms of Asian governments and foreign-exchange reserves will be far bigger than OPEC's hoards.

It's clear oil producers are far more sophisticated investors than they were in the 1970s, though no one really knows where all the money is going. Simon Johnson, chief IMF economist, says only half the oil producers' windfall is accounted for. About 20% of their investing -- as opposed to spending on buildings or baubles -- is going into banks, much of that lent to emerging markets, the IMF says.

Another 30% shows up in U.S. Treasury reports as going into various U.S. securities. But those reports are incomplete -- partly because Saudi money managed in London and invested in U.S. stocks shows up as British, not Saudi. Much of the rest is believed to be going into stock markets around the world.

But there's only one big borrower in the global economy these days: the U.S. "The U.S. has been the ultimate destination -- even if has not been the direct destination -- for petrodollars recycled into the international financial markets," a trio of New York Fed economists wrote a few months ago.

Other oil importers, taken together, have curtailed consumer spending, boosted saving or reduced investment to avoid huge U.S.-style trade deficits that require financing from abroad.

Ron Paul, the Republican presidential candidate with some distinctly unconventional economic ideas, has this one right: "Right now we owe foreigners $2.7 trillion," he said in a recent debate. "No wonder they have money to come back in here and buy stuff up. And then we object … but that is a natural consequence of what happens when you live beyond your means."

So is all of this good or bad? Well, this money has helped keep U.S. interest rates one-half to three-quarters of a percentage point lower than they would otherwise be, a welcome counterweight to the economic harm done by higher oil prices. And, as the Citigroup deal illustrates, it's nice to have someone with capital to invest when American financial institutions suddenly need it, even if it is costly.

Yet every day, the U.S. economy sells a bit more of itself to oil producers and thrifty Asian economies because it doesn't save enough to finance its investment. In exchange, future profits from those assets will flow abroad instead of staying home.

Some Details on the Citigroup – Abu Dhabi Deal

The article below from the WSJ goes into some of the details of the cash injection that Citigroup received from Abu Dhabi. We will see just how good a deal this is in a decade or so. Unlike those of us in the US, everyone else has a much longer time horizon on their investments. Text in bold is my emphasis.

At first glance, Citigroup looks like it paid a dear price to the Abu Dhabi Investment Authority for its $7.5 billion capital infusion.

This week Citigroup, in exchange for Abu Dhabi's investment to buttress Citigroup's coffers, agreed to issue convertible preferred shares to the Middle Eastern sovereign wealth fund. The shares will convert to a 4.9% stake in the bank in about three years and Citigroup will pay Abu Dhabi an 11% interest rate in the interim.

Critics said Citigroup was taken to the cleaners by Abu Dhabi and pointed out that even companies rated junk only pay 9% interest rates.

But looks can be deceiving.

Details of the deal, which is private, are scant, and therefore analysts say it is difficult to value. However, many agree that the dividend on the preferred shares isn't unreasonable compared with the 7.4% dividend yield on Citigroup's common shares at the time the deal was announced.

Looked at this way, Abu Dhabi is getting a 3.4 percentage-point premium for stepping up when everyone else was fleeing the sector. In addition, the structure of the deal limits Abu Dhabi's upside and the potential dilution of Citigroup shares, other reasons why the investment fund should get a premium to the dividend. Finally, Abu Dhabi's ability to sell its shares will be restricted through 2014.

In this deal, Abu Dhabi's shares will convert into Citigroup common stock between March 2010 and September 2011, with the amount of the shares to be determined by where Citigroup shares are trading. The terms include a lower strike price of $31.83 and a cap of $37.24. The lower strike price limits Abu Dhabi's downside but also caps its upside if the share price increases sharply.

The number of common shares granted to Abu Dhabi falls as the share-price rises. If it rises to $37.24 or above, Abu Dhabi will receive a maximum of 201.4 million shares, but if it falls to $31.83 or below, the fund receives 235.6 million. If the price is within the range, Abu Dhabi gets some amount of shares in between, depending on an undisclosed formula. Traders call this range, which limits Abu Dhabi's upside, the "dead zone."

For its part, Citigroup managed to raise tax-deductible, tier-one capital. It has also locked in a long-term investor who has promised not to meddle much in its daily affairs, which, in this age of shareholder disgruntlement and activism, could be worth its weight in gold.

What Part Does Psychology Play in a Recession?

I found this interesting, gives one pause to think. However, with all the comments below I still think a potential credit crisis in conjunction with housing is a major problem. Text in bold is my emphasis. From Market Watch:

As the U.S. economy was sliding into recession in December 1957, a Dallas bank executive suggested to Time magazine the key to how bad things might get: "Psychology is the joker in the economy's deck of cards."

Yet just as quickly, the nation suppressed its fear of being showered with nukes and showed the Soviets how resilient capitalism is. Our economy took off like a rocket, growing 9.5% for an entire year beginning July 1958 -- a performance unrivaled since.

FDR's admonition that "we've nothing to fear but fear itself" resonates still because we know our state of mind has a major bearing on our economic well-being. The reality now is we're dangerously close to talking ourselves into a recession, as evidenced by the unexpectedly sharp drop in consumer confidence reported Tuesday.

U.S. consumers have taken $3-a-gallon gas and a drop in our home equity in stride. Yet the media seems hell-bent on convincing us multinational banks' subprime mortgage losses and a weak dollar will torpedo the economy in a way the stock market's collapse, mass layoffs and 9/11 scarcely did in 2001.

"There is a herd mentality with prevailing outlooks on economic conditions because few of us want to be caught unprepared," says Mitchell Marks, an organizational psychology professor at San Francisco State University. "If people get bombarded with a grim message, that herd grows bigger and stronger."


Not convinced we risk succumbing to fear-mongering? Consider these five signs that we're getting needlessly skittish:

1. Grinch steals Christmas


When two major retailers announced plans to open stores at 4 a.m. the day after Thanksgiving, the media widely characterized it as the industry running scared about consumers' holiday-shopping appetite. It was nothing of the sort.

Retailers have been moving up holiday-kickoff openings for years for one reason -- competitive advantage. Whoever attracts early-bird shoppers with advertised loss-leaders stands the best chance of capturing offshoot gift spending as well. That's especially true as consumers increasingly shop online, where they can't touch and feel merchandise and aren't as inclined to whimsical purchases.

Lo and behold, Friday's total sales rang in a blistering 8.3% higher than a year ago. Yet naysayers immediately turned the surprisingly good news into bad, attributing the rise to financially squeezed bargain hunters seizing on deals and predicting sales will slow sharply in the weeks ahead.

