Thursday, January 31, 2008

Do We Have a Minsky Moment?

From time to time it is a good idea to re-visit the Minsky Moment. Simply put the Minsky Moment is the point in a market cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins, leading to a collapse of asset values (from Wikipedia). I found the following in the New Yorker and thought it was an interesting review. In spite of the fact that the author does play the "blame game" from time to time It is always nice to read things from people who can actually write. Text in bold is my emphasis.

Twenty-five years ago, when most economists were extolling the virtues of financial deregulation and innovation, a maverick named Hyman P. Minsky maintained a more negative view of Wall Street; in fact, he noted that bankers, traders, and other financiers periodically played the role of arsonists, setting the entire economy ablaze. Wall Street encouraged businesses and individuals to take on too much risk, he believed, generating ruinous boom-and-bust cycles. The only way to break this pattern was for the government to step in and regulate the moneymen.

Many of Minsky’s colleagues regarded his “financial-instability hypothesis,” which he first developed in the nineteen-sixties, as radical, if not crackpot. Today, with the subprime crisis seemingly on the verge of metamorphosing into a recession, references to it have become commonplace on financial Web sites and in the reports of Wall Street analysts. Minsky’s hypothesis is well worth revisiting. In trying to revive the economy, President Bush and the House have already agreed on the outlines of a “stimulus package,” but the first stage in curing any malady is making a correct diagnosis.

Minsky, who died in 1996, at the age of seventy-seven, earned a Ph.D. from Harvard and taught at Brown, Berkeley, and Washington University. He didn’t have anything against financial institutions—for many years, he served as a director of the Mark Twain Bank, in St. Louis—but he knew more about how they worked than most deskbound economists. There are basically five stages in Minsky’s model of the credit cycle: displacement, boom, euphoria, profit taking, and panic. A displacement occurs when investors get excited about something—an invention, such as the Internet, or a war, or an abrupt change of economic policy. The current cycle began in 2003, with the Fed chief Alan Greenspan’s decision to reduce short-term interest rates to one per cent, and an unexpected influx of foreign money, particularly Chinese money, into U.S. Treasury bonds. With the cost of borrowing—mortgage rates, in particular—at historic lows, a speculative real-estate boom quickly developed that was much bigger, in terms of over-all valuation, than the previous bubble in technology stocks.

As a boom leads to euphoria, Minsky said, banks and other commercial lenders extend credit to ever more dubious borrowers, often creating new financial instruments to do the job. During the nineteen-eighties, junk bonds played that role. More recently, it was the securitization of mortgages, which enabled banks to provide home loans without worrying if they would ever be repaid. (Investors who bought the newfangled securities would be left to deal with any defaults.) Then, at the top of the market (in this case, mid-2006), some smart traders start to cash in their profits.

The onset of panic is usually heralded by a dramatic effect: in July, two Bear Stearns hedge funds that had invested heavily in mortgage securities collapsed. Six months and four interest-rate cuts later, Ben Bernanke and his colleagues at the Fed are struggling to contain the bust. Despite last week’s rebound, the outlook remains grim. According to Dean Baker, the co-director of the Center for Economic and Policy Research, average house prices are falling nationwide at an annual rate of more than ten per cent, something not seen since before the Second World War. This means that American households are getting poorer at a rate of more than two trillion dollars a year.

It’s hard to say exactly how falling house prices will affect the economy, but recent computer simulations carried out by Frederic Mishkin, a governor at the Fed, suggest that, for every dollar the typical American family’s housing wealth drops in a year, that family may cut its spending by up to seven cents. Nationwide, that adds up to roughly a hundred and fifty-five billion dollars, which is bigger than President Bush’s stimulus package. And it doesn’t take into account plunging stock prices, collapsing confidence, and the belated imposition of tighter lending practices—all of which will further restrict economic activity.

In an election year, politicians can’t be expected to acknowledge their powerlessness. Nonetheless, it was disheartening to see the Republicans exploiting the current crisis to try to make the President’s tax cuts permanent, and the Democrats attempting to pin the economic downturn on the White House. For once, Bush is not to blame. His tax cuts were irresponsible and callously regressive, but they didn’t play a significant role in the housing bubble.

If anybody is at fault it is Greenspan, who kept interest rates too low for too long and ignored warnings, some from his own colleagues, about what was happening in the mortgage market. But he wasn’t the only one. Between 2003 and 2007, most Americans didn’t want to hear about the downside of funds that invest in mortgage-backed securities, or of mortgages that allow lenders to make monthly payments so low that their loan balances sometimes increase. They were busy wondering how much their neighbors had made selling their apartment, scouting real-estate Web sites and going to open houses, and calling up Washington Mutual or Countrywide to see if they could get another home-equity loan. That’s the nature of speculative manias: eventually, they draw in almost all of us.

You might think that the best solution is to prevent manias from developing at all, but that requires vigilance. Since the nineteen-eighties, Congress and the executive branch have been conspiring to weaken federal supervision of Wall Street. Perhaps the most fateful step came when, during the Clinton Administration, Greenspan and Robert Rubin, then the Treasury Secretary, championed the abolition of the Glass-Steagall Act of 1933, which was meant to prevent a recurrence of the rampant speculation that preceded the Depression.

The greatest need is for intellectual reappraisal, and a good place to begin is with a statement from a paper co-authored by Minsky that “apt intervention and institutional structures are necessary for market economies to be successful.” Rather than waging old debates about tax cuts versus spending increases, policymakers ought to be discussing how to reform the financial system so that it serves the rest of the economy, instead of feeding off it and destabilizing it.

Among the problems at hand: how to restructure Wall Street remuneration packages that encourage excessive risk-taking; restrict irresponsible lending without shutting out creditworthy borrowers; help victims of predatory practices without bailing out irresponsible lenders; and hold ratings agencies accountable for their assessments. These are complex issues, with few easy solutions, but that’s what makes them interesting. As Minsky believed, “Economies evolve, and so, too, must economic policy.”
The Bond Insurers Bail-Out Fund

Do you remember M-LEC, the bank bail-out fund for SIVs that started late last summer and crashed by Christmas? Well, now they are trying out a new bail-out fund except this time it is for bond insurers that insured many of the derivatives related to the mortgage industry. Guess what? They are running into the same type of problems. Text in bold is my emphasis. From the WSJ:

Regulators are pursuing a plan to shore up troubled bond-insurance companies -- linchpins of modern debt markets. But the Wall Street firms that would put up cash are already wrangling over how much each should have to pony up.

Talks are preliminary, and a deal is far from certain at this point, according to people close to the negotiations. Already some firms are raising questions about the various plans, offering insight into just how hard it will be for regulators to broker a bailout.

Currently, regulators and bankers are bandying around three or so possible solutions. But the main stumbling blocks are these questions: Is a plan even needed? And if so, how will the tab for each bank be calculated?

Last week, New York state insurance regulators met with banks in hopes of structuring a bailout of some of the nation's biggest bond insurers, including Ambac Financial Group Inc. and MBIA Inc. Bond insurers are at the center of the mortgage-debt storm because they have guaranteed billions of dollars of financial instruments now going sour. If the mortgage-market tumult results in downgrading of the bond insurers, a new wave of write-downs on Wall Street are likely.

This also has spillover into the municipal-bond market because the insurers cover many bonds issued by local governments to finance local roads, schools and other projects. If triple-A insurance is harder to get, it could increase the cost of borrowing for those governments.

Senior executives of Wall Street's top firms, including Morgan Stanley, Merrill Lynch, Citigroup and Goldman Sachs Inc., met last week with New York State Insurance Superintendent Eric Dinallo. Since then, the department has hired Wall Street firm Perella Weinberg Partners LP, run by former Morgan Stanley executive Joseph R. Perella, to help put together a rescue plan.

Among the possible solutions being formulated are capital infusions from outside investors or the banks themselves. The Wall Street firms could also arrange to provide a massive line of credit to the bond insurers, giving those firms a cushion of cash.

Another possibility is that the banks could fund a newly created firm that would assume some of the risks or liabilities on bond insurers' books -- an arrangement known as reinsurance. This could free up capital to the insurers but is unattractive to some Wall Street firms wary of taking on unpredictable liability.

The first stumbling block, said one senior Wall Street executive, is that no one has yet put a figure on just how big the big the bailout would need to be. Figures so far range from $3 billion to $15 billion.

There has been discussion between regulators and the Wall Street firms that each bank should contribute the same amount, which has appeal because of its simplicity.

