naked capitalism

When Apple announced the general outlines of the iPhone service, one of the things that the techies pounced on was that the data would run on AT&T’s EDGE technology, which is slow by modern standards.

Turns out that may be the lesser part of the network worries. Because the new iPhones are sold without a plan (you get the hardware and activate it yourself via ITunes), the actual process of buying one is like buying any other consumer product, meaning you pay your money and you are gone (versus the usual, tedious, form-filling-out that goes one with buying a new cell phone). Thus iPhones got into the hands of people in queues pretty fast.

And AT&Ts activation system is swamped. Users are getting error messages like this:

It’s even worse if you tried to port your phone number over. Some customers have wound up having their old service deactivated while the transition is in process.

Moreover, this inability to activate the phone means all users have is a beautiful slab that toggles between two screens, You can’t even use the iPod or camera functions until the phone is activated.

This is not only hugely frustrating to customers, but it’s a complete shame, because from what little I can tell, the launch was a success on all other dimensions. The lines in Manhattan were large, and the object lust is palpable. I heard about the activation mess from a buddy who was so excited about the phone he had to bring it over to show it to me Friday evening, and even in its almost totally useless state, it’s quite a thing to behold. The screens are simply remarkable, and the touch screen works perfectly (and for me, with lousy manual dexterity, it works better than mechanical buttons).

If AT&T can get this fixed by early next week, this problem will probably be in the same category as the iPod Nano problems (remember some of the ones in the first release cracked, but Apple replaced them quickly), meaning an embarrassment that doesn’t do permanent damage to the product’s image (let’s face it, most consumers of technology are smart or skeptical enough not to buy the 1.0 version). But if this continues unresolved, it could tarnish the product. It also demonstrates why Apple historically has seldom partnered. Partners introduce greater chance of screw-ups.

Some sort of concession from AT&T to users who had trouble would be a smart gesture, but I wouldn’t count on AT&T being smart about this.

For more information, see:

iPhone Activation Problems Plaguing Countless New iPhone Owners

iPhone Activation Problems Plaguing Countless New iPhone Owners

iPhone Activation Disasters

Update (9:30 PM EDT): AT&T is doing a terrible job in its stores as well as on its network. One comment below suggests the problem is that AT&T is paying its employees commissions to activate the phones in the stores, which holds up all buyers, and making no effort to manage the queue.

The whole motivation for AT&T to offer the iPhone was to attract new customers. But they seem to be doing everything they can to undermine that opportunity. More details from gizmodo.com, “A Tale of Two Companies: iPhone Launch, AT&T Vs. Apple Store“:

One of our readers, Frank Beacham, wrote in this morning after experiencing the iPhone launch first-hand in lines at both AT&T and the Apple. We thought his piece was well-written and quite telling about the difference in customer service between the two companies, so we posted it:

Last night, at the last minute, I succumbed to iPhone lust as I passed a line in front of an AT&T store on Broadway in the Upper West Side of Manhattan.

The line was less than a hundred, and it seemed for a while that the wait might not be too long. Wrong! The employees at the AT&T store at 2195 Broadway were in no hurry. In fact, a woman employee at the door seemed annoyed by all the people in line and would offer no information about wait times or availability of the iPhones.

But one thing she did make certain, this AT&T location was closing at 11 p.m., line or no line. There were no promises to service those who had been waiting for hours.

A friendly restaurant next door handed free samples of a mango drink and even offered take-out food, but not one AT&T employee ever came outside to interact with waiting customers or to explain the situation.

At about 9 p.m. a customer who finally got in the store spilled the beans that all the 8 GB models were sold out. AT&T remained silent. At this point, several of us hopped cabs to head to the nearby Apple
store on 5th Ave. There, we saw the other side of this take of two American companies.

Even though the line was longer than that at AT&T, the wait was short — less than 15 minutes. Friendly Apple employees stood by with wireless credit card terminals taking orders. The process took only
minutes. Leaving the store, a cheering row of Apple workers high-fived new iPhone owners.

Day one revealed what all Apple aficionados fear. That AT&T, through the depths of its incompetence, could derail the iPhone.

James Hamilton of Econbrowser, in “CDOs: what’s the big deal?” weighs in on the question of what went wrong in the CDO market. He makes a point I haven’t seen stated as clearly anywhere else, namely, some CDO tranches may have been been likely to lose money from the get-go:

The benign view of CDOs is that they represent an important technological improvement that allows for better pooling of risk. I would characterize the main concerns as centering on whether in the process existing financial arrangements have accurately priced aggregate risk.

First let me clarify what I mean by aggregate risk. Some risks are inherently undiversifiable. One can understand that point most clearly with Robert Lucas’s elegant asset-pricing model. Suppose that the entire economy consisted of one big potato farm. All financial assets would then ultimately be nothing more than claims against future potato production, and there is no way they can credibly promise to deliver more potatoes than are actually available. If there is a bad harvest, people will be hungry, and no clever set of financial instruments can possibly insure you against that.

An example of the kind of aggregate risk I have in mind is thinking through what would be the consequences of, say, a 20% decline in average U.S. real estate prices, and what that might mean for default rates.

Let me next clarify what I mean by mispricing of this risk. I am not concerned about whether those who are bearing the aggregate risk (i.e., setting themselves up to be the guy who has the fewest potatoes when times are bad) earn a higher expected return to compensate them for the risk. Rather, my concern is whether they may have invested in assets with a negative expected return. For example, if you purchased an asset with an 85% chance of a 15% return (which you’ll earn as long as a recession does not occur), and a 15% chance of a -100% return (you’re wiped out if it does), then your expected return would be -2.25%.

The specific kind of example that comes to mind is New Century Financial Corporation, which was pushed into bankruptcy from a substantially more modest aggregate shock than the one I am concerned about here. The concern about mispricing is that if loans were extended that should not have been, the magnitude of both the real estate boom and its subsequent bust are amplified substantially relative to what they would have been with accurate pricing of aggregate risk.

But who would be so foolish to have invested hundreds of billions of dollars in extra risky assets with negative expected returns? The logical answer would appear to be– someone who did not understand that they were accepting this risk.

Now for purposes of discussion, Hamilton posits that the buyers of the riskiest CDOs might have ponied up hard dollars for a likely money loser. This is one of the reasons the so-called equity tranches of CDOs (and most asset-backed securities) are commonly called “toxic waste” or “nuclear waste.” They are dubious at best.

Now you might be asking, how could investors be so dumb? The buyers were institutional investors, after all. These guys are supposed to be pros.

There are two possible causes. One is that the sellers of this paper knew it was lousy, but also knew that with high yield paper in high demand, there would be buyers for it (let’s call this the “lipstick on a pig” theory, or Pig).

The second is that while they may have known they were hyping the paper, the sellers also had overestimated its value (this is the “believing your own PR” theory, or PR).

Now I’ve witnessed both Pig and PR in operation. In the early days of the OTC derivatives business (the early 1990s) one of the two biggest dealers was known among professional traders to take customers whenever they could. And we don’t mean take a little, we mean sell customers (generally big corporates) custom derivatives which were guaranteed money losers (and not small numbers either). How could they do that? They were structured to require no cash payment (mind you, that practice wasn’t unique to these bad deals, but you’d be amazed how the due diligence standards drop when no one has to cut a check).

Fooling yourself about the value of merchandise, or PR, also happens all the time. Consider buy-side M&A. Every study every done says most acquisitions fail (the estimates generally range from 60% to 75%) and the single biggest reason for deals not working out is that the buyer overpaid. Now admittedly, there are a lot of perverse incentives at work (everyone does better, including the acquiring CEO, even if the deal doesn’t turn out well). But it is amazing to watch how the participants will tweak the models to make the deal work. They fall under a peculiar spell, and act as if they believe that changing numbers in an Excel spreadsheet will influence reality. The financial model becomes more real than the business it is meant to represent.

Now if PR happens in M&A, with pretty simple math and line items in a spreadsheet that readily be compared with real world measures (target past performance, analyst report, forecasts by industry experts), imagine how easy it is to do with highly complex financial structures and pools of assets that are often heterogeneous?