Illustrating the media's recent propensity for gloomy spin was a story in The New York Times, whose reporter threw objectivity to the wind in discounting the "huge crowds" he encountered at stores Friday by adding "but the mood was one more of desperation than of celebration." Oh, brother, let's just slit our wrists now to escape these bleak times.

2. Twisting a Fed chairman's words

In testimony to Congress on Nov. 8, Federal Reserve Chairman Ben Bernanke predicted the economy would "slow noticeably" in the months ahead. Those two words were highlighted in broadcast reports and headlines as if he were warning of a coming economic Armageddon.
Forget that the word noticeably means perceptibly and not calamitously. In the last two quarters, the economy grew nearly 4% -- well above the 2.5% to 3% sweet spot former Fed Chairman Alan Greenspan aimed for in setting monetary policy. Economic growth could slow by a third and still be within that range.


Worse yet, Bernanke's remarks became fodder for political opportunists like U.S. Sen. Charles Schumer, D-N.Y., who opined during his testimony: "I think we're at a moment of economic crisis." A slumping economy would certainly benefit Democrats in next November's elections -- so there went Schumer, chairman of Congress's Joint Economic Committee, dutifully talking up the specter of recession.

3. Fretting two bits for coffee

Two weeks ago, Starbucks reported its third-quarter "customer transactions" fell by 1%. Many analysts trumpeted that as a sign we're all into a belt-tightening mode that could crimp consumer spending, which drives two-thirds of economic growth.

The far more likely cause: the retailing colossus's brazen price hikes this year amid rising competition from lower-cost Dunkin Donuts and McDonald's. Maybe the markups awoke its diehard patrons, finally, to the realization they're paying ridiculous sums for water run through coffee grinds that they can brew at home or work.

Rather than reading Starbucks' tiny traffic slip as an omen of declining incidental purchases, it might just be the first sign the giant coffee peddler will need to introduce a value menu like its fast-food counterparts have in their mature market.

4. Not just any port in a storm

A sudden anxiety seems to be developing over who our Democratic and Republican presidential nominees will be in 2008, driven by more than just the advent of primary season. Mounting economic uncertainty is the root cause.

Three months ago, many Americans couldn't care who next occupies the White House; they were just eager for the current resident to vacate.

Let's just hope we don't slip into recession in 2008, however slight, or we'll be hearing from all candidates how they're best equipped to save us from economic ruin. Such trash talk relayed daily across every major media outlet could become a self-fulfilling prophecy.

5. Wall Street's profound neurosis

U.S. investors have a serious mental-health problem these days, namely, a case of manic depression.

The Dow has whipsawed up and down by 100, 200 and 300 points in a day with such regularity that it's almost become more the norm than the exception. Indeed, a 132-point drop Monday blamed on "new credit fears" preceded a 215 point jump Tuesday linked to ailing Citigroup drawing a $7.5 billion capital fusion and a 331 gain Wednesday on a hint of another Fed rate cut.

The trouble is 200-point daily jumps in the Dow don't register on our collective psyche nearly as deeply as 200-point drops. So the Dow is down 7% from its record high in October; it's still up 9.5% in the last 12 months. Yet we focus on the former and ignore the latter.

Too often, we forget the stock market's performance is only one of 11 gauges in the Index of Leading Economic Indicators. If you let its present bipolar disorder depress your outlook, it's no mere theory -- you are the bigger fool.

Certainly, the weak housing market and its related ills are putting a serious damper on potential economic growth. The median U.S. home price will drop slightly this year -- the first nationwide decline since statistic-gathering started in 1950 -- and may again in 2008.

Our bigger problem today is the toll years of uninspired political leadership in both parties have taken on our spirit. The vast majority of us, Republicans and Democrats alike, believe the country's run off course. We see a glass neither half-empty nor half-full -- a mindset that's formed cataracts on our view of the future. (I seldom make political comments, but I do think this one is has legs.)

Consider this: The combination of the Nasdaq's 80% drop, a two-thirds rise in our unemployment rolls and the trauma inflicted by a puissant Arab extremist together produced just one of the shallowest recessions in U.S. history. You gotta believe it'll take more than a passing credit squeeze to cause the world's greatest economy to falter again.

A View of the Credit Crisis from the UK

The following gives a good summary of what is on the minds of central bankers in the UK and the US. The real concern continues to be the effect of asset values (CDOs, SIVs, etc.) on the banks and the effect this will have on their ability to lend. This in turn effects consumers (the real issue.)Text in bold is my emphasis. From Bloomberg:

Bank of England Governor Mervyn King said there's a risk a further drop in asset prices will lead to more deterioration of credit conditions.

``Market fears about the possibility of further movements in asset prices might impair the balance sheets of the banking system in the U.S., which would lead to a classic credit squeeze,'' King told U.K. lawmakers today. ``This is a risk rather than something that's actually happened yet.''

The world's biggest banks have written down more than $50 billion on credit-related losses and UBS AG, Citigroup Inc. and Merrill Lynch & Co. fired their chief executives. The Bank of England today joined the European Central Bank and the Federal Reserve in moving to stem a renewed rise in lending rates, offering banks emergency funds with longer repayment terms.

Borrowing costs have soared as banks hoard cash before the end of the year on concern losses from the collapse of the U.S. subprime mortgage market will spread, keeping lenders from offering money to all but the safest borrowers.

``Continuing fragility in the banking system'' has increased the risk that money markets will ``tighten'' at year end, the bank said today. The cost of borrowing pounds for three months rose 3 basis points to 6.59 percent yesterday. That's 84 basis points more than the Bank of England's benchmark rate and the highest since Sept. 18.

Fed Deputy Governor Donald Kohn yesterday helped spark a stock-market rally when he said market ``turbulence'' may reduce credit to businesses and consumers, reinforcing investors' expectations the Fed will cut interest rates again next month.

While the Fed has reduced its key rate by 75 basis points to 4.5 percent, the ECB and the Bank of England have kept their benchmark rates unchanged since markets seized up in August.

King and other British policy makers said today a reduction in lending will eventually hurt investment and consumer spending in the U.K.

``The big area of concern in my mind is consumption,'' said Bank of England Deputy Governor Rachel Lomax. ``It's the most important component of demand and it's most likely to be hit by tighter credit conditions.'' King said corporate investment and commercial property are his biggest concerns.