However, it quickly gets complicated, given that the banks themselves have differing levels of risk exposure to the bonds in question and also have differing abilities to provide cash. Calculating how much each should put up on a pro rata basis could be complicated and spark disagreement.

Not everyone thinks it will be tough to find an acceptable formula. "As long as it was fairly objective and accurate, I don't think that would be a problem," says one person familiar with the matter.

Still, one Wall Street executive said a pro rata solution will have to look not only at how much exposure each Wall Street firm has to each bond company, but also at which insurance company the exposure is to, because some firms need more money than others to help protect their triple-A ratings.

Another wrinkle: Any downgrade will affect the business of issuing new municipal bonds. Therefore, some firms involved in talks with Mr. Dinallo's office are arguing that companies with a big muni-bond business should kick in more.

Several executives involved in the talks say federal officials may need to get involved if a deal is to be struck. But so far, neither the Treasury nor the Federal Reserve has taken an active role.

MBIA Takes a Q4 Loss $2.3B

The all important bond insurer MBIA took a $2.3B loss in Q4 resulting from wiritedowns on its credit derivative portfolio. As stated before in a previous posts (post #1 and post #2) it is the bond insurers that could that could be the problem in the credit-debt swap (CDS) market. Text in bold is my emphasis. From the WSJ:

Bond insurer MBIA Inc. reported its second consecutive quarterly net loss as write-downs in its credit derivatives portfolio rose to $3.5 billion.

The Armonk, N.Y., financial guarantor posted a fourth-quarter net loss of $2.3 billion, or $18.61 a share, compared with year-earlier net income of $181 million, or $1.32 a share.

At the same time, the company said it closed on its $500 million stock sale to private equity investor Warburg Pincus, part of a deal announced earlier this month that will have Warburg invest up to $1 billion in the troubled bond insurer. As part of the deal, two Warburg managing directors took seats on MBIA's board of directors, replacing two current directors. . . . .

. . . . . MBIA's fourth quarter derivatives write-down is more than 10 times as large as the $352.4 million write-down it reported in the third quarter, an indication of the rapidly worsening U.S. housing market and its effect on securities backed by loans made to credit-challenged customers.

Of the $3.5 billion charge, MBIA estimated it would realize $200 million of credit impairment or actual claims payments on the portfolio. In addition to the credit impairment on its derivatives portfolio, MBIA also set aside $713.5 million of pretax loss and loss-adjustment expense due to an expected loss of $613.5 million on its guarantees, and a special addition of $100 million to the unallocated loss reserve for MBIA's prime, second-lien mortgage exposure.

Second lien, or home-equity loans, have shown rising losses as home values plunge in some parts of the country.

MBIA, the nation's largest bond insurer, reported a fourth quarter after-tax operating loss of $407.8 million or an operating loss per share of $3.30. Operating earnings or losses don't take into account unrealized mark-to-market losses or investment gains or losses.

The mean per-share loss estimate of analysts polled by Thomson Financial was $2.97 on revenue of $778 million.

"We are disappointed in our operating results for the year, as the performance of our insured prime, second-lien mortgage portfolio and three insured CDO-squared transactions led to unprecedented loss reserving and impairment activity," Mr. Dunton said in the press release.

MBIA's adjusted direct premiums fell 38% to $262.4 million, on a 98% drop in global public finance and big drops in structured finance worldwide.

MBIA also wrote down the value of its carrying interest in reinsurance unit ChannelRe from $85.7 million to zero.

Earlier this month, MBIA received a "surprise" notice that its all-important triple-A credit rating is under review by Moody's Investors Service. MBIA relies on its credit rating to secure business: lowering the interest rate on municipal bonds by insuring them and, in effect, covering them with its superior rating.

MBIA and other bond insurers have put their ratings at risk by straying from their core municipal-bonds business and insuring the exotic mortgage-backed debt instruments that have led to billions of losses throughout the financial services industry. Fitch Ratings recently cut its triple-A ratings on AmbacInc., Security Assurance Capital Ltd., and FGIC Corp., with all moving down two notches to double-A.

Billionaire investor Wilbur Ross, said to be in discussions with Ambac over a potential acquisition, underscored the ratings urgency in a CNBC interview Wednesday, saying that if he carried through with a potential deal to buy a bond insurer, it would have to take place before a downgrade.

Speaking on CNBC, Mr. Ross wouldn't confirm any interest in Ambac, but said a buy must be made before a downgrade. "Once you lose a triple-A rating, it's hard to get it back," he said. Although Ambac was downgraded by Fitch, it still retains the top rating from the two largest raters, S&P and Moody's.

The credit derivatives problems have bled into bond insurers' municipal bond-insurance business, with many government issuers deciding to skip insurance altogether, and insurance penetration in that sector dropping to around 30% in recent months, according to industry reports.

MBIA seems to have beat that trend with a 13% increase in its fourth-quarter U.S. public finance, though public finance outside the U.S came to a virtual halt, with $2.5 million adjusted direct premiums for the quarter.

As bond insurers have been hit by the plummeting value of their subprime portfolios, regulators in New York and Wisconsin have begun working on a bailout plan that would have big U.S. banks establish a $15 billion line of credit for MBIA and Ambac. The growing uncertainty about the amount of eventual claims the insurers will have to pay on their guarantees is an issue that could complicate any bailout plan.

Insurers play a key role in the financial system by guaranteeing some $2.4 trillion in debt.

On Wednesday, an Oppenheimer Holdings analyst issued a report saying credit downgrades at major bond insurers could cause another $40 billion in write-downs at major U.S. financial institutions because insurers may not have the capital to cover losses on the complex debt instruments they insure. Oppenheimer also said it doesn't see an insurer bailout as a viable option.

Wednesday, January 30, 2008

The Reason B of A Bought Countrywide?

I never saw the announced purchase of Countrywide by B of A for $4B in B of A stock as a good deal or a happy event, regardless of what spin the press put on it. I always assumed that the regulators were involved, either directly or indirectly. The article below sheds a little more light on the purchase. Although I have no way of knowing, I still think there is more to this story. Text in bold is my emphasis. From the WSJ:

The fear of potential regulatory crackdowns helped drive Countrywide into the arms of acquirer B of A, people familiar with the situation say.

Though the big home-mortgage lender faced large and unpredictable losses on defaults, the more immediate danger was pressure from regulators, politicians and rating firms, these people say. That realization helped spur Countrywide co-founder and Chief Executive Angelo Mozilo to call Bank of America in December and start talks that led to the Charlotte, N.C., bank's $4 billion deal to acquire Countrywide, which was announced Jan. 11.

Countrywide, due to report fourth-quarter results today, faced "a cascading series of regulatory issues" as it pondered whether to try to stay independent, says one person briefed on the situation. Countrywide had a Q4 loss of $421.9M, announced 1/30/08.

After falling home prices and mounting mortgage defaults rattled investors in mid-2007, Countrywide could no longer raise money through short-term borrowings in the capital markets or sales of mortgages other than those that could be guaranteed by government-sponsored investors Fannie Mae and Freddie Mac. That forced Countrywide to rely much more heavily on two other sources of funding: deposits at its savings-bank unit and borrowings -- so-called advances -- from the Federal Home Loan Banks system. But the sustainability of those funding sources was increasingly in doubt by late last year.

In late November, Sen. Charles Schumer, a New York Democrat, wrote to regulators of the 12 regional Federal Home Loan Banks, cooperatives that lend money to banks and other financial institutions. Mr. Schumer argued that a surge in Countrywide's home-loan bank borrowings to $51.1 billion as of Sept. 30 from $28.8 billion three months earlier might "pose a risk to the safety and soundness of the FHLB system as a whole."

Countrywide already was near a cap on the amount of FHLB borrowings it could obtain under rules that limit those to 50% of assets held by the borrower. Ordinarily, FHLB borrowings equal no more than about 15% to 25% of a bank's assets, a former bank regulator says, and much higher levels would tend to make regulators jittery.

Sen. Schumer says Countrywide now has reduced its FHLB borrowings by about $4 billion (to about $47B). The next quarterly disclosures on those borrowings are due in late March.

A spokesman for Countrywide says the FHLB borrowings declined "primarily because of growth in customer deposits, which reduced our need" for funding from the home-loan banks. "This decline was not driven by any action taken by the FHLB of Atlanta," the spokesman says.