Mind you, I’m not defending the people who designed and sold CDOs. But the abstractness and complextiy of these deals makes it way way too easy for everyone to con themselves. And here, I imagine the biggest con was in the way the rating agencies and packagers analyzed subprime risk. They used historical subprime data as a basis for forecasts, but those past subprimes had little in common with the paper being originated. Early subprime lending was done on a cautious basis, with a fair amount of borrower scrutiny, and more conservative loan terms (most importantly, lower loan to value ratios). If you have explosive growth in a risky asset category, almost without exception it is done by lowering quality standards. But that adjustment appears not to have been made.

In addition, even if the historical subprime data was applied to a comparable set of borrowers and deals, my impression is that the data was still questionable. The market started only in the mid 1990s and went into retrenchment in 1998, then came back in 2002 and grew rapidly. There is no data on how these loans perform in a serious down cycle like the 1991-1992 recession. And I have a sneaking suspicion that no attempt was made to create proxies for that severe a downturn.

As readers may know, I sometimes find marked differences in how the Financial Times and the Wall Street Journal report the same story, with the FT typically doing a much better job. In this case, I was underwhelmed by both papers’ coverage, but together they conveyed some useful information.

Federal banking regulators (including credit union and thrift supervisors) released new guidelines on subprimes. The Journal and the FT focused on completely different aspects of the story. The Journal, in “Regulators Tighten Subprime-Lending Rules,” discussed tightened standards on new mortgages:

The guidelines require more than 8,000 federally regulated lenders to underwrite loans based on a borrower’s ability to make payments on a loan’s adjusted rate, not just its low introductory rate. Roughly 75% of the subprime adjustable-rate mortgages offered last year were loans with a low flat or “teaser” rate for the first two or three years and then a higher, floating rate for the life of the 30-year mortgage.

The guidelines are very similar to a March proposal, with two significant changes.

First, with limited exceptions, the guidelines expect lenders to collect much more information to prove that borrowers have the capacity to pay. Second, lenders are directed to give borrowers the option to refinance out of an adjustable-rate mortgage at least 60 days before the interest rate jumps to a higher level, without penalty.

There isn’t yet much consensus as to how the changes will affect the issuance of subprime mortgages. Indeed, some of the guidelines have already been implemented by the banking industry…..

Both Washington Mutual Inc. and HSBC Holdings PLC’s HSBC Finance Corp., two of the country’s largest federally regulated lenders offering subprime loans, said they would comply with the new policies.

The guidelines wouldn’t directly address Wall Street’s involvement in the subprime market, but they could indirectly reduce the supply of these loans available for securitization.

When crafting the guidelines, regulators walked a fine line between trying to curb lending practices without imposing prohibitions that could kill a market that has helped many purchase homes.

“There is no doubt in my mind that anytime you put in more stringent standards you are likely to reduce the supply of credit,” Comptroller of the Currency John Dugan said. “We don’t do that lightly.”

Steven Antonakes, Massachusetts’ commissioner of banks, said state bank supervisors were working on a parallel version of the guidelines. Independent state lenders, which aren’t supervised by the new federal guidance, originated more than half of all subprime loans last year.:

The industry should be cheering to have gotten off so lightly. Congress was pushing earlier to create liability for “mis-selling” (presumably that would be a lower threshold than fraud) and also have investors be included in liability for any originator fraud (“assignee liability). Although the latter idea would put a chill on the issuance of mortgage backed securities, it isn’t completely nuts. If investors benefit from a fraud, shouldn’t the damaged party be able to seek recourse from them? It would have the effect of making investors vastly more scrupulous about who they bought paper from (but not to worry, this proposal will never see the light of day).

Despite the banking industry’s good fortune, count on Mortgage Bankers Association to complain about anything that might reduce home sales, even if the buyer goes bust in short order:

Kurt Pfotenhauer, senior vice president of government affairs at the Mortgage Bankers Association, said the guidelines were too restrictive and predicted they would force lenders to deny more borrowers access to mortgages.

“All regulatory actions come at a cost,” Mr. Pfotenhauer said. “The people being stuck with the bill for this one are those who have been making successful use of [novel mortgage arrangements] and have paid their bills on time.”

The whole point of this exercise is to restrict the extension of credit to borrowers who can’t afford it. Guess the MBA doesn’t accept the premise that some people really can’t afford to buy a house. And anyone who can make sense of the second sentence in Pfotenhauer’s quote deserves a prize.

Update: Tanta at Calculated Risk, a world leading expert at explicating stupidity and duplicity (both of which are at work here), comes to the rescue (thanks Tanta!):

It’s simple: “The cost of not making loans to people who really can’t afford to buy a house will be passed on to those people who can afford to buy a house in the form of more junk fees and higher rates, because pigs will fly before subprime lenders actually allow their profit margins to shrink. Yes, dammit, we know perfectly well that this means that the people who can afford to buy a house will no longer be able to afford to buy a house and therefore will not be able to get a loan anymore, which will require us to find more people who can afford to buy a house to cover those costs without allowing RE prices to drop which would kinda farkle up the recoveries on the foreclosures of the loans we made to the people who really can’t afford to buy a house but did, but this business is a whole lot more complicated than you wankers at the OCC seem to think. The American public has a constitutional right to have its monthly payment subsidized by a practice of offering easy credit to the wrong people, and quite frankly I pity anyone who can’t see how that math works out. Look, over there–there’s a shiny object!”

Back to the original post:

If I were the MBA, I wouldn’t be seeking so much air time when the topic of subprimes arises. With Congress considering getting investors on the hook, I’m surprised no one has voiced the idea of going after brokers who knowingly put buyers in deals they can’t afford.

The FT story was surprisingly incomplete (it didn’t identify the regulators nor did it cover the new restrictions, although they were mentioned in a related video on its website). However, it mentioned something neglected by the Journal, namely, that the regulators are directing lenders to try to salvage subprime borrowers:

US regulators on Friday told banks to be more lenient with subprime mortgage borrowers in difficulties, potentially compounding uncertainties in the troubled mortgage securities market.

Such changes could affect the value of securities backed by subprime loans, which have already fallen sharply following a recent surge in defaults.

“Banks will have to work out how to reconcile the requirements of the regulators and the interests of holders of mortgage securities,” said one official.

American International Group has said implementing the guidelines will cost it at least $178m, while Washington Mutual has committed to cut rates on up to $2bn of subprime loans, some of which have been securitised.

The turmoil in the mortgage-backed securities market has brought two Bear Stearns hedge funds near to collapse, spreading wider concerns across credit markets. Richard Marin, Bear’s head of asset management, on Friday became the first high-profile casualty when he was replaced by Jeffrey Lane, a senior Lehman Brothers executive.

Several junk-rated deals coming to market were forced either to drop their most aggressively-structured elements or raise pricing.

The moves reflected investor jitters fuelled partly by subprime worries but also by rising global interest rates, expectations of heavy supply of debt for leveraged buy-outs and resistance to increasingly fashionable borrower-friendly debt structures.

Regulators have also expressed concern about rising levels of risk. A senior Bank of England official warned the vulnerability of the global financial system had increased as financial institutions have taken on greater risks in search of higher returns.

Meanwhile, investors are still struggling to evaluate the potential scale of subprime exposure in financial markets after the losses at Bear’s two funds and at others, including a listed fund run by London-based Cheyne Capital.

Much of the exposure to the subprime sector is through opaque and complex instruments known as collateralised debt obligations, which repackage tranches of debt of varying risk.

Morgan Stanley estimates the total volume of CDOs issued since the start of 2005 with some subprime mortgage exposure is about $550bn.

Strange as it may seem, this directive is also a boon to banks. It’s much easier for organizations to have clear decision rules. And you don’t mess with regulators. Banks can take the position that they are to work out loans up to the mod limits in their securitization agreements. Those vary, but my understand is that most permit either no loan modification or restrict it to 5% of the total (not clear whether this is based on number of loans or % of value). It’s likely, given the level of subprime defaults (some put the number at over 20%) that many banks will be restricted by their agreements as to how many they can modify, and thus will be able to select the ones most likely to make it.

I’m a bit late to this article from Friday’s Financial Times, “Bear Stearns assured investors on leverage,” which gives some new information on the formation of the Enhanced Leverage Fund, the one that went into crisis first, and how it went pear shaped. Cioffi had the bad luck to not only have some trades fall in price, but also to have his hedge against them go the wrong way at the same time.

The piece also cleared up a point I (and perhaps my sources) got wrong. I was perplexed that the Enhanced Leverage Fund, the bigger fund with what was reportedly riskier assets, was allowed to fail (the smaller fund is being worked out). “Bigger” and “riskier assets” presumably mean greater losses to the lenders, and if the rest of Wall Street forced Bear to salvage the other fund, ti was a mystery to me why they wouldn’t be even more insistent with this one.