The Bank of England is aiming to curb market lending rates and inflation at the same time. King said today that ``the near- term outlook for inflation and growth has become less benign'' and policy maker Timothy Besley said there's still ``a fair amount of inflationary pressure out there.''

King drew a distinction between the jump in credit costs in August and September, stemming from the plunge in the U.S. market for subprime mortgages, and the latest increase. King said the first round was driven by concerns about banks' liquidity and the latest by concerns about the health of their balance sheets.

``Although that fear has so far run well ahead of realized losses, it has the potential to lead to a further tightening in credit conditions,'' said King. ``The bank will continue to assess how these developments will impact on the outlook for inflation.''

Home Foreclosures in October are up 94% from Last Year

I realize that everyone is tired of hearing about all the bad news in the housing market, but it is part of process and there is more to come. Text is bold is my emphasis. From Yahoo:

Home foreclosure filings in October edged up 2 percent from September but at 224,451 were a whopping 94 percent higher than a year earlier, real estate data firm RealtyTrac said on Thursday.

The figure, a sum of default notices, auction sale notices and bank repossessions, was down from a 32-month peak in August however, RealtyTrac, an online market of foreclosure of properties, said in its monthly foreclosure market report.

RealtyTrac said the national foreclosure rate was one filing for every 555 U.S. households in October.

"Overall foreclosure activity continues to register at a high level compared to last year but it appears to have leveled off over the past two months after hitting a high for the year in August," James Saccacio, chief executive officer of RealtyTrac, said in a statement.

In September, home foreclosure filings fell 8 percent.

Default rates in the subprime segment of the U.S. mortgage market, which caters to borrowers with poor credit histories, have jumped this year as the housing industry slowed and prices fell in many regions, particularly areas that benefited the most during the housing market's boom from 2000 to 2005.

"Default notices were down nearly 9 percent in October, indicating that some of the efforts on the part of homeowners, lenders and advocacy groups to find alternatives to foreclosure may be starting to have an impact. On the other hand, bank repossessions were up nearly 35 percent, evidence that more homeowners who enter foreclosure are losing their homes," Saccacio said.

Nevada, once one of the hottest real estate markets and a favorite among investors, led the nation with one foreclosure filing for every 154 households, 3.6 times the national average. Its 6,618 filings were up 20 percent from September and were nearly triple those reported in October 2006.

California foreclosure activity fell nearly 2 percent from the previous month, but its rate of one filing for every 258 households still ranked the second-highest in the nation.

California's reported foreclosure filings totaled 50,401, more than triple the number reported in October 2006.

Florida's rate of one foreclosure filing for every 273 households ranks it third-highest. Its 30,190 filings in October were down more than 9 percent from September but still up nearly 165 percent from a year earlier.

Ohio, Georgia, Michigan, Colorado, Arizona, Indiana and Illinois were other states with foreclosure rates ranking among the country's 10 highest.

Pipeline Fire in Northern Minnesota Has the Potential to Cause Some Real Problems

A pipeline fire in northern Minnesota has the potential to cause some real problems in the US, especially for people in the upper Midwest. This is a perfect example of a low-probability random event with severe consequences, a so-called “black swan” event. If you live in the Midwest you are about to find out how local oil and gas markets are. Also people may find out about the seldom discussed emergency supply system that Uncle Sam can impose if necessary. Text in bold is my emphasis. From Yahoo:

An explosion crippled the main pipeline supplying Canadian crude to U.S. Midwest refineries on Wednesday, forcing operator Enbridge to halt nearly a fifth of U.S. imports and sending crude prices as much as $4 higher.

One of the set of four lines will require repairs and regulator inspections, while the largest is "not likely" to start up any time soon, Larry Springer, a spokesman for Calgary, Alberta-based operator Enbridge Inc, said on Thursday.

The smaller two lines were several hundred feet from the fire and appear to be undamaged, but will be inspected soon before they are restarted, Springer said by phone. He was not able to give a specific time frame for restarting any of the network.

Two employees were killed in the blast and fire on the 450,000 barrels per day (bpd) Line 3, which had been shut earlier to inspect a leak, Springer added. Enbridge said in statement that the cause of the explosion had not yet been determined.

The explosion about 3.0 miles southeast of its Clearbrook, Minnesota, terminal, shut down a line that carries an estimated 1.9 million bpd of Canadian crude, equivalent to about 9 percent of total U.S. oil demand.

Oil prices roared more than 4 percent higher on the news, with traders fearing that the outage would leave mid-continent refiners short of crude. By 5:15 a.m. EST U.S. futures were up $3.51 at $94.13 a barrel, rebounding from Wednesday's fall.

"My initial impression is that (this) will put a halt to the slide in oil prices and put us back on the march towards $100 a barrel," ANZ senior commodities analyst Mark Pervan said. "The timing is pretty bad. We are coming to the strongest demand period for crude with the approach of the northern winter."

Canada is the biggest supplier of foreign crude to the United States, accounting for almost one-fifth of its over 10 million bpd of imports, government data show.

Nearly all of that is delivered via the Enbridge system.

The outage comes two years after powerful hurricanes knocked out a swathe of U.S. Gulf of Mexico oil production, which prompted the International Energy Agency and the U.S. government to release government-held emergency oil reserves.

The U.S. holds 700 million barrels in its Strategic Petroleum Reserves (SPR) in four sites around the Gulf, although there is limited capacity to pump those supplies to northern refiners.
The head of the IEA's oil and industry markets division said the West's energy watchdog was closely monitoring the outage.


"You have to look at whether there are opportunities for re-routing supplies... and how long it's going to take for repairs," Lawrence Eagles said.

A county official said the fire could burn for three days.

"The area under fire now is 100 feet by 100 feet," Jeanine Brand, County Attorney and Public Information Officer for Clearwater County, said by telephone.

Enbridge was not able to say what caused the blast but said it was working with federal and state authorities to begin a thorough investigation.

A lasting disruption to Lines 3 and 4 -- which combined pump over 1.1 million bpd of mainly heavy and medium crude -- would put a strain on landlocked Midwest refiners such as Flint Hills Resources and Marathon Oil Corp, which have few immediate alternatives to the Canadian supplies.

That in turn could drain stocks in the Cushing, Oklahoma, delivery point for New York Mercantile Exchange (NYMEX) oil futures, although the Enbridge line does not flow directly there.

Refineries owned by Exxon Mobil Corp, BP Plc and Murphy Oil Corp are also linked to the pipeline.