Countrywide's deposits from consumers, attracted by unusually high interest rates of more than 5% on certificates of deposit, grew rapidly in recent months, expanding by $2.3 billion in December alone. Countrywide could attract that money, despite its financial problems and $1.2 billion third-quarter loss, because the deposits are insured by the Federal Deposit Insurance Corp.

But advisers to Countrywide's board -- including representatives of Promontory Financial Group, a Washington consulting firm headed by Eugene Ludwig, a former U.S. bank regulator -- saw the risk that the FDIC would start asking tougher questions about the safety of funding Countrywide's large mortgage holdings through those insured deposits, people familiar with the discussions say. These people viewed the FDIC's chairman, Sheila Bair, as a tough regulator willing to take on the big players.

An FDIC spokesman declined to comment on Countrywide. There is no indication that the FDIC plans any action that would jeopardize its insurance of Countrywide deposits.

Another threat to the deposit base was that further cuts in Countrywide's credit ratings could prevent it from placing funds from custodial accounts at its savings-bank subsidiary, the company has disclosed.

Meanwhile, Countrywide was dealing with investigations of its lending practices by attorney-general offices in California, Illinois and Florida and facing suits from shareholders, borrowers and employees. The Securities and Exchange Commission has been investigating share sales by Mr. Mozilo as well as Countrywide's accounting. Mr. Mozilo has denied wrongdoing.

Greenspan Puts the Chances of a Recession at 50%+ and It Is Basically Unstoppable

Recently, Greenspan has become every one's favorite economist to dislike, but the man still has a lot of experience on these issues. From Yahoo:

The likelihood of the United States slipping into recession is at least 50 percent, former Federal Reserve Chairman Alan Greenspan was quoted as saying on Wednesday, in an interview with a German newspaper.

"I believe the probability of a recession is at least 50 percent, but up to now there are few signs that we are already in one," Greenspan said in an interview with weekly Die Zeit.

Asked whether central bankers and finance policymakers could head off a recession in the world's biggest economy, Greenspan told the paper: "Probably not. Global economic influences are stronger than almost anything that monetary or fiscal policy can counter them with."

Tuesday, January 29, 2008

Foreclosures Are Up 75% in 2007

The beat goes on. From

The number of foreclosures soared in 2007, with 405,000 households losing their home, according to a report released Tuesday.

Total foreclosure filings soared 97% in December alone compared with December of 2006, according to RealtyTrac, an online seller of foreclosure properties. For the year, total filings - which include default notices, auction sale notices and bank repossessions - grew 75%.

More than 1 percent of all U.S. households were in some stage of foreclosure during 2007, up from 0.58 percent the year before.

"There are parts of the country where we're seeing many more bank repossessions," said Rick Sharga, a spokesman for RealtyTrac. "People are flat out losing their homes."

In California alone, nearly 66,000 people lost their homes last year. In Michigan, 47,000 families went through foreclosure. Also hard hit was Nevada, where 10,0000 people had their homes repossessed, a per-capita rate more than twice as high as California.

California had a total of 250,000 foreclosure filings, the highest number of of any state. Florida was second with more than 165,000 total filings.

Other hard-hit states include Michigan, which has been battered by job losses in the auto industry and had over 87,000 filings, Ohio, with more than 89,000 filings, and Colorado, with 39,000.
Nevada had 3.376 filings for every 100 households - a foreclosure rate of more than three times the national average, and the highest of any state.

According to Gail Burks, the CEO of the Nevada Fair Housing Center, a community advocacy group that aids home owners facing foreclosure, some communities in Las Vegas, Nevada's biggest city, have as many as 40 percent of homes in foreclosure.

The rise nationally has confounded some community advocates. "Last December, we thought the national numbers were bad, and now they're up almost 100 percent," said John Taylor, CEO of the National Community Reinvestment Coalition. "It just shows we need a comprehensive approach to solve the problem."

Fed Will Be Forced to Cut the Fed Funds Rate Below the Inflation Rate This Year

The Fed will more than likely cut the Fed Funds rate below the inflation rate this year potentially creating an entire new set of problems that will have to be dealt with later. The new problems would in fact be new asset bubbles. For example, if interest rates are below the inflation rate people will rush out to borrow and plow it into new projects (of a dubious nature) such as alternative energy projects, which will in turn fail. Voila, the next asset bubble. The assumption that is made with this analysis is that the banks will be willing to lend even with low interest rates. My prediction is that the willingness of banks to lend this year will be limited regardless of the rate. The banks cannot take anymore losses right now. Rates are not the issue. That sound you hear in the background is credit being crunched. Text in bold is my emphasis. From Bloomberg:

The Federal Reserve may push interest rates below the pace of inflation this year to avert the first simultaneous decline in U.S. household wealth and income since 1974.

The threat of cascading stock and home values and a weakening labor market will spur the Fed to cut its benchmark rate by half a percentage point tomorrow, traders and economists forecast. That would bring the rate to 3 percent, approaching one measure of price increases monitored by the Fed.

``The Fed is going to have to keep slashing rates, probably below inflation,'' said Robert Shiller, the Yale University economist who co-founded an index of house prices. ``We are starting to see a change in consumer psychology.''

So-called negative real interest rates represent an emergency strategy by Chairman Ben S. Bernanke and are fraught with risks. The central bank would be skewing incentives toward spending, away from saving, typically leading to asset booms and busts that have to be dealt with later.

Negative real rates are ``a substantial danger zone to be in,'' said Marvin Goodfriend, a former senior policy adviser at the Richmond Fed bank. ``The Fed's mistakes have been erring too much on the side of ease, creating circumstances where you had either excessive inflation, or a situation where there is an excessive boom that goes on too long.''

The Federal Open Market Committee begins its two-day meeting today and will announce its decision at about 2:15 p.m. in Washington tomorrow. Officials will also discuss updates to their three-year economic forecasts at the session.

Bernanke, and his colleagues on Jan. 22 lowered the target rate for overnight loans between banks by three-quarters of a percentage point. The cut was the biggest since the Fed began using the rate as its main policy tool in 1990 and followed a slide in stocks from Hong Kong to London that threatened to send U.S. equities down by more than 5 percent.

The central bank will probably lower the rate to at least 2.25 percent in the first half, according to futures prices quoted on the Chicago Board of Trade. The chance of a half-point cut tomorrow is 88 percent, with 12 percent odds on a quarter- point.

Inflation, as measured by the personal consumption expenditures price index minus food and energy, was a 2.5 percent annual rate in the fourth quarter, economists estimate. The Commerce Department releases the figures tomorrow.

The last time the Fed pushed real rates so low was in 2005, in the middle of the three-year housing bubble, when consumers took on $2.9 trillion in new home-loan debt, the biggest increase of any three-year period on record.

Aggressive rate cuts are justified if there's ``conclusive evidence'' that household income prospects are in danger, said Goodfriend, now a professor at the Tepper School of Business at Carnegie Mellon University in Pittsburgh.

They might be. Real disposable income grew at a 2.1 percent annual pace in November, the slowest in 16 months, as higher food and energy costs eroded paychecks. Home prices in 20 U.S. metropolitan areas fell 6.1 percent in October from a year earlier, the most in at least six years. The Standard & Poor's 500 Index is down 15 percent from its record on Oct. 11.

The last time household real estate, stocks and real incomes all declined in a quarter was during the 1974 recession, according to calculations by Macroeconomic Advisers LLC.

``Wealth had been rising because of strong home prices'' and stock gains, said Chris Varvares, president of Macroeconomic Advisers in St. Louis. ``Now, we are losing that prop to consumption, so it all comes down to growth in real income.''

Varvares predicted that housing and investment portfolios will add nothing to consumption this year, while incomes, after inflation, may gradually rise ``so long as oil behaves.'' The firm expects the economy to grow at a 1 percent to 2 percent annual pace in the first half.

``A big part of the 75 basis point surprise was to blunt the worsening of financial conditions'' that may reduce employment and hurt income growth, Varvares said. The firm predicts a half-point cut tomorrow.

``That need not be the end,'' Harvard University economist Martin Feldstein, said in an interview. ``They can keep coming back and revisiting it every six weeks.''

Feldstein, a member of the group that dates U.S. economic cycles, said any recession this year ``could be much more painful because of the fragility of the financial sector.''

The Fed incorporates wealth effects, or the impact of changes in household assets on spending, in its economic model. Americans cut spending by about 5 cents for every $1 of decline in their home values or stock portfolios, economists estimate.

``We are likely to see another wave of problems in the consumer-credit side,'' John Thain, chief executive officer of Merrill Lynch & Co., said at the World Economic Forum in Davos, Switzerland, last week. ``This is going to be exacerbated by the rise in unemployment and we have issues with higher energy prices.''