It turns out the Enhanced fund was riskier all right, but not by having riskier assets (in fact, it had higher quality assets) but by being more leveraged. Remember, that was the fund that scheduled an auction for $4 billion of its assets that went off well. Apparently the lenders thought it best just to take the whatever losses there were on the loans against the remaining assets and call it a day.

From the Financial Times:

Bear Stearns told potential investors in a now-stricken hedge fund that it could cope with even higher leverage because it put money into “high quality” assets – many of them hard-to-value structured products based on subprime mortgage bonds.

However, Bear also warned investors that taking on higher leverage could increase its volatility and brings with it “an additional risk element”.

That warning, in marketing material inviting investors to switch into a more highly-geared version of its High-Grade Structured Credit Strategies fund last year, proved prescient.

Bear last week agreed a $3.2bn bail-out of the older fund, and is negotiating with lenders who provided $7bn to the highly-geared High-Grade Structured Credit Strategies Enhanced Leveraged fund.

The prospect of forced sales of the rarely-traded collateralised debt obligations in which the Bear funds invested has unnerved the market and contributed to a re-evaluation of how bonds issued by CDOs, which invest in portfolios of other bonds, should be valued.

Ralph Cioffi, manager of the two Bear funds, invited investors last year to switch to the new Enhanced Leverage fund, saying in a letter: “Additional leverage brings with it additional risk, however we feel the form of leverage we are utilising will complement our current strategy.”

The new fund was created after Barclays Bank in London agreed to provide a financing facility of up to three times investor capital through an over-the-counter derivative, according to people familiar with the structure.

Bear trumpeted the borrowing facility when it was agreed last year, telling investors that it gave the fund more flexibility and was “better quality leverage” than previous funding.

Enhanced Leverage had attracted $638m from investors by the end of March, which it geared up more than 10 times using a mixture of repo financing and the Barclays facility, documents sent to investors show.

Barclays said its exposure was “not material”, and it is understood Bear did not draw down all the financing facility provided by the bank because it was cheaper to borrow through repos. According to documents Bear sent out in late May, Enhanced Leverage had $11.5bn invested in bonds and bank debt and short positions of $4.5bn via credit default swaps, primarily on the ABX index linked to bonds backed by subprime mortgages.

All of the long positions were in bonds and bank loans with AAA or AA credit ratings, which have first call on assets and are supposedly safe. But increased scrutiny by markets of the assets underlying CDOs led to a fall in the value of top-rated CDO bonds this year, hurting both the Bear funds in February.

The credit default swaps, a form of hedge, should have partially protected both funds against a fall in credit quality and so in the value of the bonds they had bought. However, in a note to investors Bear revealed the funds had been caught out in March when both the bonds and hedges worsened.

“The widening in [credit] spreads we experienced in February and March was the result of fear of an unprecedented increase in the cumulative losses these portfolios will suffer over time, not of an actual deterioration in credit on the underlying bonds in our portfolio,” Bear wrote in May.

At the same time, its hedges – bought in late 2006 using the ABX index of credit derivatives linked to subprime mortgage bonds – failed to perform as the ABX rallied after a sharp drop in February.

As a result, the 10-month old Enhanced Leverage fund then fell sharply. Its older sibling, which was less geared with 5.8 times leverage at the end of March, saw its first down month.

The older fund was the larger, with $925m from investors, but it also had a larger exposure to lower-rated bonds. It had $9.6bn invested in bonds at the end of March, with credit default swap hedges of $4bn.

The falls in March were reported in late May, when Bear also closed the funds to redemptions. Further falls in April and a mark down of previous valuations led to margin calls by banks owed money, which last week seized and began to sell assets before Bear agreed to the bail-out.

Bear has now said it will not rescue Enhanced Leverage. It did not reply to requests for comment on its warnings to investors.

In a move intended to restore confidence, Bear Stearns has sidelined former asset management head Richard Marin (he remains as an advisor) and has brought in Jeffrey Lane, vice chairman of Lehman, as his replacement.

Ousting Marin was pretty much required, and on paper Lane has the right stuff (Lehman is a serious bond player, Lane had a major asset management role via his earlier tenure at Neuberger & Berman. But some of the comments in the Bloomberg story give me cause for pause:

“He’s not known as a fixer of failed things, but he’ll have some fixing to do,” said Geoffrey Bobroff, a mutual fund industry consultant.

Asset management typically accounts for less than 5 percent of Bear Stearns’s revenue. Lane said he’s used to building up money managers. When he joined Neuberger, the firm had $40 billion under management. Now it has about $135 billion, he said.

“I didn’t come here to unwind an asset-management company,” Lane said. “I came here to grow one. I saw a great opportunity to build on what’s already a successful platform, to create for Bear Stearns an outstanding, diversified asset management company.”

Even if growth is Lane’s objective, you’d think he’d at least acknowledge the need to clean things up first…..

There’s been plenty of discussion on this blog and elsewhere of the questionable role of rating agencies, particularly regarding collateralized debt obligations. Rating agencies are slow to downgrade weakening credits (if you are in the debt business, this is very old news), suffer from acute conflicts of interest in rating CDOs (they are a de facto part of the underwriting team and earn handsome fees from the issuers, yet claim to be independent), and use a methodologies to rate mortgage paper that, because they were initially developed for corporate borrowers, are inappropriate for mortgage instruments and inherently lead to late downgrades.

As reported in a Bloomberg story, “S&P, Moody’s Hide Rising Risk on $200 Billion of Mortgage Bonds,” 65% of the bonds in indexes that track the subprime market don’t meet the ratings criteria under which they were sold. That’s a huge proportion.

But downgrades, particularly downgrades below the magic “investment grade” level of BBB would force many investors to sell bonds (many institutional investors either aren’t permitted to hold sub-investment grade paper, or if they can, they are only allowed a certain proportion of their portfolio to go into risky investments, and most have already used it to the max for hedge funds, private equity, and other “alternative” investments).

The rating agencies argue that until they see losses on foreclosure sales, the underlying assets aren’t impaired and downgrades aren’t warranted. But that flies in the face of the slippage of these securities on other credit measures. And bond market luminary Bill Gross of Pimco argues that many investment grade CDOs were overrated at their creation.

To give you a taste of the story, here’s a quote from the latter part:

“We’re talking about massive, massive downgrades here,” Dubitsky, the No. 2 asset-backed real estate debt analyst in last year’s Institutional Investor magazine poll of researchers, said in a telephone interview.

S&P abandoned seven-year-old criteria for determining a bond’s protection against default in February….

From Bloomberg:

Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.

The highest default rates on home loans in a decade have reduced prices of some bonds backed by mortgages to people with poor or limited credit by more than 50 cents on the dollar and forced New York-based Bear Stearns Cos. to offer $3.2 billion to bail out a money-losing hedge fund. Almost 65 percent of the bonds in indexes that track subprime mortgage debt don’t meet the ratings criteria in place when they were sold, according to data compiled by Bloomberg.

That may just be the beginning. Downgrades by S&P, Moody’s and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets.

“You’ll see massive losses from banks, insurance companies and pension managers,” said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co. in New York and co-author of a study last month that said S&P, Moody’s and Fitch understate the risks of subprime mortgage bonds. “The longer they wait, the worse it’s going to be.”

Loss Estimates

Rosner estimates that collateralized debt obligations, which have packaged thousands of bonds and derivatives into new securities, will lose $125 billion. Institutional Risk Analytics, a Hawthorne, California-based company that writes computer programs for the four biggest accounting firms, says 25 percent of the face value of CDOs is in jeopardy, or $250 billion.

Losses may rival the savings and loan crisis of the 1980s and 1990s. The Resolution Trust Corp., formed by the U.S. government to resolve the thrift crisis, sold $452 billion of assets at a cost to taxpayers of about $140 billion.

The current debacle threatens the growth of asset-backed bonds, securities that use consumer, commercial and other loans and receivables as collateral. That market, which includes mortgage securities, has doubled to about $10 trillion since 2000, according to the Securities Industry Financial Markets Association, a New York-based trade group.

Executives at New York-based S&P, Moody’s and Fitch say they are waiting until foreclosure sales show that the collateral backing the bonds has declined enough to create losses before lowering ratings on some of the $6.65 trillion in outstanding mortgage-backed debt.