Previous disruptions caused by leaks on the Enbridge system earlier this year have been patched up quickly enough to avoid any significant impact on customer deliveries, and the company was hopeful of restarting the smaller lines quickly.

"There is nothing from any other sources that would make us think there is any damage (to Lines 1 and 2), but as prudent operators we have to inspect them before we start them back up," Enbridge's Springer said.

The fire occurred at a main juncture in the line shortly before the U.S. portion splits into a network of other lines.

It supplies 62 percent of the crude refined in the Chicago area and 82 percent of Ontario's demand, according to the Web site of U.S. arm Enbridge Energy Partners, L.P.

Wednesday, November 28, 2007

Another Alternative Way to Handle SIVs

So far SIVs have been liquidated, brought on to the balance sheets of banks, potentially purchased by a big bank bail out fund (M-LEC). Well, there is another, less preferred alternative. It is amazing the vehicles that financial people can come up with when their backs are up against the wall. Text in bold is my emphasis. From the WSJ:

Creditors in the $7 billion structured investment vehicle formerly known as Cheyne Finance are moving closer to a deal that would allow them to avoid being forced to realize hundreds of millions of dollars of potential losses in the short term, people familiar with the situation said.

The proposed deal would involve transferring the assets to a new vehicle, with senior creditors being offered the opportunity to refinance their debt into longer-term instruments or to take a discounted cash pay-out, the people said.

The full structure of such a deal remains unclear, and one person said it was only one of the options being considered. If successful, it could become a route for creditors in other troubled SIVs, two people familiar with the matter said.

SIVs are investment pools that issue short-term debt to buy portfolios of longer-dated assets, pocketing the difference on the interest paid and received. Many of the vehicles ran into trouble in August when commercial-paper markets shut down for most issuers, after investors became concerned about the quality of some of the underlying assets.

The SIV formerly known as Cheyne Finance was managed by London hedge-fund group Cheyne Capital Management (UK) LLP. Now called SIV Portfolio PLC, it was one of the first SIVs to have trouble funding itself in August.

Restructuring this and other vehicles has proved tricky because senior debtholders, which include money-market funds, don't want to book losses, despite the drop in trading prices on the SIVs' underlying portfolios of residential-mortgage-backed securities and bank debt. It has also been difficult to agree on a restructuring that satisfies the objectives of the group of investors in an SIV, people familiar with the matter said.

Cheyne Finance entered receivership Sept. 5 after having drawn down its three liquidity lines to help repay maturing debt. The SIV's receiver, Deloitte & Touche LLP, has been looking for a buyer of its portfolio or a refinancing agreement with creditors. A spokeswoman for Deloitte & Touche declined to comment.

If senior creditors agreed to the proposed interim solutions, they would have at least until next year to consider selling the portfolio of assets, one of the people said. The hope is that the market for the structured assets will have improved by then.

Only a minority of the senior creditors are expected to opt for the cash payout as it would be at a highly discounted price, one of the people said.

Receivers previously held exclusive talks with RBS about setting up an entity to buy Cheyne Finance's assets that would have led to senior creditors ultimately being repaid in full. Other banks proposing restructuring plans and reaching advanced talks with the receivers included Goldman Sachs Inc., J P Morgan Chase & Co. and Morgan Stanley.

However, those proposals stalled after the value of the portfolio of assets fell further and as the transaction would no longer result in senior creditors being repaid in full -- let alone some $720 million of more subordinated mezzanine and capital notes, people familiar with the matter said.

Another Loss Forecast on CDOs, This Time From J P Morgan Chase

The loss forecasts for various banks due to the housing crash are coming in regularly between $250B to $500B. The J P Morgan Chase forecast of $260B is coming in on the low end of this range, but their forecast only includes CDOs. Text in bold is my emphasis. From Bloomberg:

Losses on collateralized debt obligations at the world's biggest banks may double to $77 billion, JPMorgan Chase & Co. analysts predict.

Losses marketwide on CDOs linked to U.S. mortgages will reach about $260 billion, the New York-based JPMorgan analysts, led by Christopher Flanagan said in a report.

Merrill Lynch & Co., Citigroup Inc. and other banks that underwrote the so-called structured finance CDOs have already taken losses of at least $47.2 billion, a tally that also includes other holdings aside from CDOs. . . . .

. . . . .``One of the benefits of securitization is the offloading and global distribution of risk,'' the JPMorgan analysts wrote. ``Ironically, this is now a capital markets hazard, since no one is sure where subprime losses lurk.''

Structured finance CDOs repackage asset-backed debt including subprime-mortgage bonds and other CDOs into new securities with varying risks. CDO sellers including Merrill, Citigroup, UBS AG and Deutsche Bank AG are taking losses on the ``super-senior,'' or safest, pieces of the CDOs, according to JPMorgan. Writedowns on that debt should be between 20 and 80 percent, the analysts wrote.

The banks ended up holding so many super-senior classes of CDOs partly because they were forced to retain about two thirds of the securities when underwriting deals in 2006 and 2007 because of weak demand from other investors, the JPMorgan analysts wrote.

Other holdings came from promissory agreements and from banks seizing collateral on bad loans to hedge funds, the analysts said.

Some banks may have ``successfully hedged'' their exposure to CDOs, though the timing of the gains on the offsetting positions may not match the timing of losses, the analysts wrote.

Zurich-based UBS may lose $8.6 billion, Frankfurt-based Deutsche Bank may lose $5.1 billion, and New York-based Goldman Sachs Group Inc. may lose $5.1 billion, the report said.

With regard to bonds, bond insurers including Ambac Financial Group Inc. and MBIA Inc., which have ``taken few reserves,'' own CDOs that have had $29 billion in losses, JPMorgan estimated.

Losses on all subprime mortgage assets may reach $300 billion to $400 billion worldwide, Deutsche Bank analysts said Nov. 12. Credit losses on subprime, Alt-A and second mortgages made in the past three years will rise to $394 billion, excluding the effect of CDOs and credit-default swaps linked to the loans, UBS said.

Collateralized loan obligations, which repackage buyout loans and other high-yield company debt, may have lost $45 billion of value, the report said. The losses aren't ``credit-driven,'' the report said.

Why is Oil at a $100/barrel Speculation or Just the Fundamentals

Good discussion about the oil markets and whether or not the high prices are due to speculation or the fundamentals. It is probably both, but speculation has played a large part in the market since August. Text in bold is my emphasis. From CNNMoney:

Greed is driving oil prices to $100 a barrel. That's a common feeling among the general public, which sees record profits for investment banks that bet on oil prices - making wealthy oil companies even wealthier - while drivers shell out $3 and more for a gallon of gas.