Monday, January 28, 2008

Mozilo to Give Up His Severance Package Worth $37.5M

With all the talk about the coming recession , Davos, housing, etc. Angelo Mozilo seems to have been forgotten in the shuffle. Well he is back in the news, he gave up his $37.5M severance package. My guess is that he will be back in the news again. Text in bold is my emphasis. From

Countrywide Financial Corp. CEO Angelo Mozilo, under fire over the size of his potential payout from the proposed sale of his troubled mortgage company, says he is forfeiting some $37.5 million in severance pay, fees and perks he was scheduled to receive upon his retirement.

Mozilo, however, will still retain retirement benefits and deferred compensation that he has already earned, Countrywide said in a statement released Monday.

In addition to $36.4 million cash severance payments, Mozilo also walked away from $400,000 per year he was to be paid under an agreement to serve as a consultant to the company following his retirement, and perks including the use of a private airplane, the company said.

"I believe this decision is the right thing to do as Countrywide works toward the successful completion of the merger with Bank of America," Mozilo said in the prepared statement.

Damon Silvers, associate general counsel of the AFL-CIO, which operates a Web site that tracks executive pay, said that by giving up his severance pay Mozilo "seems to recognize that there's something wrong with this picture."

"It would be best if Countrywide and Bank of America froze all of his compensation until a thorough inquiry could be completed as to exactly what happened at Countrywide," Silvers said, referring to allegations raised in some shareholder lawsuits filed last year that the company failed to warn investors about the depth of its financial troubles.

Calabasas-based Countrywide agreed earlier this month be acquired by Bank of America Corp. for $4.1 billion in stock.

The spread between Countrywide's stock price and the value of Bank of America's offer has remained unusually large, a reflection some investors see a significant risk that Bank of America may turn its back on the deal or press for a lower price.

Countrywide shares closed at $6.02 on Friday, 19.5 percent below what each share would be worth in Bank of America stock if the deal was closed based on the bank's $39.48 closing share price Friday.

Bank of America has maintained its intent to acquire Countrywide.

Mozilo is not slated to receive any cash payments tied to the completion of the acquisition, Countrywide noted.

The chief executive has come under criticism since the deal was announced and media reports suggested he stood to receive a multimillion-dollar payout when he leaves the company.

Mozilo had been in line to receive a package, including his retirement pay and stock holdings, of nearly $66 million, according to estimates by The Hay Group, a compensation consulting company. Other estimates have suggested Mozilo's payout could exceed $110 million.

Under his employment agreement, Mozilo was entitled to a severance cash payment equal to three times his annual salary of $1.9 million, and three times his incentive cash bonus for the year preceding a change in the company's ownership or the average of two years' bonuses.

The size of his bonus depends on how well the company performs. His 2007 employment agreement sets a target of $4 million for his annual incentive compensation bonus and a cap of $10 million.

Now, he'll leave with a pension plan and supplemental executive retirement plan that totaled $23.8 million as of December 2006, according to the most recent proxy statement the company filed with the Securities and Exchange Commission.

Mozilo also accrued about $20.6 million in deferred compensation, according to the filing.

The executive has sold shares of the company's stock since last year but still has shares worth around $5.8 million.

Mozilo's decision to give up some of his pay comes amid increasing scrutiny over the size of pay packages for CEOs at some of the nation's largest financial institutions, many of which have sustained heavy losses during the mortgage market's downfall.

He is among several banking industry executives who have been asked to appear next month before the House Oversight and Government Reform Committee for a hearing to examine whether their compensation and severance packages are justified.

Mozilo's stock trades have also drawn negative attention.

He's been criticized for cashing in company stock options by switching his trading plans as the mortgage industry's woes multiplied last year. Some shareholders have called for his removal.

The SEC launched an informal inquiry last fall into his sales of Countrywide stock.

Mozilo has denied making any trading decisions based on material nonpublic information.
Countrywide rose to become the nation's largest mortgage lender but has been struggling since last year amid rising mortgage defaults, particularly subprime loans to borrowers with questionable credit histories.

The company, which posted a $1.2 billion loss in the third quarter ended Sept. 30, is due to report fourth-quarter and 2007 financial results Tuesday.

Sunday, January 27, 2008

This Weekdend’s Contemplation #2 – Economic History is Being Made in Davos

Few people appreciate the meetings in Davos, the site of a lot of very powerful economic and financial people. The results of this meeting may not yet be that far reaching, but the ground work is being laid for substantial changes in the future. The primary one is that the days of allowing the markets to fix all the problems are over. The state or government is going to be taking a much larger role going forward. The US is not well equipped to play this game. From the International Herald Tribune:

Is economic history about to change course? Among the chieftains of politics and industry gathering in Davos for the World Economic Forum on Wednesday, a consensus appears to be building that the capitalist system is in for one of those rare and tempestuous mutations that give rise to a new set of economic policies.

As the prospect of a U.S. recession overshadows a tense and drawn-out election campaign in the world's most emblematic market economy, a corrosive cocktail of factors is eating away at old certainties: Power is steadily leaking from West to East. Income inequalities are rising in rich countries.

And signs of a protectionist backlash are multiplying as worries about climate change, the rise of state-run investment funds and the bursting of the recent credit bubble give novel ammunition to those in the West who question free markets and clamor for more shelter from globalization.

What exactly will emerge when the dust settles is hard to predict, economists and executives say.

But this much seems clear: With the frontier between state and market once again up for grabs, the era of easy globalization is over - and big government in one form or another is back.

"The pendulum between market and state is swinging back," Pascal Lamy, director general of the World Trade Organization, said by telephone before traveling to Davos. "The year 2008 is a crucial year that could end up setting the tone for some time to come. What we need is an ideological mutation without falling into the trap of protectionism."

One such mutation in mainstream economic policy took place after the Depression of 1929, which led to a protectionist interlude and then gave rise to Keynesian demand-side policies and eventually the welfare state. Another took place following the oil price shocks in the 1970s, which refocused policy makers' attention to supply-side measures and strengthened those pushing for privatization and free markets as the best way to stimulate growth.

When students of economics open their history books in 2030, they might read about 2008 as the year when the groundwork was laid for a re-regulation of certain markets, a more redistributive tax system and new forms of international policy coordination, economists say.

"We are seeing the seeds of a new paradigm," said Kenneth Rogoff, a professor at Harvard University and former chief economist of the International Monetary Fund, who will be at Davos this year. "Whoever wins the U.S. election will have to pay more attention to equity. And whatever comes out of the next climate change agreement will be international economic cooperation on a scale never seen before."

According to Stephen Roach, chief economist for Asia at Morgan Stanley, who will also be among the 2,400 participants in Davos to ponder what forum organizers have labeled "The Power of Collaborative Innovation," some basic notions guiding economic thinking in recent decades have been challenged by ever-faster globalization.

In theory, Roach said, wages increase with productivity growth and all economies have a comparative advantage in the production of something. But real wage stagnation in some of the richest economies and increasing fears that China and India combined will eventually be able to make just about everything the West can, only cheaper, were turning that theory on its head, he said.

Weekly earnings for full-time American workers in the second quarter last year were unchanged from their 2000 levels - even though productivity grew by 18 percent in the same period.

Fifty-four percent of Western Europeans and 43 percent of Americans now believe their children will be worse off than they are in economic terms, according to a Gallup International poll in the last quarter of 2007 across 60 countries.

"Economic theory tells us that globalization is a win-win, but it isn't, at least not in the West," Roach said. "The theory was written for another era. We have to ask some hard questions about unfettered capitalism. We need a new script."

The risk is that Western governments, mindful of the growing backlash among voters, will be tempted to rewrite the script by engaging in old and new forms of protectionism.

Roach counted more than 20 anti-China bills in the U.S. Congress last year. In 2006, when the number of such initiatives was already high, it never resulted in action, he said. But with presidential candidates from both parties vowing to take a tough stance on China, there is a greater than 60 percent chance, Roach predicted, that some of the pending bills will become law in coming months with bipartisan majorities big enough to avoid a presidential veto.

And suddenly there are a lot of broadly acceptable concerns that can help disguise protectionist tendencies.

The most prominent one is the environment. Since climate change was catapulted onto the global agenda, European and American officials have looked into ways of making importers - like China and India - pay, since they do not adhere to the same greenhouse emission standards.