`Knee-Jerk Responses’

Homeowners may be delinquent on mortgage payments for at least three months before foreclosure proceedings begin, and the process can be delayed if a borrower files for bankruptcy or fights eviction. Even when lenders repossess a home, the value of the mortgage isn’t written down until the house is sold. Bondholders only see a loss if the price of a house is lower than the loan used as collateral for debt securities.

“We’re taking action as we see it,” said Brian Clarkson, Moody’s global head of the structured products in New York. “We’re not doing knee-jerk responses.”

Ratings companies are postponing the inevitable and are dumping securities as defaults by subprime borrowers increase, investors say.

Lehman Brothers Holdings Inc., the biggest underwriter of mortgage bonds, sold $2.43 billion of Structured Asset Investment Loan Trust bonds a year ago. An $18 million portion of the bonds rated BBB- fell to 43 cents on the dollar from 98 cents in January, according to prices compiled by New York-based Merrill Lynch & Co.

Increased Delinquencies

More than 15 percent of the mortgages in the securities are at least 60 days delinquent and another 8 percent are in foreclosure, according to the bond trustee. Moody’s and S&P say they are considering downgrading the debt.

A total of 11 percent of the loan collateral for all subprime mortgage bonds had payments at least 90 days late, were in foreclosure or had the underlying property seized, according to a June 1 report by Friedman, Billings, Ramsey Group Inc., a securities firm in Arlington, Virginia. In May 2005, that amount was 5.4 percent.

The increase in delinquencies means CDO investors, who sometimes use borrowed money to magnify their bets, may be holding securities that are riskier than their ratings indicate, said Bill Gross, chief investment officer at Pacific Investment Management Co., based in Newport Beach, California.

“The Petri dish turns from a benign experiment in financial engineering to a destructive virus,” Gross, who oversees the world’s biggest bond fund, said this week in a commentary on the firm’s Web site. The companies gave the mortgage bonds investment-grade ratings, duped by the “six-inch hooker heels” of collateral that can’t be trusted, he said.

No Disclosure

CDOs aren’t required to disclose the contents of their holdings to the U.S. Securities and Exchange Commission and most can change them after the bonds are sold.

Losses reflect the decline of the U.S. housing market, where the national median home sale price is poised for its first annual drop since the Great Depression, according to the National Association of Realtors.

Investors are responding by retreating from all sorts of riskier assets, threatening to reduce credit. Companies canceled at least $3 billion of bond sales worldwide in the past two weeks. U.S. Treasury notes snapped a six-week losing streak last week, pushing yields down from the highest in five years, as investors sought the haven of government bonds.

The subprime meltdown is sending shock waves through the capital markets in part because mortgage bonds are the world’s biggest debt market, according to the Securities Industry Financial Markets Association.

Thousands of Investors

Thousands of investors own mortgage bonds, ranging from fund managers such as Pimco, a unit of Munich-based Allianz SE, to the California Public Employees’ Retirement System, the biggest U.S. public pension fund, and foreign banks like Fortis SA in Brussels.

CDOs are created by taking bonds, loans and other securities, pooling them together and chopping them into new securities with ratings ranging from the safest AAA to ones so risky they have no rankings. Investors snapped up $500 million of the securities globally last year because they typically yield more than bonds with the same credit ratings. Sales of CDOs have risen five-fold since 2001, according to JPMorgan Chase & Co.

One reason for the higher yields on some CDOs is that subprime-related debt made up about 45 percent of the collateral backing the $375 billion of CDOs sold in the U.S. in 2006, data compiled by Moody’s and New York-based Morgan Stanley show.

Drexel Creation

Credit Suisse Group, based in Zurich, created a $1 billion CDO called Class V Funding III Ltd. in February by combining the A rated portions of 91 other CDOs that invest in debt backed by consumer obligations.

The biggest portion, or $859.2 million of bonds, is rated AAA and pays interest as low as 5.70 percent. The smallest piece, or $2.5 million, is ranked BBB and has a coupon of 10.61 percent, according to a May 22 report produced by the trustee for the CDO.

At the time of the report, AAA rated corporate bonds had an average yield of 5.45 percent, while BBB debt yielded 6.03 percent, according to Merrill Lynch index data.

Demand for CDOs, first used in 1987 by bankers at now- defunct Drexel Burnham Lambert Inc., is drying up as mortgage bond losses spread. Planned sales of CDOs that rely on high- rated asset-backed debt dropped to $3 billion this month from $20 billion in May, according to analysts at JPMorgan, the third-largest U.S. bank.

First Year Rankings

“A lot of these should be downgraded sooner rather than later,” said Jeff Given at John Hancock Advisors LLC in Boston, who oversees $3.5 billion of mortgage bonds. The ratings companies may be embarrassed to downgrade the bonds, he said. “It’s easier to say two years from now that you were wrong on a rating than it is to say you were wrong five months after you rated it.”

Fitch is “deliberate” in its actions, John Bonfiglio, the firm’s head of U.S. structured finance ratings, said in an interview in his New York office. Fitch is a unit of Paris-based Fimalac AS. “I would not say we were slow.”

The ratings companies point out they have downgraded bonds less than a year after they were sold, the first time that has ever happened. S&P has lowered a total of 15 subprime bonds sold in 2005, or 0.31 percent of the total, and 32 sold in 2006, or 0.68 percent.

“People are surprised there haven’t been more downgrades,” Claire Robinson, a managing director at Moody’s, said during an investor conference sponsored by the firm in New York on June 5. “What they don’t understand about the rating process is that we don’t change our ratings on speculation about what’s going to happen.”

Bear Stearns Jolt

Accurate rankings for mortgage bonds and CDOs become even more important because the securities rarely trade, so investors can’t immediately value their holdings when market conditions change. Instead, they often rely on sales of similar securities or computer models that use ratings and past performance of the underlying collateral to come up with a value.

CDO investors were jolted this month by the losses in the Bear Stearns hedge funds.

The funds, called High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund, had borrowed $10 billion from securities firms and banks to make bets on CDOs, mortgage bonds and other securities. As the values of the holdings declined, creditors seized some of the collateral pledged for the loans and sold them through auctions.

Fire Sale

A concern was that a forced sale would slash prices on CDOs, providing new, lower benchmarks that investors would have to use to value their holdings, resulting in billions of dollars of losses.

“We remain nervous about the end of the week, when many leveraged investors in the CDO markets will have to mark down their positions,” debt strategists at Barclays Capital in New York said in a June 28 report. “The worry is that this will be large enough to trigger margin calls which, in turn, will cause other liquidations and so on.”

Merrill Lynch threatened to take and sell $850 million of bonds held as collateral for loans it had made to the funds. Lehman, JPMorgan and Cantor Fitzgerald LP, all based in New York, also pulled out.

Bear Stearns avoided an even worse fallout by offering to provide one of the funds with loans. The original $3.2 billion provision was reduced to $1.6 billion after the firm sold securities and lenders took some of the collateral.

UBS, Queen’s Walk

Other hedge funds are closing down or reporting losses because of subprime losses. Zurich-based UBS AG shuttered a hedge fund unit that saddled the biggest money manager for wealthy investors with 150 million Swiss francs ($122 million) of first-quarter losses.

Queen’s Walk Investment Ltd., a London-based fund, reported a loss of 67.7 million euros ($91.2 million) last week for the year ended March 31. Cambridge Place Investment Management LLP, another London money manager, said yesterday that it will close Caliber Global Investment Ltd., a fund that had $908 million of assets in March.

A sweeping downgrade of bonds would lead to sales of assets by investors, banks and pension funds who operate under rules that would cause them to adjust their portfolios to reflect the new ratings. S&P, Moody’s and Fitch have restricted their ratings changes on BBB- rated mortgage bonds to 1.3 percent of those outstanding, according to Credit Suisse analyst Rod Dubitsky in New York. About 80 percent of the remainder will eventually have their ratings reduced, he said.

Abandoned Criteria

“We’re talking about massive, massive downgrades here,” Dubitsky, the No. 2 asset-backed real estate debt analyst in last year’s Institutional Investor magazine poll of researchers, said in a telephone interview.

S&P abandoned seven-year-old criteria for determining a bond’s protection against default in February.

Under the old guidelines, S&P said a bond’s “credit support” must be twice the rolling 90-day average of the sum of value of mortgages delinquent by three months or in foreclosure plus real estate that has been seized by the lender.