It's also a common refrain from OPEC states. Having to defend themselves against charges their production quotas are responsible for the high prices, they point to near-average crude oil supplies and say speculation is what's behind the frenzy.

But industry experts offer mixed opinions on speculative investment's impact on oil prices. Some say it's marginal, that strong demand and limited supply are the real reasons oil prices have risen five-fold since 2002, and say additional investors actually benefit the market by adding more liquidity.

Others say the tight supply and demand situation has been known for a while, and nothing but speculation is behind the doubling of oil prices over the last year. They say there is a cost to the sheer number of oil contracts now traded on the oil exchanges, and this trading has just enriched Wall Streeters at the expense of average Americans.

The Energy Information Administration, the Energy Department's independent statistical and analysis arm, thinks strong demand and limited supply - otherwise knows as "the fundamentals" - is why oil is so pricey.

"Our view is that the market is tighter [than last year]," said Doug MacIntyre, senior oil market analyst at EIA. "We don't have the inventories now."

MacIntyre said inventories in developed countries - crude oil stored at refineries, or in tanks at ports, pipeline terminals and other locations - went from 150 million barrels above their five-year average at the start of the year to 10 million barrels below the five-year average now.

"That's a big difference," he said. "There's less slack in the system than there was a year ago."
EIA attributed the decline to OPEC production cuts of about 1.5 million barrels a day beginning at the start of 2007, when inventories were so high and oil prices briefly dipped below $50 a barrel.
The cuts came despite continued strong worldwide economic growth, which EIA said caused oil demand to rise by 1.3 million barrels a day over the last year. The agency projects an increase in demand of 1.5 million barrels a day in 2008.


"High oil prices are not rationing demand," Addison Armstrong, director of market research at the brokerage Tradition Energy Futures, said, adding that speculative money might be tacking on just $5 or $10 to the price of a barrel. "The fundamentals are much tighter than they were a year ago."

EIA said other factors contributing to a doubling in oil prices over the last year include moderate growth in new supplies from non-OPEC countries, the inability to immediately produce much more oil in OPEC countries, a lack of refining capacity and ongoing geopolitical threats.

But longtime Oppenheimer oil analyst Fadel Gheit doesn't buy it.

Gheit said inventories are declining because high oil prices give people an incentive to sell crude now and wait until later to restock supplies, when hopefully oil is cheaper.

Other than the decline in supplies, Gheit says all the other factors EIA lists have been with us since last year, when oil traded at under $50 a barrel.

"It's pure speculation," he said. "What's changed that we didn't know in January? Not a single thing."

It's hard to gauge the amount of money investment interests - as opposed to refiners or airlines or people who actually use oil - have in the oil markets. The government tracks contracts held by what it calls "commercial' and "non-commercial" users, but it lumps investment banks in with the commercial side.

Either way, the amount of investment money in oil is certainly large. It's been rumored Goldman Sachs has over $80 billion in the market, although the investment bank declined comment for this story.

Its influence is so big, traders refer to the day of the month when the bank sells the current month contract and buys the future month as the "Goldman roll" due to its effect on price. When Goldman last month told its clients to sell oil when it approached the mid-90's, crude lost over $3 in one day.

Goldman is of course not the only one. Morgan Stanley, which also declined comment, has reportedly bought facilities to store oil. Hedge funds, pension funds, commodity-centered mutual funds, insurance companies - all have gotten in on the act.

"Just the multiple [contract] turnovers in the futures markets has a cost of its own," said Judy Dugan, research director at the Center of Taxpayer and Consumer Rights.

Dugan, echoing recent sentiments by oil company executives themselves, said there's no fundamental reason why oil prices should be anywhere near $100 a barrel.

"There's no inability to buy oil, this is not 1981," she said.

The high prices and talk of speculation has attracted the attention of Congress, which is holding hearings on the matter beginning next month.

Among things lawmakers could do is increase the margin requirements - or require oil traders to put down a greater percentage of a contract's worth in-order to buy or sell it. Currently, traders can buy or sell oil with just 4 percent down, compared to 50 percent for stocks. (With no skin in the game, this will certainly encourage speculation.)

Another option could be to require traders to hold oil contracts for a certain amount of time before they sell them.

But one source familiar with the oil markets said that while the physical number of oil barrels available is limited, there is no limit on the number of contracts that can be written. So just because there's more money chasing oil contracts, that in and of itself doesn't necessarily guarantee higher prices.

He said speculators provide liquidity in the oil markets, and noted that they can lose money just as fast as they make it.

Big Banks Don’t Fail

Since late summer there have been a number of calls on the internet for the larger financial institutions that are really in a fix, due in large part to their own efforts, to be allowed to fail. Here is a clue - Big Banks don’t fail. They have too many advantages for other people with money to stand around and allow a large bank, like Citigroup, to slide underneath the waves. Better to get emotional about college football, but never get emotional about money. Money does not care. Text in bold is my emphasis. From Yahoo:

Citigroup Inc got a call from a prominent investment banker suggesting a merger with Bank of America Corp as it was dealing with billions of dollars in mortgage-related losses and the departure of Chief Executive Charles Prince, the Wall Street Journal reported Wednesday in its online edition.

Citigroup's board dismissed the informal approach as "totally out of hand" and no discussions have taken place, the Journal said, citing a source familiar with the matter.

Bank of America, meanwhile, said it never authorized a formal proposal to Citigroup, according to the Journal.

A person familiar with the matter said Citigroup's board would be unlikely to view a merger with Bank of America favorably, as the past few months have shown the bank is difficult to manage, the Journal said, adding combining it with another giant would exacerbate the problem.

A source told the Journal that Citigroup got a feeler from Bank of America several months ago.
Earlier this week, Citigroup sold up to 4.9 percent of itself for $7.5 billion to the Gulf Arab emirate of Abu Dhabi, giving it fresh capital as it wrestles with the subprime mortgage crisis.


Abu Dhabi will be Citigroup's largest shareholder.

Bad News for the Housing Market Continues

There is not much new concerning declining home sales. It is more like checking in once every 30 minutes to find out your team is still losing. Text in bold is my emphasis. From Market Watch:

Sales of existing homes fell further in October even as more homes came on the market, driving the supply of homes to the highest level in 22 years, the National Association of Realtors reported Wednesday.