Another concern is financial markets. The credit bubble associated with U.S. subprime loans was the latest in a series of asset bubbles, from equities to housing, to burst in recent years and has further shaken confidence in markets.

There has also been an outcry against state-run investment funds from places like China, Kuwait and soon Russia buying stakes in Western companies. The noise has subsided somewhat as American banks, squeezed by the subprime crisis, are in desperate need of capital.

But as these so-called sovereign wealth funds grow, and the shift in savings from West to East and from private to public sector accelerates, complaints are bound to flare anew, said Daniel Yergin, chairman of Cambridge Energy Research Associates in Boston and the author of "Commanding Heights," a history of the world economy.

"This is new, it's big and it's only going to get bigger," Yergin said. "People are really going to struggle with the issue of capital flows. The question is: will there be international norms and rules or is the focus going to be on protection?"

The same question could be asked about the growing number of takeovers of Western companies by a new breed of cash-rich and technology-hungry multinationals from emerging economies. By 2006, the slice of cross-border mergers and acquisitions from emerging economies had reached a record 14 percent. Companies like Mittal Steel of India and Lenovo of China spent $123 billion in more than 1,000 deals, according to the United Nations Conference on Trade and Development. K.V. Kamath, chief executive of ICICI Bank of India, recalled a workshop he attended three years ago in Davos, at which participants unanimously agreed that despite globalization, no non-Western banks would crack the ranks of the world's largest banks by market capitalization anytime soon. Today, 3 Chinese banks are in the top 10. "I didn't see it coming either, but the same thing will happen in other sectors," Kamath said. His bank, the biggest private bank in India, calculates that Chinese and Indian companies on average double in size every three years. "Investment is increasingly flowing from east to west," he said.

So far there has been more talk of protectionism than action, but that could change, said Lamy, the WTO chief. This year might prove crucial for finalizing the Doha trade round, stalemated by sparring over agricultural subsidies in the developed world, and tariffs and market access in developing countries. "It is perhaps the last chance we have," Lamy said.

Part of the battle has to be fought at home, where Western governments are feeling the need to address the growing malaise voters feel toward globalization. More equitable tax systems are one response; Rogoff, the Harvard professor, argues that a flat rate tax in the United States would be less regressive than the current system. Others say an even deeper review might be called for. Nicolas Sarkozy, the French president, this month commissioned two Nobel economists, Amartya Sen and Joseph Stiglitz, to help devise a more holistic indicator of economic progress than growth in gross domestic product, which fails to account for issues like income inequality that have been at the heart of the globalization debate.

"Economics is not just politics," Sen said. "There is more to human progress than aggregate statistics of growth. We have to ask the right questions and concentrate on what matters to people."

These ideas are becoming more mainstream. I hope through French initiative they will become more widely accepted in Europe and beyond."

A year and a half ago, researchers at Yergin's group drew up a number of scenarios for the world economy in 2030. One of them, "Asian Phoenix," saw a world in which protectionism was kept at bay and Asian economies kept underpinning swift global growth. The other, "Global Fissure," was a troubled world economy with widespread economic nationalism and a backlash against globalization.

At the time, the latter scenario seemed to be the more remote. But that may be changing, Yergin said. "What seemed highly unlikely," he said, "could become rather more likely."

Saturday, January 26, 2008

This Weekend's Contemplation #1 - Comparison of the Current Economic Situation to 1929

The article below from Market Watch makes a comparison of the current situation to the one our relatives faced in the not so distant past of 1929. Text in bold is my emphasis.

A number of people I talk too have commented that Ben Bernanke, George Bush, and others appear to be very worried when they have been on the news recently discussing the economy. For good reason, there are too many similarities between the current situation and 1929. The similarities go far beyond the stock market, which I continue to argue is a minor part of this process. There was an economic slowdown starting in 1930, consumer spending slowed, unemployment began to increase as consumer spending slowed, all resulting in the bank insolvencies in 1930 – 1931, ultimately ending in the bank failures of that period. Once that happened the economy slid very quickly into a deflationary period that only WWII was able to end. Now we have bank insolvency (the credit crunch), a slowing economy (threat of a recession), consumer spending is beginning to slow (that is why the Administration wants to put money in everyone’s hands), and unemployment is moving up. So are bank failures next? They are already here, not just nation wide yet. When Citigroup and Merrill Lynch need equity injections and B of A buys Countrywide, these are not growth plays, these are survival moves.

Lately, whenever the market has a bad day, the reflex among financial-news editors is to compare our current situation with 1987 and wonder if a "Black Monday"-style crash is on the horizon.

But some observers draw a darker metaphor, noting that much of what we are seeing now also took place in 1929. As we know, that meltdown -- unlike the 1987 crash -- was not followed by a happy ending, but rather by a decade of poverty, shantytowns and sporadic famine.

Popular imagination has the Great Depression opening with a bang in October 1929. We forget that even by December of that year, the market had no idea what was really in store. After a period of wild, bipolar volatility, stocks had taken two big tumbles (a 12.8% drop on Oct. 28 and an 11.7% fall the next day) while the top bankers and "captains of industry" rushed to shore up the market. By November, the Dow had hit its low for the year at 198, down from the giddy September high of 381.

But, the financial pundits and government leaders of the day insisted, the economy's fundamentals were still strong. Mass unemployment was, some months after the crash, still just something that went on in Germany and Britain. America was strong and merely needed a push to keep the financial markets from harming the broader economy.

With that in mind, Herbert Hoover -- only nine months into his presidency -- assembled leaders from the public and private sectors to create an economic-stimulus package. Among the measures, Time magazine reported at the time, was a promise from Congress to offer bipartisan support for a tax-cut package. The proposal called for $160 million in tax relief -- only about $22 billion if adjusted against the gross domestic product at the time, and therefore much smaller than the plan under consideration here in 2008.
(The article contains a link to an article in Time Magazine dated December 1929, just to get some historical perspective.)

Also on the table was an assurance from the Federal Reserve that it would provide cheaper credit. Granted, the Fed had much less power over the money supply in those days, mainly because the amount of liquidity it could create was limited by the supply of gold it held to back the dollar.

Of course, there were a litany of public-works projects, plans for new corporate investments, and even a promise by Henry Ford to raise wages at his auto plants.

None of this worked. What was first seen as speed bump to the expansion of American finance became something much larger. The Dow continued falling, hitting 157 in 1930, 73 in 1931 and finally a mere 41 points in 1932. It did not reach its 1929 high again until 1954, a generation later.

Certainly, our economy now has far more differences than similarities with the economy of 1929, and few expect a new depression for the decade ahead. But it's also worth remembering that the best laid plans of presidents, chief executives and senators can sometimes come to nothing.

Friday, January 25, 2008

The Worst Case Scenarios from Three Economists

No one knows what the future holds and if they tell you that they do they are lying. With that said how does one plan for the future in these times. The issue in all risk analysis is that you “hope for the best and plan for worst”, something that was not done at a number of large financial institutions. Hence the reason that I commonly talk about worst case scenarios. It isn’t that I am a pessimist, but I do plan for the worst case. Below are three worst case scenarios from three industry economists. Text in bold is my emphasis. From

. . . . . Most economists who believe a recession is already here or at least near are looking for a relatively short and mild downturn, perhaps lasting only two or three quarters.

But many of those same economists say they also can envision a worst-case scenario where spending by consumers and businesses falls off sharply, unemployment heads higher than normal during a typical recession and housing and credit market problems worsen.

"I can easily imagine [the economy] going into a free fall," said Dean Baker, the chief economist for the Center for Economic and Policy Research. "The danger is that housing prices continue to tumble and accelerate, people's ability to pull out equity will evaporate, and you'll see a serious downturn in consumption."

We talked to three more leading economists to find out their biggest economic fears. Here's what they had to say.

Greenback blues David Wyss, chief economist with Standard & Poor's, said that among his biggest concerns is that overseas investors could pull back on investing in the dollar and other U.S. assets.

That could cause an even greater sense of fear among U.S. consumers and businesses, as stock prices fall and bond yields rise, which in turn would lift mortgage rates and be a bigger drag on the already battered housing market.

"Americans could just get scared by a barrage of bad news," Wyss said. "The stock market could continue going down because of foreigners pulling money out, and between that and home values going through the floor, it could lead to a real pullback of spending, particularly by Baby Boomers who are getting close to retirement."

Wyss said he's also concerned that oil prices could shoot higher, even if a recession cuts into global demand. He said supply disruptions in the Middle East could send oil prices up to $150 a barrel and help deepen any recession.