Credit support for a bond is determined by looking at the number of lower-rated securities that would have to go bust before it suffered losses, the dollar amount of mortgages available to pay back the interest and the annualized interest the mortgages generate in excess of what needs to be paid to bondholders.

The measure was one of four tests used by S&P, said Chris Atkins, a spokesman for the company, a unit of New York-based McGraw-Hill Cos. A failure to meet the credit support standard wouldn’t have automatically resulted in a downgrade, he said.

$200 Billion

Of the 300 bonds in ABX indexes, the benchmarks for the subprime mortgage debt market, 190 fail to meet the credit support standard, according to data released in May by trustees responsible for funneling interest payments to debt investors.

Most of those, representing about $200 billion, are rated below AAA. Some contain so many defaulted loans that the credit support is outweighed by potential losses. Fifty of the 60 A rated bonds fail the criteria, as do 22 of the 60 AA rated bonds and three of the 60 AAA bonds.

All but five of 120 securities in BBB or BBB- rated portions of the mortgage-backed securities would have failed S&P’s criteria, according to data compiled by Bloomberg.

None have been downgraded, though S&P and Moody’s have parts of three pools of securities linked to the index under review for a downgrade. Fitch has downgraded parts of three mortgage pools tied to the ABX and put four on watch for downgrade.

`Warrant Our Attention’

“Don’t misunderstand me: I’m not saying these others are performing great,” Robert Pollsen, a director in S&P’s residential mortgage surveillance in New York, said in an interview last month. “And they certainly might warrant our attention several months from now, which obviously we’re going to do.”

Some investors say the ratings companies are waiting too long before downgrading the mortgage bonds and the CDOs that contain them. They noted that S&P and Moody’s maintained their investment-grade ranking on Enron Corp. until days before the Houston-based energy trader filed for bankruptcy.

“That’s like saying these trees are just fine as there’s a forest fire on the other side of the hill,” said James Melcher, president of money-management firm Balestra Capital Ltd. in New York, who runs a $105 million hedge fund.

OK, schizophrenia is a bit too strong a word, but it got your attention, right? “Dissonance” is closer to the mark, and differing points of view in a plugged-in, market-savvy paper like the Financial Times is an interesting sight to behold.

Both stories address the same general topic, namely, whether the current mess in subprimes is likely to lead to a a broad scale credit contraction. The FT editorial page gives a largely reassuring view in “Global credit woes,” while its capital markets editor Gillian Tett sounds a more worried note in her report, “Banks become barometer of woes in credit markets.”

My view is that framing the question in terms of subprime contagion is the wrong way to think about it. The very fact that we have had overeager credit extension on so many fronts: subprimes, CDOs, commercial real estate (it’s as frothy as subprimes before their rude awakening), LBOs, emerging markets means at some point we are bound to have a serious credit contraction. Pick a risky credit, any risky credit, and you got boatload of dough, no questions asked. The last time we saw this movie, in the late 1980s, there was also frantic lending, but not in anywhere near as many categories, yet the aftermath back then still brought the US and Japanese banking systems to their knees. So a correction, and a very large and broad based one, seems inevitable.

So it almost doesn’t matter whether subprimes will be the catalyst or not. Personally (and this distinction may be so subtle as to be irrelevant), I believe the trigger will be the need to revalue CDO paper. A massive amount of this stuff has been issued and is being carried at prices that are likely too high. Subrprimes may have been the trigger, but at some point the day of reckoning was going to come.

Tett has another take on it: she sees a pullback as being triggered by banks’ concerns about their reputation. That view has merit. Bear Stearns, once one of the most cocksure firms on the Street, is now so rattled that even its London private equity unit, which is about as remote from its hedge fund mess as you can get, is defensive (see “Eau de Panic at Bear Stearns“). An SEC investigation into its hedge fund woes is going to keep a harsh light on Bear. Similarly, Lehman was shellacked yesterday in the Wall Street Journal for its role in promoting subprime financing (“How Wall Street Stoked Mortgage Meltdown“). Hedge fund failures, admittedly relatively small ones, seem to be cropping up daily. Continuing bad press will engender caution.

The editorial sets up a straw man. Its view is that there won’t be a “systemic meltdown in the credit markets” but one can have plenty of credit tightening and a resulting economic slowdown without the problem rising to the level of a “systemic meltdown.”

First, the meat of the editorial, “Global credit woes“:

[W]idespread, lasting contagion from the subprime crash seems unlikely, because alongside these wobbles has come broadly good economic news. Real interest rates have risen as US investors reassessed the prospects for growth, and the chances of the Federal Reserve cutting interest rates this year.

Credit spreads remain unusually low – perhaps driven by global financial integration – and there is no question that the markets for securities such as high-yield corporate bonds are vulnerable to a fall. But a more substantial trigger than subprime will probably be needed for that setback to materialise.

The CDO market needs to grow up, fast. Participants need to improve the transparency and independence of pricing and develop more liquid markets for secondary trading. If the subprime slide does get worse, this lack of liquidity could lead to a wider crisis.

But balance of probability is that we are just seeing a shake-out in a market – subprime – that was always high-risk. If investors in other assets take note, and moderate their appetites for risk, today’s jitters may prevent a nastier credit crunch in months to come.

Now to Tett’s “Banks become barometer of woes in credit markets“:

As the shockwaves from the woes in America’s subprime sector spread, one of the biggest transatlantic hedge funds held an intensive internal debate yesterday to assess whether the big tipping point had finally been reached in credit markets – or not.

The conclusion? This fund apparently believes there is a 60 per cent chance the current bout of jitters is just a bout of modest(and badly needed) risk repricing, as opposed to a nastier crunch. But this is notably more gloomy than during the last bout of creditturmoil three months ago, when it had a75 per cent plus belief that calm would soon be restored.

“The credit market feels like a boxer in a ring,” one official told me. “It keeps taking blows, but then staggers back up. But you have to feel there is a limit to how many times you can get up from the mat.”

Quite so. On paper there are still plenty of reasons to think these current subprime-related jitters are just a temporary phenomenon that will subside soon. After all, the global economy remains strong, earnings are high, liquidity is rife – and the subprime sector, for all its gory drama, remains very small in the global scheme of things.

But markets, as financial history shows, have a nasty habit of overshooting when psychologies change. And I suspect the real key to whether we are now reaching a tipping point lies not so much in the technicals but in some subtle debates that are likely to be waged in the coming days behind the closed doors of hedge funds and investment banks.

After all, on June 30 the second quarter of the year ends and many of these funds are poised to calculate their performance data. It may take some time for these results to be given to investors and creditors for funds dealing with illiquid instruments such as subprime securities, since – as my colleagues point out on the opposite page – valuing complex instruments is a time-consuming affair.

However, some institutions are already mulling over whether to cut hedge fund exposures, alongside other credit risks. And there are at least two reasons why they may be feeling jumpier than macro-economic factors might imply.

One is that the penny is now, belatedly, dropping that some of the valuation techniques underpinning the recent explosion in the structured finance world may be dubious, not just in the subprime sector, but in the much larger leveraged finance world too.

But second, some senior bankers are rediscovering a long-ignored truth, namely that while modern financial whizz-kids may be brilliantly clever at moving credit risks off the books of banks, it is much harder to offload reputational risk.

If a highly leveraged buy-out deal blows up, in other words, this not only causes economic damage, but can also hurt the reputation of the banks that arranged the deal. Similarly, when a hedge fund goes down, this is embarrassing for any bank with close links to that fund. Just lookat the public relations woes besetting Bear Stearns, on top of its tangible economic losses.

No doubt some dealer banks will simply shrug their shoulders about this. But others may not. Or not when it is also becoming clear that the banks have not always offloaded quite as much economic risk as was widely assumed. It is instructive, for example, to see how rapidly Merrill Lynch has recently acted to extract itself from various embarrassing credit messes. No doubt the senior management at many other banks are now also debating whether it is time to pull in the horns, by imposing new haircuts or credit limits (or banning some of the nuttier things recently in vogue, such as providing equity bridges for buy-out deals).

It remains an open question whether this will lead to much tangible action. But if banks do start quietly turning off the credit spigot in the coming weeks – and it remains a big “if” – then we are indeed near a tipping point. Either way, if you are exposed to the credit sector, better not plan to take too much holiday this summer, particularly given how thin (and thus potentially volatile) the markets tend to be in late July and August.