Sales dropped 1.2% to a 4.97 million seasonally adjusted annualized pace in October, the real estate advocacy group said. The sales pace is the lowest since 1999, when the group began tracking combined sales of single-family homes and condos.

Sales are down 20.7% in the past year and are down 31% from the peak of 7.21 million two years ago.


The inventory of unsold homes rose by 1.9% to 4.45 million, representing a 10.8 month supply, the highest since 1999.

For single-family homes alone, the inventory of 10.5 months is the highest since July 1985.

The median sales price fell 5.1% in the past year to $207,800. That's the largest year-over-year price decline ever recorded.

Sales fell 4.4% in the West, where sales have plunged 33% in the past year and down 48% from the peak. The seizure of the jumbo mortgage market was a major factor in the sales slump in the West, Yun said.

Sales dropped 1.7% in the Midwest and were unchanged in the South and Northeast.

Sales of single-family homes were flat in October at a 4.37 million pace, matching September for the lowest level since January 1998. The median sales price for single-family homes is down a record 6.3% in the past year to $205,700.

Sales of condos fell 9.1% to a 600,000 annual pace. The median sales price rose 4.9% year-on-year to $223,500.

Tuesday, November 27, 2007

Continued Borrowing of Countrywide Results in a Call for a Review

Continued borrowing by the Countrywide at the Federal Home Loan Bank of Atlanta has caused Senator Charles Schumer to call for a review of the lending to Countrywide. There is an article in yesterday's WSJ related to this issue. Text in bold is my emphasis. From the WSJ:

Sen. Charles Schumer, a New York Democrat, urged regulators to examine potential risks posed by a rapid increase in lending by the Federal Home Loan Bank of Atlanta to Countrywide Financial Corp., the nation's biggest mortgage lender by volume.

In a letter sent yesterday to Ronald Rosenfeld, chairman of the Federal Housing Finance Board, which regulates the 12 regional home-loan banks, Sen. Schumer said he is concerned that mortgages pledged by Countrywide to secure its borrowings "may pose a risk to the safety and soundness of the FHLB system as a whole." He called for a review of the Atlanta bank's policies for evaluating collateral and of the loans pledged by Countrywide to secure its advances.

The home-loan banks were created by Congress in 1932 to prop up failing banks and provide money for housing. They borrow money through global bond issues on the strength of investors' belief that the U.S. government would rescue them in a crisis. The banks have taken on a larger-than-usual role over the past few months in providing funds for mortgages. They have stepped up their secured loans, known as advances, to mortgage lenders to fill a void created in August, when investors' fears of default shut off mortgage lenders' ability to raise money through commercial paper or other short-term borrowings.

As of Sept. 30, Countrywide owed the Atlanta bank $51.1 billion, 77% more than the $28.8 billion it owed three months earlier. Although it is based in Calabasas, Calif., Countrywide deals with the Atlanta home-loan bank because Countrywide owns a savings bank based in Alexandria, Va., part of the Atlanta bank's territory.

"Countrywide is treating the Federal Home Loan Bank system like its personal ATM," Sen. Schumer wrote in a press release.

Daris Meeks, a spokesman for Mr. Rosenfeld of the finance board, declined to comment on the senator's letter. Last week, Mr. Meeks said the finance board carefully monitors lending and collateral policies of the home-loan banks. Christopher McEntee, a spokesman for the Atlanta bank, also declined to comment. Officials of that bank last week said they had remained prudent in their lending.

Sen. Schumer, a member of the Senate Banking Committee, said he was concerned about the quality of the collateral partly because many of the loans held as investments by Countrywide are so-called pay-option adjustable-rate mortgages, or option ARMs. These loans allow borrowers to make minimal payments in the early years, resulting in far-higher ones later.

The Effects of the Housing Crash on Local Municipalities

Often forgotten in all the discussion about the housing crash is what the housing crash is doing to the various cities. Specifically, what is it doing to tax revenue. People may scoff at tax revenues, but it is good there is enought money to pay the firemen in southern California, or for snow removal in the Rocky Mountain West, etc. Text in bold is my emphasis. From CNNMoney:

The mortgage meltdown will take a heavy toll on home prices in 2008 with declines expected to average 7 percent across the nation and lost property value of $1.2 trillion, according to the United States Conference of Mayors.

The mayors, meeting in Detroit this week, are predicting even more substantial plunges in local markets, with California home prices expected to shrink 16 percent.

The organization has representatives from more than 1,100 cities and were meeting to address problems brought on by spikes in foreclosure rates.

"Today the foreclosure crisis has the potential to break the back of our economy, as well as the backs of millions of American families, if we don't do something soon," said USCM President Douglas Palmer, Mayor of Trenton, N.J., in a written statement.

Foreclosures in 2008 will increase by at least 1.4 million, according to the mayors. The home building industry will suffer disproportionately, with new home construction sinking to its lowest level since 1993, the organization predicts.

And, with home equity levels in steep decline, growth in consumer spending will be curtailed - the mayors expect it to increase by just 2 percent.

Municipalities will start to feel the pinch with a decline in the property tax growth rate. Some places could even experience an outright decline in collections. The housing decline will also affect state coffers, as transfer taxes plummet along with home sales volumes.

Florida, according to the mayors, could lose $589 million loss in property tax, $148 million loss in sales tax and $99 million loss in transfer tax.

Gross metropolitan product, the group projects, will contract by $166 billion. The heaviest burden will fall in New York, the nation's largest metro area, where the gross metropolitan product (GMP) will go down by about $10.4 billion, according to the organization.

The Case-Shiller Index is Down Again for September

In terms of housing prices, prices continue to decline with no end in sight. Text in bold is my emphasis. From Market Watch:

U.S. home prices were falling in every region of the country in September, according to a closely watched index of home prices released Tuesday.

"There is no real positive news in today's data," said Robert Shiller, chief economist at MacroMarkets LLC, and the co-developer of the index. Shiller said it's nearly impossible to forecast when the market could turn around.

For the national Case-Shiller home price index, prices fell 1.7% in the third quarter compared with the second quarter, and were down a record 4.5% in the past year. It was the largest quarter-to-quarter price decline in the 20 years covered by the index.

For the first time in this housing cycle, prices in all 20 cities dropped from the previous month, with the biggest declines in the former bubble cities of Miami, Phoenix, San Diego, Las Vegas, Los Angeles and Tampa.

For the 20 cities, prices fell a record 4.9% year-over-year. Meanwhile, prices were down 5.5% year-over-year in the original 10-city index, the largest drop in the 10-city index since 1991.