Wyss said that in his worst case scenario, the unemployment rate would climb to 7.5 percent by early 2009, up from its current level of 5 percent.

He also believes gross domestic product, the broad measure of the nation's economic activity, could wind up as much as 2 percent lower at the end of 2008 than it was at the end of 2007. That would be the biggest downturn since 1982. Many of those forecasting a recession this year are expecting GDP to show a slight gain by the end of the year.

House of pain. Edward McKelvey, senior economist at Goldman Sachs, agreed with Wyss that, in a worst case scenario, GDP could fall 2 percent this year.

His biggest fear is that home prices could fall much further in the coming months. In fact, Goldman and economists at Merrill Lynch have both predicted that home values could fall another 15 percent, on top of the 10 percent drop from earlier peaks that has already taken place.

McKelvey said further declines could cause much deeper problems for consumers and credit markets.

"One of the most likely candidates would be credit markets acting more violently than we thought, a tightening of the supply of credit to businesses and households," he said when asked what could bring about his worst case outlook.

"You could also see a more substantial response by businesses to the downturn through layoffs, cuts in their spending and business plans," he added.

Bank woes just beginning. Paul Kasriel, chief economist at Northern Trust, said he thinks there's a good chance that the economic pullback will be much steeper than now widely assumed. This weak forecast is based on his belief that the billions in dollars of writedowns already reported by Merrill Lynch, Citigroup, JP Morgan Chase, Bank of America, and other big banks are just the beginning of the problem in the financial sector.

Kasriel said that if banks have to report more losses due to bad bets on subprime mortgages, they will be unwilling, or unable, to make large loans to businesses and consumers.

So even if the Fed keeps cutting interest rates, the impact of the cuts may be "less potent" than rate cuts in previous recessions since consumers and businesses may not be able to borrow enough to keep spending. That could make this recession more like the one in 1991-92 than the relatively short and mild recession of 2001.

"Historically, and not surprisingly, recessions accompanied by declines in consumer spending tend to be more severe. And people are going to be constrained from spending by the declines in housing," Kasriel said.

He added that state and local governments might have to cut back spending as a result of declining tax revenue. And that would be another sizable blow to the overall economy.

"People forget about state and local government spending, but it represents 11 percent of GDP," Kasriel said.

George Soros on the Inevitable Contraction of the US and European Economies

The following interview with George Soros gives his views on how we got to where we are and how a recession or contraction is inevitable. Text in bold is my emphasis. From the Financial Times:

The current financial crisis was precipitated by a bubble in the US housing market. In some ways it resembles other crises that have occurred since the end of the second world war at intervals ranging from four to 10 years.

However, there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.

Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available. A bubble starts when people buy houses in the expectation that they can refinance their mortgages at a profit. The recent US housing boom is a case in point. The 60-year super-boom is a more complicated case.

Every time the credit expansion ran into trouble the financial authorities intervened, injecting liquidity and finding other ways to stimulate the economy. That created a system of asymmetric incentives also known as moral hazard, which encouraged ever greater credit expansion. The system was so successful that people came to believe in what former US president Ronald Reagan called the magic of the marketplace and I call market fundamentalism.

Fundamentalists believe that markets tend towards equilibrium and the common interest is best served by allowing participants to pursue their self-interest. It is an obvious misconception, because it was the intervention of the authorities that prevented financial markets from breaking down, not the markets themselves. Nevertheless, market fundamentalism emerged as the dominant ideology in the 1980s, when financial markets started to become globalised and the US started to run a current account deficit.

Globalisation allowed the US to suck up the savings of the rest of the world and consume more than it produced. The US current account deficit reached 6.2 per cent of gross national product in 2006. The financial markets encouraged consumers to borrow by introducing ever more sophisticated instruments and more generous terms. The authorities aided and abetted the process by intervening whenever the global financial system was at risk. Since 1980, regulations have been progressively relaxed until they have practically disappeared.

The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility.

Everything that could go wrong did. What started with subprime mortgages spread to all collateralised debt obligations, endangered municipal and mortgage insurance and reinsurance companies and threatened to unravel the multi-trillion-dollar credit default swap market. Investment banks’ commitments to leveraged buyouts became liabilities. Market-neutral hedge funds turned out not to be market-neutral and had to be unwound. The asset-backed commercial paper market came to a standstill and the special investment vehicles set up by banks to get mortgages off their balance sheets could no longer get outside financing. The final blow came when interbank lending, which is at the heart of the financial system, was disrupted because banks had to husband their resources and could not trust their counterparties. The central banks had to inject an unprecedented amount of money and extend credit on an unprecedented range of securities to a broader range of institutions than ever before. That made the crisis more severe than any since the second world war.

Credit expansion must now be followed by a period of contraction, because some of the new credit instruments and practices are unsound and unsustainable. The ability of the financial authorities to stimulate the economy is constrained by the unwillingness of the rest of the world to accumulate additional dollar reserves. Until recently, investors were hoping that the US Federal Reserve would do whatever it takes to avoid a recession, because that is what it did on previous occasions. Now they will have to realise that the Fed may no longer be in a position to do so. With oil, food and other commodities firm, and the renminbi appreciating somewhat faster, the Fed also has to worry about inflation. If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end.

Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.

The danger is that the resulting political tensions, including US protectionism, may disrupt the global economy and plunge the world into recession or worse. (This is one of the things that happened during the Great Depression.)

Thursday, January 24, 2008

New York is Trying to Aid Ambac and MBIA by Arranging a Bail-Out

This dovetails nicely with the post below about CDS contracts. However, we have seen attempted bail-outs before with the M-LEC or the SIV bail-out plan started by Citigroup, J P Morgan, and B of A. After four months of wrangling the project was dropped in December. We will see how this one succeeds. However, if the insurance companies for CDS contracts cannot step up when required this could be the torpedo that sinks the financial system. Text in bold is my emphasis. From Bloomberg:

New York's insurance regulator said a plan to have U.S. banks aid bond insurers will ``take some time to finalize.''

``Clearly it is important to resolve issues related to the bond insurers as soon as possible,'' Insurance Superintendent Eric Dinallo said in an e-mailed statement. ``However, it must be understood that these are complicated issues involving a number of parties.'' MBIA Inc. and Ambac Financial Group Inc., the industry's two largest firms, are both based in the state.

Dinallo, who met with industry executives yesterday, is trying to bolster the bond insurers with help from banks and securities firms. A failure of an insurer might trigger downgrades among $2.4 trillion of debt they guarantee, spawning a new round of losses and writedowns on top of the $133 billion already posted by the world's biggest financial firms.

``We believe it is important that the goals of market stability, protection for policyholders and a healthy and competitive bond insurance market be realized in the near future,'' Dinallo said in the statement.

Any rescue plan may be fraught with the same difficulties that befell Treasury Secretary Henry Paulson's attempt last year to lead a combined bailout of structured investment vehicles, analysts said. The effort was ultimately dropped after banks failed to reach agreement.

A plan that limits participants to U.S. financial institutions may fail, said David Havens, an analyst at UBS AG in Stamford, Connecticut.

``Although it may be something they're trying with the best of intentions, trying to get everybody globally to agree on something would be like herding cats,'' Havens said.

If Dinallo succeeds, the insurers may get fresh capital of as much as $15 billion, the Financial Times said on its Web site yesterday. The figure may be smaller, a person familiar with the talks told Bloomberg yesterday.

What is a Credit-Default Swap (CDS) - The Torpedo That Could Sink the Ship!

First, a formal definition of a credit-default swap (CDS) from a CDS is a specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange of regular periodic payments (essentially an insurance premium). If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal.

The value of the definition above is it includes all the buzz words used when talking about a CDS.

A CDS in plain English is an insurance policy. Let us say that you lend somebody money to purchase a house (a mortgage). You want to sell that debt to someone else, but they want you to assume the risk on the debt if the borrower defaults on the morrtgage. Using the definition above that makes you the lender and the person that borrows the money is the third party. If you have to assume the risk that if borrower defaults on the debt you are assuming the third party credit risk. So what you do is you go to an insurance company and you purchase a credit-default swap (CDS). This does two things: 1) it makes the person that purchases the debt from you feel better because they do not have to worry about the credit risk and 2) you don’t have to worry about the credit risk because you have insurance for it. You have in essence transferred the credit risk to the insurance company (the counterparty). The drawing below from the WSJ is a good description of a CDS.

Sounds pretty good so far, right? So what is the big deal?