A Wall Street Journal article, “Subprime: Point to Where It Hurts,” endeavors to clarify the issues in modifying loans to try to save defaulting mortgage borrowers. Previous stories have mentioned that the fact that most residential mortgages go into mortgage backed securities makes it harder to change terms than in the old days, when the bank that made the loan also held the loan.

The piece feels a bit superficial, since it only deals with mortgage backed securities, and completely neglects to mention what happens to borrowers if their loan goes into an MBS that then gets repacked into a collateralized debt obligation (other stories have suggested that the CDO buyer has to provide a waiver, and that it’s onerous finding the investors, let alone getting the needed releases). However, the Journal story does do a nice job of explaining why holder some classes of MBS paper favor “mods”, as they are called, while others oppose them.

From the Journal:

As defaults on home loans mount, mortgage companies are scrambling to work out deals to help as many borrowers as possible stay in their houses.

On the surface, it seems an obvious tactic. Lenders usually end up losing money on foreclosed homes because of legal and other costs and the need to sell those properties fast, often at a knockdown price. Also, politicians are pressing mortgage companies to minimize the damages foreclosures cause to families and neighborhoods.

Still, the effort to hold down foreclosures threatens to create clashes between mortgage companies and investors in securities backed by bundles of home loans, a $6 trillion market that has been shaken recently by losses on some of the riskier types of mortgage bonds. And because of the way these securities are sold, these efforts can pit groups of holders against each other….

When borrowers can’t keep up, lenders typically consider whether it makes sense to offer a loan modification. Such workout deals, known as “mods,” often involve lowering the interest rate or stretching out the term. Lenders have used mods for years, but the practice is expected to proliferate as defaults rise.

Sharon Greenberg, an analyst for Credit Suisse Group in New York, estimates that before this year modified loans typically accounted for less than 2% of all those outstanding. Within the next couple of years, she says, they may peak at several times that level.

Investors holding mortgage-backed bonds are watching nervously because mods may not always be in their best interest. Some investors fear that loan servicers — the firms, often owned by lenders, that collect payments and deal with defaults — will make too many mods. Generally, investors favor mods that ease a normally reliable borrower through a rough patch, but not those that merely buy time for deadbeats.

Investors doubt some homeowners merit a rescue plan. In some cases, says Kishore Yalamanchili, a fund manager with BlackRock Inc., New York, “by making these people current, you are pushing losses to another year or so.”

Credit Suisse analysts recently examined loans that had been modified over the past few years by one nationwide lender and found that borrowers missed at least one monthly payment after a mod in nearly 40% of the cases. (That failure rate may have been skewed upward by victims of Hurricane Katrina who never returned to their homes.)

If the borrower is unlikely to keep up with payments even after a mod, many investors would prefer that servicers pursue a foreclosure quickly, especially in regions where house prices are falling, reducing the value of the collateral.

Servicers are required by their contracts to act in the interests of the investors and modify loans only when that can be expected to reduce losses. That puts servicers in the tricky position of trying to figure out which borrowers are basically sound and when it makes more sense to foreclose quickly.

One complication is that different classes of investors have different interests, reflecting the complicated mechanics of mortgage securities. Issues of mortgage-backed securities are divided into slices with various ratings, depending on the level of risk. Holders of the highest-rated slices (those with the lowest risk) are first in line to collect payments of interest and principal flowing from the loans. Many such bond issues are structured so that there is initially more than enough cash flow available to cover obligations to all the investors, leaving a cushion to cover potential losses from loan defaults. If after three years or so the loans have performed well enough to meet certain performance measures, the cushion may be reduced.

In that case, some of the excess cash available goes to holders of lower-rated securities and “residuals,” the highest-risk parts of the securities that are last in line for payments.

If loan mods delay the onset of foreclosures, holders of the lower-rated securities and residuals are more likely to get those payments. But, holders of AAA and other high-rated securities may argue that the loan mods have artificially boosted the performance of the loans and that the holders of lower-rated securities and residuals are getting payments that should be preserved to protect owners of higher-rated paper against the risk of a resurgence of defaults later.

Even where there are no clashes among investors, servicers face restrictions on how they modify loans.

Moody’s Investors Service, a ratings provider, recently reviewed roughly 400 subprime mortgage-security transactions issued last year: 5% of those deals prohibit any kind of loan mod; among those that allow mods, about a third stipulate that no more than 5% of the loans backing the securities can be modified. Subprime loans are those to people with spotty credit histories.

“Those restrictions may prevent servicers from doing the things they need to do,” says Larry Litton Jr., chief executive of Litton Loan Servicing, a unit of C-BASS LLC, New York. Mr. Litton says his firm hasn’t bumped up against any ceilings. Still, he favors eliminating restrictions in future issues of mortgage securities to give servicers more flexibility

.
One thing I find a bit disingenuous is the notion implied in the BlackRock comment that helping troubled borrowers is merely postponing the inevitable. I imagine it’s more like triage: some borrowers clearly won’t make it even with revised terms; some look like good bets (for instance, the default might be due to a personal crisis that has been resolved), and some are hard to judge. It’s the third category that is most contentious, precisely because reasonable people can differ on whether the borrower will come through. But to judge a borrower that has one missed payment after a loan mod as a complete deadbeat (as the article does) seems unreasonable (a “missed payment” could merely be a late payment, and the source doesn’t indicate what proportion of those who missed a payment were able to make it. That’s the germane number).

Another day, another subprime casualty? The Caliber hedge fund was heavily exposed to 2005 subprimes, which is a new cause for pause, since heretofore, it was the 2006 subprimes that had shown the worst performance. But now troubles are showing up in the 2005 cohort.

The UK fund isn’t as big as either of the Bear funds ($900 million in assets) but still large enough to be noteworthy.

From the Wall Street Journal, “As London Firm Shuts Down, Worries Spread To American Home Loans Made Back in 2005“:

Bond market turmoil spread yesterday as a London investment fund shut down because of bad bets on mortgage-backed securities and, separately, banks were left holding part of a closely watched corporate bond offering.

The London fund, Caliber Global Investment Ltd., announced it was shutting down because of souring investments in bonds backed by mortgages to American homeowners with sketchy credit. So far, most of the pain in the mortgage market was caused by loans made in 2006, when lending standards reached a low. Caliber, a unit of hedge-fund operator Cambridge Place Investment Management LLP, was hurt by loans made in 2005. Delinquencies in these older loans are also building, and investors have been selling off bonds backed by these mortgages in anticipation of problems.

Caliber, which listed on the London Stock Exchange in June 2005, lost 53% of its value. It said it will unwind the fund and attempt to return about $900 million to investors in the next 12 months. The company said in a statement there was “insufficient demand currently for investment through listed investment companies exposed to this asset class.”….

In the mortgage sector, the 2006 vintage of subprime loans have already been labeled a bust because delinquencies and defaults on these loans started rising shortly after they were made. The 2005 vintage is now showing more signs of stress.

Among its mortgage bond holdings, those tied to 2005 loans were most prominent in Caliber’s portfolio. As of March 31, Caliber had $320.1 million worth of 2005 residential mortgage backed securities, versus $40.5 million worth of 2006 securities. The bonds tied to these 2005 loans are losing their value.

Caliber’s unrealized losses for its 2005 holdings were $58.4 million, including a $12 million second-quarter charge, are $46.4 million, the company said in a report last month. This week, Caliber threw in the towel.

Defaults and foreclosures on 2006 loans are worse than 2005. But the rates of bad loans for 2005 are rising and are considerably worse than for 2004 and 2003.

According to First American LoanPerformance, 19.6% of 2006 subprime home loans that are at least 15 months old were delinquent as of April. The 2005 loans are going bad at a slower pace — but the delinquencies are mounting. As of April, delinquencies accounted for 18.9% of 2005 subprime loans that were at least 26 months old. A delinquency is a loan that is 60 days or more overdue or already in foreclosure.

One portfolio manager, Bryan Whalen at Metropolitan West Asset Management, said the worst loans were made between September 2005 and November 2006, as cutthroat competition encouraged some lenders to push down their lending standards to new lows.

Investors are also concerned about borrowers who took out 2005 adjustable-rate mortgages, many of which will reset with higher interest rates this year. In some cases, the value of bonds backed by these mortgages are falling in anticipation of problems. Moreover, borrowers have had trouble refinancing out of these loans and into fixed rate mortgages because lenders have been tightening their credit standards.