The last time prices fell so much, it took more than eight years for home prices to return to their peak level.

"We judge the recent decline in home prices to be the beginning of an extended decline," wrote Drew Matus, an economist for Lehman Bros., who said prices would probably fall 15% from peak to trough nationally.

"With supply overhang growing and mortgage financing tougher to obtain, home prices are going to soften considerably further in the quarters ahead," wrote Joshua Shapiro, chief economist for MFR.

Falling prices make it more difficult for homeowners to tap the equity in their homes or refinance their mortgages. Millions of homeowners who took out adjustable-rate loans in 2005 and 2006 face sharply higher mortgage payments this year and next, with foreclosures having already soared as the result of payment resets.

"It is surprising that the weaker housing market so far has had such a limited effect on U.S. household spending," wrote Gabriel Stein, an analyst for Lombard Street Research. "However, if house prices do continue to fall at their recent pace, it would be astonishing indeed if this did not badly hit consumer confidence and hence spending."

Former boom towns in Florida and Southern California have now passed Detroit for the dubious honor of having the largest price declines in the past year. Prices are still up in the Pacific Northwest and in areas of the South, but they're rising at a slower pace.

Optimists are Finding it More Difficult Not to Use the “R” Word

Below is another point of view on the chances of a recession. What bothers me is that 3 months ago many people were saying that the chances of a recession were pretty small. Now the markets and businesses are flashing recession signals. I don’t know what is going to happen and neither does anyone else, but signals are definitely becoming more pessimistic. Text in bold is my emphasis. From the WSJ:

Battered stock and bond markets are sending an increasingly ominous signal that a U.S. recession could be near.

The markets, however, haven't swayed Federal Reserve officials and most private economists from their view that the nation's economy can escape a downturn and get back on a steadier course.

The disparity between those two views of the economy -- one growing bleaker, the other remaining sanguine -- stood out starkly last week. . . . .

. . . . . Who's right? History isn't much help. The stock market is notorious for predicting downturns that never materialized, while economists have failed to acknowledge some recessions until after their arrival. "Economists are extremely bad at predicting turning points, and we don't pretend to be any better," Fed Chairman Ben Bernanke told Congress earlier this month.

This time around, much depends on how tight a rein financial institutions keep on their lending and consumers keep on their spending.

By itself, the housing slump seems unlikely to choke off U.S. economic growth. Home construction accounts for less than 5% of the nation's gross domestic product. But if banks curb their lending in response to billions of dollars of mortgage-related write-offs, or if consumers cut their spending as home values fall and gasoline prices rise, it could knock the economy out of its delicate balance.

"Even if you're a dyed-in-the-wool optimist you have to say it's a more challenging time than normal," says Michael Feroli, an economist at J.P. Morgan, which cut its U.S. economic forecast last week. It now expects GDP to grow at an anemic annual rate of 0.5% this quarter and 1.5% in the first three months of 2008 -- but no recession. . . .

. . . . . The outlook for the global economy depends largely on whether the rest of the world -- particularly Europe and Asia -- can pick up the slack. But Europe's outlook is growing cloudy. Interest rates are rising in the markets European banks use to borrow money. And the banks have grown wary of lending to each other because of anxiety about potential losses on investments tied to the U.S. mortgage market.

If sustained, the jump in interest rates could further crimp economic growth in the euro zone, which already faces headwinds as a strengthening currency makes its exports more expensive. The European Central Bank, while vowing to pump credit into markets to keep market rates from rising, is also warning about inflationary pressures, a concern that could keep it from following the Fed in cutting its target for short-term rates.

Economists, however, take heart from the U.S. economy's proven ability to withstand shocks, financial and otherwise, something Mr. Bernanke noted earlier this month. So far this decade, the economy has faced terrorist attacks and a historic technology-stock bust with nothing but a mild recession. Since then, it has continued to grow despite the war in Iraq, soaring oil prices and the destruction and dislocations wrought by hurricane Katrina. All the while, consumers kept spending and corporate profits soared.

This week, the Commerce Department will be revising its estimate of third-quarter GDP, and it is expected to show the U.S. economy grew at an annual pace of well over 4% between July and September, even as the financial markets went through credit-related spasms. Part of that growth was due to a buildup of inventories at businesses. But job and income growth, which are still in positive territory, have also proved to be important in sustaining consumers.

The stock market, however, has rendered a different verdict on the outlook for spending and lending. According to Thomson Financial, the current consensus on Wall Street is that earnings of companies in the Standard & Poor's 500-stock index will grow 2% in the fourth quarter and 8% in the first quarter, but expectations are falling fast for retailers and others whose fortunes are tied directly to consumer sentiment.

Consumer discretionary stocks, which also include home builders and auto makers, have been among the market's worst performers. Discretionary stocks in the S&P 500 index are off about 13% on the year. A major cause is the deepening woes of home builders. But shares of companies like department-store operator Nordstrom Inc., handbag maker Coach Inc. and luxury jeweler Tiffany & Co. have also slumped in recent months, a possible sign that even higher-end households are beginning to feel the pinch from lower home prices and costlier oil.

The Conference Board's survey of consumer confidence fell in October for the third month in a row, sending the index to a two-year low. A similar monthly survey conducted by Reuters and the University of Michigan reported that consumer sentiment in November fell to a two-year low and, excluding the months after Hurricane Katrina hit in 2005, reached its lowest point since 1992. The survey's sponsors warned that "the risk that a recession develops is uncomfortably large.". . . .


. . . . "I don't think the consumer is going to pull back for a quarter and then rebound again," says portfolio manager Ed Maraccini, of Johnson Asset Management in Racine, Wis. "This is something that is going to be longer term," especially in light of consumers' reduced ability to borrow against the value of their homes to purchase big-ticket items.

. . . . . Other market indicators are worrisome. Instead of stocks and other risky forms of debt, investors have been buying up Treasury bonds lately. Short-term Treasury yields have plummeted, signaling that many investors believe the Fed will have to cut its own interest-rate target again when policy makers meet next month. Such a move would lower borrowing costs throughout the economy and could help to spur growth.

There are signs the housing and credit crises might be starting to affect business confidence. In a survey of manufacturing from the Institute for Supply Management, the activity index dropped last month to 50.9 -- barely staying above the 50 that indicates growth. "It does appear that the impact of the slowdown in the financial, housing and transportation segments has spilled over into manufacturing, with the exception being continued strength in new export orders," noted survey chair Norbert Ore. . . . .