The big deal is that CDSs are a barely regulated market in which banks, hedge funds, and just about anyone else including speculators can buy these financial contracts. It is estimated that the current number of contracts is about $45T (T as in trillion), which is roughly equivalent to all the bank deposits in the world.

The CDS market is perfectly legitimate and has been used for years to guarantee municipal bonds. For example, if a small town with basically no bond rating needed a sewage plant they could issue municipal bonds, guarantied with a CDS from an insurance company with a AAA rating and all of a sudden the small town with no rating is borrowing at the rates reserved for AAA credit risk companies. However, since 2000 CDS contracts have been increasingly used to guarantee the assortment of complex debt obligations coming from the banks and hedge funds. The chart below from the WSJ shows the growth in CDS obligations in the last seven years.

There are not that many insurance companies providing CDS contracts. The larger ones are Ambac and MBIA with a smaller one being ACA.

The problem that is arising is since last summer the declining mortgage CDO market is putting pressure on the insurance companies because they may have to pay on some of their CDS contracts. This is requiring Ambac, MBIA, and ACA to bolster their capital reserves in some way. If the capital reserves cannot be increased the rating agencies are threatening to decrease their credit ratings. As a matter of fact, Fitch decreased the credit rating on Ambac from AAA to AA last Friday. One can tell that these three companies are having troubles by looking at their stock prices. Ambac and MBIA have both gone from about $60 per share six months ago to prices in the lower to middle teens. ACA has fallen in the last six months from $15 per share to a price below $1 today.

However, this is not the real problem. The real problem lies within the commercial banks, investment banks, and hedge funds. If a bank is holding a bond supported with a CDS contract and the seller (Ambac, MBIA, or ACA) of the CDS has its credit rating decreased the bank must take additional losses to accommodate the lower credit rating. In other words if a bank has a CDS contract with an insurer that formerly had a AAA rating but now has a AA rating the bank is exposed to additional risk due to the lower rating so it must take additional writedowns in the affected portfolios. This can turn into very sizeable sums. For example, Merrill Lynch has been forced to writedown $3.1B in securities and Citigroup has been forced to writedown $935M in additional losses in anticipation of the insurance companies not being able to perform under the CDS contracts. So there are a number of financial institutions that could suffer very dire consequences if the CDS markets collapses. As a matter of fact I recently received an investment letter from a friend of mine with the following comment:

I want to impress upon my clients and readers that this is a very serious financial situation. Everyone who reads this needs to be familiar with the term credit default swap (CDS). It will soon be in the news and a major topic of conversation. This $45 trillion market has the potential to collapse our financial system. If our financial system collapses then 750 (the S&P 500 index) will not be the bottom of this bear market.

A good description of how the CDS contracts are involved in the complex world of debt and derivatives can be found in the WSJ and the NY Times.

Wednesday, January 23, 2008

The Fed Cannot Save Us!

I said this last week and I will say it again. The current economic problems have gone by the Fed, these problems are passed our first line of defense, they are “inside the wire” (to use an expression from my generation), or whatever other expression you may want to use. The Fed only controls the money supply and they have limited ammunition. With the recent rate cuts, now we are down to 3.75% on the Fed Funds rate. The Fed is almost out of ammunition. They know that. That is why Dr. Bernanke was in the Congress last week giving his stamp of approval to the “stimulus” package. The stimulus package is our last line of defense. What worries me is that there are still problems out there to be faced such as credit debt swaps, more charge-offs in housing as the markets continue to deteriorate, possible corporate debt losses, losses on credit card and auto portfolios, etc. Text in bold is my emphasis. From

Forget all those rational explanations about why foreign stocks markets, especially in Asia, have been melting down for two days. Despite what you've read, seen and heard, those declines weren't caused by fears of what a recession in the U.S. would do to the profits of companies whose stocks trade in places like India, China and Russia.

Rather, the meltdowns were flat-out market panics, where rationality gets tossed out the window as everyone tries to head for the door at once and gets trampled. Go-go markets, especially in Asia, had risen to ridiculous heights - they were going up because they were going up, and momentum fed on itself. Now, they're going down because they're going down, and momentum is feeding on itself again.

The fact that the Federal Reserve Board announced an emergency cut of 0.75 percent in short-term rates shows that the Fed thinks the problem is a market panic rather than economic fundamentals. Normally, the Fed would have waited until mid-day next Tuesday - the second day of its scheduled two-day meeting - to announce a rate cut. Announcing an out-of-schedule cut today before the stock market opened shows that its motivation is to calm the markets rather than to reinvigorate the U.S. economy.

Here's why. First, it won't be clear until the summer whether a recession is in fact underway in the U.S. Even though the nation's economy seems likely to have shrunk in December, there's no such thing as a one-month recession. "A recession is a significant decline in economic activity spread across the economy, lasting more than a few months," (my italics) according to the definitive authorities on such things, the business cycle dating committee of the National Bureau of Economic Research.

Second, even if you believe that the Fed's cut in short-term rates will stimulate the economy, that won't happen overnight. If you took a Fed economist out for a few drinks and promised not to quote him, he'd tell you that the benefits of a cut take at least six months to percolate through the economy. There have been market panics and freeze-ups all over the world since last summer, when the junk mortgage meltdown in the U.S. started gathering speed. These have been confined mostly to the debt markets, which - unlike the Dow Industrials - don't resonate with most people and can't be summed up neatly in one familiar number, as the Dow is.

But now there's a panic in the stock markets, where it's visible for all to see. Last year, 41 of the 100 best-performing stocks were from India, according to Russell Indexes. The Shanghai stock market almost doubled.

This makes no sense unless you consider the Indian and Shanghai markets to have been undiscovered before 2007 - which they weren't. Had the Fed not done anything today, the Dow could easily have fallen 600 or 800 points. Instead, it closed down less than 130.

The problem is that the Fed has only a limited amount of rate-cut ammunition, and expended a lot of it today. It's expected by the markets to cut rates again next week, and will have used up most of its bullets.

I don't want to get into the what-should-the-Fed do game - I'm a recovering English major, the Fed is full of brilliant people with doctoral degrees and access to information that I don't have - but I'm growing increasingly uneasy watching short-term rates in the U.S. fall when we're so dependent on foreign money to cover our trade deficit and the U.S. budget deficit.

I'm also less than thrilled watching commodities prices rise, although oil has been drifting down lately. There are already worrying signs that foreigners, who keep score in their home currencies, have grown tired of losing money because the value of the dollar's dropping. Should the dollar's decline turn into a rout, a distinct possibility, things are going to get really messy.

Look. We can't depend on the Fed - or any individual institution - to save us. The Fed isn't all-powerful - and wasn't all-powerful under Alan Greenspan, either. Current Fed Chairman Ben Bernanke doesn't have a magic wand he can wave to make everything all right on both Wall Street and Main Street. He's doing the best he can, but the Fed's influence isn't what it was when financial markets were much smaller than they are now, and far more regulated.

Because of its budget and trade deficits, the U.S. has to worry about what the rest of the world thinks. That's what happens when you're a debtor nation. There are huge risks in cutting short rates, and risks, too, in having Uncle Sam borrow another $150 billion to $200 billion (primarily from foreigners) to finance a short-term stimulus package.

The bottom line: In the long-term, markets are generally rational. In the short term they are...well, markets. They're prone to irrational run-ups and irrational declines. Don't expect them to act the way you want them to. And don't expect the Fed to save you if they don't.

The Next Recession When it Comes, Could be a Severe One

Recession talk is all over the financial press and internet these days and the most common rebuttal to the recession argument is what I believe are the six most dangerous words in the English language, “but it is different this time”. A few weeks ago a couple of professors, one from the University of Maryland and the other from Harvard, presented a paper at the American Economic Association that seems to debunk the idea that things are different this time. The article, which is very readable at only 11 pages with just words, graphs, and no calculus, basically examines past banking and currency crises starting in about 1800 and compares them to one another looking for similarities. Using basic variables that are common to many financial crises before the onset of the crisis it then compares these variables to the current US economy. At this point the variables are more relational then causal (their research is not totally complete), but make no mistake the US has all the symptoms of previous banking and currency crises.

The value of this type of research is that it sifts through the data and allows the data to “talk” about the similarities between certain economic variables and financial crises. This is opposed to what is commonly seen in the financial press or from politicians where they pick and choose which data they want to use to support their position. The latter form of analysis is really anecdotes masquerading as statistics.