Caliber said the decision was made after a review that began in early May. Later, Caliber told investors it was witnessing a “deterioration” in the U.S. subprime market and it had sold six positions in investments backed by 2006 subprime mortgages, including three at a loss.

The article also mentioned that investors balked at part of the financing for the Dollar General LBO, leaving underwriters holding $725 million of unsold bonds that had a “payment in kind toggle.” PIK paper hasn’t been seen since the long-in-tooth phase of the last LBO cycle. The underwriters plan to sell the bonds later (one of the rules of Wall Street is “everything can be solved by price”).

Barry Ritholtz gave some helpful tidbits about CDOs on his blog, The Big Picture. The source is the Bloomberg magazine (unfortunately only for those with terminals can subscribe).

From Ritholtz (quoting Bloomberg);

“Worldwide sales of CDOs—which are packages of securities backed by bonds, mortgages and other loans—have soared since 2003, reaching $503 billion last year, a fivefold increase in four years. Bankers call the bottom sections of a CDO, the ones most vulnerable to losses from bad debt, the equity tranches. They also refer to them as toxic waste because as more borrowers default on loans, these investments would be the first to take losses. The investments could be wiped out. . .

Because CDO contents are secretive, fund managers can’t easily track the value of the components that go into these bundles. “You need to monitor the collateral in your investment and make sure you’re comfortable there will be no defaults,” says Satyajit Das, a former Citigroup banker who has written 10 books on debt analysis. Most investors can’t do that because it’s extremely difficult to track the contents of any CDO or its current value, he says. About half of all CDOs sold in the U.S. in 2006 were loaded with subprime mortgage debt, according to Moody’s and Morgan Stanley. Since CDO managers can change the contents of a CDO after it’s sold, investors may not know how much subprime risk they face, Das says.”

Ritholtz was also struck by their use of antic graphics. I was surprised to learn how little was owned by hedge funds (the press has made them seem like much bigger buyers than they have been) and how much has been bought by parties that really ought to know better, particularly fiduciaries like pension funds (recall Pimco chief Bill Gross’ warning that even investment grade CDOs are pretty trashy).

Note also that the “asset managers” listed as buyers in some cases are other CDOs:

The BBC website has this grim story on how climate change and unsustainable farming practices is projected to produce an increase in deserts, leading to mass migration. Sub-Saharan Africa and central Asia are worse affected, but parts of Australia and the American West are also drying out.

From the BBC:

Tens of millions of people could be driven from their homes by encroaching deserts, particularly in sub-Saharan Africa and Central Asia, a report says.

The study by the United Nations University suggests climate change is making desertification “the greatest environmental challenge of our times”.

If action is not taken, the report warns that some 50 million people could be displaced within the next 10 years.

The study was produced by more than 200 experts from 25 countries.

This report does not pull any punches, says BBC environment reporter Matt McGrath.

One third of the Earth’s population – home to about two billion people – are potential victims of its creeping effect, it says.

Tree-planting schemes may put pressure on scarce water resources

“Desertification has emerged as an environmental crisis of global proportions, currently affecting an estimated 100 to 200 million people, and threatening the lives and livelihoods of a much larger number,” the study said.

The overexploitation of land and unsustainable irrigation practices are making matters worse, while climate change is also a major factor degrading the soil, it says.

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People displaced by desertification put new strains on natural resources and on other societies nearby and threaten international instability, the study adds.

“There is a chain reaction. It leads to social turmoil,” said Zafaar Adeel, the study’s lead author and head of the UN University’s International Network on Water, Environment and Health.

The largest area affected was probably sub-Saharan Africa, where people are moving to northern Africa or to Europe, while the second area is the former Soviet republics in central Asia, he added.

Way forward

The UN report suggests that new farming practices, such as encouraging forests in dryland areas, were simple measures that could remove more carbon from the atmosphere and also prevent the spread of deserts.

“It says to dryland dwellers we need to provide alternative livelihoods – not the traditional cropping based on irrigation, cattle farming, etcetera – but rather introduce more innovative livelihoods which don’t put pressure on the natural resources,” Mr Adeel said.

“Things like ecotourism or using solar energy to create other activities.”

Some countries like China have embarked on tree-planting programmes to stem the advance of deserts.

But according to the author, in some cases the trees being planted needed large amounts of water, putting even more pressure on scarce resources.

For those of you who are relatively new to the complexities involved in the pricing of collateralized debt obligations (CDOs), this Financial Times article, “Worries grow about the true value of repackaged debt,” gives a good overview. Since the article is lengthy, and the first part covers largely familiar ground, I’ve excerpted the second half.

One thing nags at me as I read this article. The assumption, which is articulated by a consultant, Christopher Whalen is that more liquidity would help pricing (in financial markets, that is close to a tautology):

The lack of a publicly quoted market for CDOs and like assets is exacerbating the liquidity problems for these assets beyond the underlying economics, for example, in subprime real estate

Now it is undeniable that more trading of CDOs would give more pricing benchmarks. Something is obviously better than nothing. But this market is a harder nut to crack than most people imagine. My belief is that a very considerable range of CDOs would need to be traded to provide enough data points to be useful. And lacking natural buyers and sellers (no one in the normal course of events sells this stuff, unless there is a problem, which means buyers are likely to be chary), it’s hard to imagine how market participants are going to get around this issue.

The reason I stress this issue is that readers might easily imagine that if a few “benchmark” CDOs were to be traded with some frequency, that would give this sector the anchors it needed for more realistic price marking for the CDOs that don’t trade. But these instruments are so arcane, so complex, and so highly differentiated on so many axes that one is likely to need to have a large number of CDOs trading to capture enough permutations to allow for realistic pricing.

Let’s consider the variations: underlying assets (they can contain any tranche of asset backed securities, other CDOs or even CDOs of CDOs, whole loans, mortgages), degree of credit enhancement (whether via overcollateralization or the use of guarantees), leverage, use of synthetics (I may have managed to miss an attribute or two, but you get the picture). As a result, the maturity of the deals vary, and the structures used to achieve the desired credit ratings are all over the map.

So even if a few of these puppies traded, I’m not sure what it tells you. You could try to infer what that means for illiquid issues, but unless you have a statistically reasonable sample trading, it’s hard to decompose why the liquid issues are priced the way they are priced. Or else you make an educated guess as to why they trade the way they trade and use a very complicated model to relate the price to the untraded paper you own. I’m sure it would be an improvement on what we have now, but my sense is that the public at large is overestimating the benefit of more active trading of a few issues. “A few issues” won’t scratch the surface of the variety and hairiness of the paper out there.

And there are a few other barriers: you can’t get the deal documents. No kidding. The Fed can’t even get them because it isn’t a “qualified investor.” (Should the Fed start a hedge fund so it can study this problem?). From “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions,” by Joshua Rosner and Joseph Mason (pages 83-4):

At present, even financial regulators are hampered by the opacity of over-the-counter CDO and MBS markets, where only “qualified investors” may peruse the deal documents and performance reports. Currently none of the bank regulatory agencies (OCC, Federal Reserve, or FDIC) are deemed “qualified investors.” Even after that designation, however, those regulators must receive permission from each issuer to view their deal performance data and prospectus in order to monitor the sector.

So if regulators can’t get the description of the securities, market participants certainly won’t. So what good is a price if you aren’t really certain what is being traded?

In addition, the discussion in the FT article presupposes the CDOs are passive CDOs, meaning the assets are assembled and the CDO is structured before it is sold to investors. Yet many CDOs are “active” or “managed” CDOs, meaning blind pools. Blind pools that are tranched, often with leverage and often buying other CDOs or “CDO squared” (CDOs of CDOs). That means the investors pony up money before the fund (it is like a convoluted mutual fund) is formed, and the managed gets to trade it over its three to five year life. No CDO manager is going to disclose his holdings (it would put him at a competitive disadvantage) but how can you value it otherwise?

I don’t understand how anyone with an operating brain cell could have bought this stuff, and the supervising grown-ups (the regulators) seem powerless to do anything to ameliorate the situation.

From the Financial Times:

To an extent, the valuation problem for CDOs reflects the fact that the frenetic pace of innovation seen in the financial industry this decade has outpaced the development of its infrastructure. It has often been the case that when new instruments emerge in the banking world, the market is initially quite illiquid, meaning that the level of trading is low. But the murky nature of new products has rarely had broad systemic implications, because they have typically occupied a small niche.