. . . . . Many economists are looking abroad as a growth alternative. Thanks to a weak dollar and strong growth overseas, U.S. exports grew at a 16.2% annual rate in the third quarter, making them an increasingly important contributor to economic growth.

"The world in 2007 and early 2008 is very different from what it was in 2001," says Brian Bethune, U.S. economist at Boston-based research firm Global Insight. "A strong overseas economy including a strong Asia, Latin America and a lot of demand from Middle East is enough to keep the economy from shrinking."

Another Tsunami of ARM Resets is Still to Come

Below is a good summary of the condition of the mortgage market and how we are going to be hit by another tidal wave of problems. It appears that if you add together all the resets it looks like we still have about $500B (that is one-half trillion) in resets in 2008. Ultimately, this is quite a mess. This is going to be something to watch, as a spectator. Text in bold is my emphasis. From the WSJ:

Next year, interest rates are set to rise -- or "reset" -- on $362 billion worth of adjustable-rate subprime mortgages, according to data calculated by B of A.

While many accounts portray resetting rates as the big factor behind the surge in home-loan defaults and foreclosures this year, that isn't quite the case. Many of the subprime mortgages that have driven up the default rate went bad in their first year or so, well before their interest rate had a chance to go higher. Some of these mortgages went to speculators who planned to flip their houses, others to borrowers who had stretched too far to make their payments, and still others had some element of fraud.

Now the real crest of the reset wave is coming, and that promises more pain for borrowers, lenders and Wall Street. Already, many subprime lenders, who focused on people with poor credit, have gone bust. Big banks and investors who made subprime loans or bought securities backed by them are reporting billions of dollars in losses.

The reset peak will likely add to political pressure to help borrowers who can't afford to pay the higher interest rates. The housing slowdown is emerging as an issue in both the presidential and congressional races for 2008, and the Bush administration is pushing lenders to loosen terms and keep people from losing their homes.

Bank of America Securities, a unit of the big Charlotte, N.C., bank, estimates that $85 billion in subprime mortgages are resetting during the current quarter, and the same amount will reset in the first quarter of 2008. That will rise to a peak of $101 billion in the second quarter. The estimates include loans packaged into securities and held in bank portfolios.

Larry Litton Jr., chief executive of Litton Loan Servicing, says resetting of adjustable-rate mortgages, or ARMs, has recently emerged as a bigger driver of defaults. "The initial wave was largely driven by a higher frequency of fraudulent loans...and loose underwriting," says Mr. Litton, whose company services 340,000 loans nationwide. "A much larger percentage of the defaults we're seeing right now are the result of ARM resets."

More than half of the subprime delinquencies and foreclosures this year involved loans that hadn't yet reset, and thus were due to factors such as weak underwriting and falling home prices, according to Rod Dubitsky, an analyst with Credit Suisse.

The majority of subprime ARMs due to reset next year are so-called 2-28 loans, which carry a fixed rate for two years, then adjust annually thereafter. In a speech earlier this month, Federal Reserve Governor Randall Kroszner explained how a typical 2-28 subprime loan issued in early 2007 might work. He said the interest rate on the loan would start at 7%, then jump to 9.5% after two years. For a typical borrower, that would add $350 to the monthly payment.

Besides the $362 billion of subprime ARMs that are scheduled to reset during 2008, $152 billion of other loans with adjustable rates are set to reset, according to Banc of America Securities. The other resetting loans include "jumbo" mortgages of more than $417,000 and Alt-A loans, a category between prime and subprime. The latter category is the riskier, in part because it includes borrowers who provided little or no documentation of their income or assets.

The number of borrowers facing higher payments isn't growing merely because the amount of loans with resets is higher. Another factor is that those with a looming reset now have a tougher time sidestepping it by refinancing or selling their home. "There is a large amount of borrowers who are in products that either no longer exist or that they no longer qualify for," says Banc of America Securities analyst Robert Lacoursiere.

Falling home prices mean that many borrowers have little or no equity in their home, making it tougher for them to get out from under their loans.

Treasury Secretary Henry Paulson and the chairman of the Federal Deposit Insurance Corp., Sheila Bair, have been pressing lenders to modify terms in a sweeping way, rather than going through a time-consuming case-by-case evaluation that could end up pushing many people into foreclosure. Officials at the Federal Reserve and in the Bush administration have estimated that 150,000 mortgages are resetting a month.

Ms. Bair has proposed that mortgage companies freeze the interest rates on some two million mortgages at the rate before the reset to help borrowers avoid trouble. "Keep it at the starter rate," Ms. Bair said at conference last month. "Convert it into a fixed rate. Make it permanent. And get on with it."

Picking up on that theme, California Governor Arnold Schwarzenegger in the past week announced an agreement with four major loan servicers, including Countrywide Financial Corp., the nation's biggest mortgage lender, to freeze the interest rates on certain ARMs that are resetting. The freeze would be temporary, rather than for the life of the loan. The program is aimed at borrowers who are living in their homes and making their mortgage payments on time, but aren't expected to be able to make the higher payments after reset.

The mortgage industry opposes a blanket move to modify loans that are resetting, says Doug Duncan, chief economist of the Mortgage Bankers Association. While modification may make sense in some cases, he says, it may also simply postpone the inevitable or reward borrowers who didn't manage their finances wisely. Mr. Duncan says the industry is working with government officials and consumer groups to develop principles that could be used to determine quickly who qualifies for a modified loan.

The political efforts are aimed at keeping the U.S. economy out of a housing-triggered recession. The Mortgage Bankers Association estimates that 1.35 million homes will enter the foreclosure process this year and another 1.44 million in 2008, up from 705,000 in 2005.

The projected supply of foreclosed homes is equal to about 45% of existing home sales and could add four months to the supply of existing homes, says Dale Westhoff, a senior managing director at Bear Stearns. This is a "fundamental shift" in the housing supply, says Mr. Westhoff, who believes that home prices will drop further as lenders "mark to market" repossessed homes.

Foreclosed homes typically sell at a discount of 20% to 25% compared to the sale of an owner-occupied home, analysts say. Lenders are eager to unload the properties, and the homes tend to be in poorer condition. (I don’t think the buyer is negotiating hard enough.)

Federal Reserve Chairman Ben Bernanke told Congress earlier this month, "A sharp increase in foreclosed properties for sale could...weaken the already struggling housing market and thus, potentially, the broader economy."

The big concern is a vicious cycle in which foreclosures push down home prices, making it more difficult for borrowers to refinance and causing more defaults and foreclosures.