A summary of the article follows. Portions in italics come from the article. Text in bold is my emphasis.

The first thing covered is of course the data collected and the specific crises used to compare to the US.

Rationalizations for the current situation in the US and why a recession will not occur:

This time, many analysts argued, the huge run-up in U.S. housing prices was not at all a bubble, but rather justified by financial innovation (including to sub-prime mortgages), as well as by the steady inflow of capital from Asia and petroleum exporters.

The huge run-up in equity prices was similarly argued to be sustainable thanks to a surge in U.S. productivity growth a fall in risk that accompanied the “Great Moderation” in macroeconomic volatility.

As for the extraordinary string of outsized U.S. current account deficits, which at their peak accounted for more than two thirds of all the world’s current account surpluses, many analysts argued that these, too, could be justified by new elements of the global economy.

Thanks to a combination of a flexible economy and the innovation of the tech boom, the United States could be expected to enjoy superior productivity growth for decades, while superior American know-how meant higher returns on physical and financial investment than foreigners could expect in the United States.

Reality of what happened in the US:

Starting in the summer of 2007, the United States experienced a striking contraction in wealth, increase in risk spreads, and deterioration in credit market functioning.

The 2007 United States sub-prime crisis, of course, has it roots in falling U.S. housing prices, which have in turn led to higher default levels particularly among less credit-worthy borrowers.

The impact of these defaults on the financial sector has been greatly magnified due to the complex bundling of obligations that was thought to spread risk efficiently. Unfortunately, that innovation also made the resulting instruments extremely nontransparent and illiquid in the face of falling house prices.

The comparison of the US with 18 previous banking and currency crises follows by examining the real housing prices, real equity prices, the percent of current account balance to GDP, real GDP per capita, and public debt as a share of GDP. In all cases the correlation between these variables in previous crises and the current US economy is quite high. The article contains excellent graphs for each of these five variables so the correlation between previous crises and the US can be easily seen.

From the authors:

The correlations in these graphs are not necessarily causal, but in combination nevertheless suggest that if the United States does not experience a significant and protracted growth slowdown, it should either be considered very lucky or even more "special” that most optimistic theories suggest. Indeed, given the severity of most crisis indicators in the run-up to its 2007 financial crisis, the United States should consider itself quite fortunate if its downturn ends up being a relatively short and mild one.

The article is very interesting because it shows the similarities between the US economy as it currently stands and economies of other countries and times (all post WWII) that suffered financial crises. This gives us the opportunity to judge for ourselves the veracity of the arguments used to rebut the projections of a recession.

Tuesday, January 22, 2008

The Fed Seems Very Worried

The Fed cut interest rates this morning before the market opened by 75 bps. Seems to me like the Fed is very worried. Text in bold is my emphasis. From Yahoo News:

The U.S. Federal Reserve on Tuesday slashed U.S. interest rates by a hefty three-quarters of a percentage point, the biggest rate cut in more than 23 years, in an emergency bid to lend support to a U.S. economy some fear is on the verge of recession.

The action by the rate-setting Federal Open Market Committee took the key federal funds rate, which governs overnight lending between banks, down to 3.5 percent, its lowest level since September 2005. The Fed also lowered the discount rate it charges on direct loans to banks to 4 percent.

"It is obviously a surprise but it seems the markets could not wait for the promised rate cut at the end of the month and neither could the Fed given the behavior of the markets over the last few days," said Kevin Logan, economist at Dresdner Kleinwort Wasserstein in New York.

It was the largest single shift in interest rates since November 1994, when the Fed raised rates by three-quarters of a point, and it was the first rate cut in between regularly scheduled policy meetings since September 17, 2001, the first day U.S. financial markets reopened after the September 11 terror attacks.

The last time there was a rate cut of at least three-quarters of a point was in October 1984. . . .

. . . . Fed policy-makers are scheduled to meet on January 29-30 and, in the wake of the central bank's bold rate cut on Tuesday, financial markets were expecting the Fed to again lower borrowing costs by at least a quarter of a point.

The Alphabet Soup of Bank Regulation

My parents always told me that the stock market crash of 1929 was the cause of the Great Depression. With a different perspective I have come to realize that the Stock Market Crash of 1929 was a symptom of an economic system in trouble and was not the cause of the Great Depression. The real cause of the Great Depression was the failure of the banking system in 1930 – 1931. The banking system is where the vast majority of citizens interfaces with the monetary system. If the banking system fails then citizens do not have access to money either theirs or someone else’s (that is called borrowing). It is that simple. With that in mind and given that the banking system in the US is in considerable turmoil, I thought it would be interesting to review the regulation of the banking system in the US. As a former banker I am quite familiar with the regulatory environment, but for those that do not work in the industry I think it seems confusing.

Commercial banks in the US are some of the most heavily regulated businesses in the US. For those that are not involved in the day-to-day workings of a bank it is often confusing as to how banks are regulated and who does what. In addition the press often talks about one regulatory agency as if they have all the power, while neglecting all the others as unimportant. Nothing could be further from the truth. For example, one always hears about the Federal Reserve Board (the Fed) in the press concerning banks, when in reality it is the Office of the Comptroller of the Currency (OCC) that exerts more power over the operations of the banks.

After going through the various agencies one will soon realize that the Great Depression was a watershed period for bank regulation. Up until that time only two regulatory agencies existed that still exist today, the Fed and the OCC, and they excerpted limited power over the banking system. The banking system as we know it basically came into existence during the Great Depression. This resulted from the realization that the banking system is the primary financial intermediary in which the citizens come in contact with the monetary system. Having a strong banking system is key to having a strong functioning economy.

A bank's primary federal regulators are the Federal Deposit Insurance Corporation (FDIC) the Federal Reserve Board (FRB), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS).

Which agencies regulate a bank is a function of the type of charter the bank has and its organizational structure. There are two types of charters: national and state. In simple terms there are two types of organizational structure: banks and savings and loans (the latter includes S& Ls and savings banks). National banks are regulated by the OCC and state chartered banks are regulated by the state regulatory agency. National S&Ls or savings banks (and some state chartered S& Ls) are regulated by the OTS.

Let us go through the various agencies to get a better idea what they do.

OCC – formed in 1863 to charter, regulate, and supervise all national banks. It also manages the federal agencies and branches of foreign banks in the US. The primary duties of the OCC is to ensure the safety and soundness of the national banking system, allows banks to offer new products, and ensures fair and equal access to financial services. The OCC monitors credit, asset quality, earnings, liquidity, computer systems, market risk, and community reinvestment of all banks under its supervision. Anyone working in banking understands that the OCC exerts more control over the day-to-day operations of a bank then any other group, but most people don’t even know they exist.

FDIC – formed in 1933 provides insurance for depositors against the inability of a bank to return a customers deposits. The insurance premiums that the FDIC charges is a function of the amount of deposits being insured and the risk of the institution purchasing the insurance. The FDIC insures the deposits of both banks and the S&Ls.

FRB – formed in 1913, is the central bank for the US. Its primary responsibilities are to control the money supply, set the rate charged for loans at the discount window, set the rate for federal funds (fed funds rate), and to regulate and monitor the reserves that a bank must hold against withdrawals (fractional reserve system).

OTS – formed in 1989 in response to the S&L crisis is the equivalent of the OCC for S&Ls.

There are a couple of laws worth mentioning that have strongly affected the banking industry over time.

The Glass-Steagall Act of 1933 not only formed the FDIC, it separated commercial and investment banks, and restricted the types of companies that a bank could own, namely securities and insurance companies. The Gramm-Leach-Bliley Act of 1999 repealed some of the provisions of the Glass-Steagall Act, specifically the prohibition of banks or their holding companies to own insurance and securities companies.

The Bank Holding Company Act of 1956 governs the type of financial and non-bank companies that a holding company may own if that holding company also owns a bank. Most banks are in fact held by a holding company. The holding company for larger businesses holds the banks, securities, and insurance companies as separate entities under the holding company. The regulation of the bank holding company falls under the responsibility of the FRB. Therefore, it is possible for the FRB to regulate the holding company and the OCC to regulate the bank held by the holding company.

The holding company distinction is important because oftentimes there may be a portion of a holding company that is not performing well. For example, say an insurance company has high losses, but the bank of the holding company may be performing very well. The holding company makes certain that a non-bank business does not torpedo a well performing bank due to bad performance of the insurance company. As the saga of a number of poorly performing holding companies continues (i.e. Citigroup) the corporate segregation under the holding company will become an important factor in their survival.