What makes the CDO sector unusual is that it has exploded at such a breakneck pace with bankers packaging bonds, loans and other debts into ever more complex structures. Last year alone, about $1,000bn (£500bn, €745bn) in cash and derivatives CDOs was issued in Europe and the US, according to data from the Bank for International Settlements. More than one-third was composed of asset-backed securities, often including low-grade mortgages.

As this explosion has occurred, some corners of this universe have already become relatively widely traded and transparent. Every day in the London and New York markets, for example, billions of dollars worth of deals are struck involving indices of derivatives on well-known corporate bonds – making it easy to obtain prices.

However, many other such products are created by bankers directly with their clients and then simply left to sit on the books of an investor. Since such instruments typically last three to five years – and the CDO boom is so recent – many have not come to the end of their life. Nor have they been traded. Christopher Whalen of Institutional Risk Analytics, a consultancy, says: “The lack of a publicly quoted market for CDOs and like assets is exacerbating the liquidity problems for these assets beyond the underlying economics, for example, in subprime real estate.”

To compensate, investment institutions and banks use a variety of techniques to assign a value to these instruments in their accounts. In some areas, third-party data groups exist that can offer price estimates. However, the pace of innovation is so intense that it is hard for these providers to keep up with all corners of the market. So in many cases, investors are turning to alternative techniques to create prices. One tactic used by hedge funds entails asking several brokers for price quotes and taking an average. Results vary – not least because dealer banks may hold positions in these instruments themselves.

“It is very easy for hedge funds to shop around to find valuations that suit them best and then book their assets at that,” says one banker who advises hedge funds. “Going back to the bank that sold you a CDO and asking for a price is rarely likely to produce an accurate picture.”

Another approach is to estimate valuations based on the ratings the instruments receive from credit rating agencies. Yet this does not offer a fail-safe valuation method either. The rating agencies have been downgrading bonds backed by subprime mortgages in recent weeks but critics say they have been slow to act and face difficulties in analysing the market.

Christian Stracke, analyst at CreditSights, a research company, says: “With so little truly relevant historical data on the behaviour of subprime mortgages, and with such massive structural changes having occurred in the mortgage landscape in recent years, any time-series analysis approach is little more than a not-so-educated guess.”

Moreover, while ratings attempt guidance on the chance of default, they offer no indication of how market prices could behave – as the rating agencies stress. As the BIS noted in its annual report this week, ratings reflect expected credit losses rather than the “unusually high probability” of events that “could have large effects on market values”.

That means that on the rare occasions that instruments are traded, a large gap can suddenly emerge between the market price and its book value. This week Queen’s Walk Fund, a London hedge fund, admitted it had been forced to write down the value of its US subprime securities by almost 50 per cent in just a few months. That was because when it was forced to sell them, the price achieved was far lower than the value created with the models the fund had previously used – which had been supplemented with brokers’ quotes.

But unless circumstances arise that force a market trade, valuations often remain at the investment managers’ discretion. While managers say they strive to assign honest values, these are often difficult for an outside accountant to verify, since the techniques used are invariably highly complex.

Moreover, incentives do not always encourage fair valuations: hedge fund managers, for example, are typically paid a percentage of the profits they book, giving them a vested interest in reporting a high asset valuation. At best, this means that the valuations of CDOs, for example, may often lag behind any swings in broader asset classes; at worst, this ambiguity may enable hedge fund managers or investment bankers to keep posting profits – even when markets fall.

But Amitabh Arora, head of interest rate strategies at Lehman Brothers, points to a further potential impact from the Bear Stearns upheaval. “The bigger risk now is that it calls into question CDOs as a financing vehicle in the corporate credit market – I think in the next six to 12 months we will see a significant reassessment of CDOs as a financial vehicle not just in the subprime world but the corporate world too.”

Adil Abdulali, a risk manager at Protégé Partners, a fund of funds, recently studied the performance of hedge funds and discovered clear statistical indications that they tend to stage-manage their earnings [known in the industry as “smoothing” them] when they trade illiquid instruments. “Conservatively, 30 per cent of funds trading illiquid securities smooth their returns,” says Mr Abdulali.

Some bankers and policymakers argue that this is simply a teething problem that will fade as structured finance becomes more mature. History suggests that most opaque, illiquid markets eventually become more transparent when they grow large enough – and behind the scenes, the Bear Stearns hedge fund problems are prompting bankers and investment managers to re-examine their valuation techniques. “We are getting a lot of calls from worried people,” says one third-party data provider.

However, history also shows that large-scale structural dislocations – such as a serious mispricing of assets – are rarely corrected in an orderly manner. Thus the big risk now is that if thousands of banks and investment groups suddenly have to slash the value of the securities they hold, the wave of accounting losses might at best leave investors wary of purchasing all manner of complex financial instruments. At worst, it could trigger more distressed sales and a broader repricing of financial assets, not just in the subprime sector but in other illiquid markets too.

“If every CDO [manager] was forced to mark to market their subprime holdings, it would be – well, I can’t think of a strong enough word to describe what it would be,” confesses a US policymaker.

A page one story in the Wall Street Journal, “Market’s Jitters Stir Some Fears For Buyout Boom,” discusses how creditors are suddenly rediscovering that they can say no to deals that don’t offer them reasonable terms. This is coming as quite a shock to private equity firms, who were used to getting their own way and were able to extract concessions that were what one might politely call unusual: “cov lite” deals (meaning few or no covenants) and payment in kind (meaning the borrower can pay in crappy paper if it is short of cash, a practice we haven’t seen since the overwrought phase of the 1980s buyout boom).

The $3.6 billion financing for a big deal, the $7.2 billion acquisition of US Foodservice by KKR and Clayton, Dubilier & Rice, was “rejected by investors”, leaving underwriters holding the unsold securities (a smaller deal for Canadian company Catalyst Paper was also pulled, and financings for other deals, such as Myers Industries and Magnum Coal, were postponed). A hung underwriting is a rare and painful event (the deal will presumably be repriced, at a loss for the underwriting group. Underwriters usually get “circles,” which are pretty firm indications of interest, before pricing a deal. I gather in this brave new world of finance that was another practice that went out the window). Other deals, such as Dollar General, are moving ahead.

The odd thing is that both US Foodservice and Dollar General were reported to be having trouble last week. The Journal doesn’t give enough detail as to why the two deals had different outcomes, but one suspects that the Dollar General group was more willing to bend than the US Foodservice cohort.

The most revealing comments, however, weren’t about the deals in particular but the general environment:

Taken together, the setbacks are stoking unease across Wall Street. “The biggest risk we face — and there are a lot of things that contribute to this risk — would be a very big crisis in the credit markets,” Lloyd Blankfein, chief executive of Goldman Sachs Group Inc., told an audience at The Wall Street Journal’s Deals & Deal Makers conference in New York. A “sentiment shift,” he said, “could unravel very quickly” the vast wealth that has been created by the takeover boom.

At the same conference, Treasury Secretary Henry Paulson called the market jitters “a wake-up call to focus on excesses” that have developed in recent years in the debt markets.

For a toad like that to hop out of Blankfein’s mouth says the industry is rattled.

Apologies for being a tad late on this item, an article by the Financial Times’ lead editorial writer Martin Wolf, “Risks and rewards of today’s unshackled global finance.” Power went down in parts of Manhattan today, which put a crimp in my schedule. So I will be briefer than I might otherwise be.

I was struck by an odd disconnect. Wolf’s tone in this piece on what he calls the finance brain is largely reassuring (although he makes no bones about the conflicts of interest between financiers and the parties they allegedly serve). And he does point to research by Dani Rodrik that says the benefits of financial liberalization in emerging economies isn’t as great as in their first world counterparts (likely because it gives the elites yet another opportunity to skim). But towards the end, he segues into a long list of risks, followed by six “policy issues” that look like a call for root and branch reform. It feels as if Wolf is either pulling his punches, conflicted about where he stands, or perhaps simply had to finish the piece before his thinking had gelled fully. It’s a noteworthy departure from Wolf’s usual self-assured posture.

To Wolf:

Finance is the brain of the market economy. Alas, like the brains of individual human beings, it can shift in an instant from greed to fear. Sometimes, as now, the brain behaves as if indifferent to risks and uncertainties. At other times, it is consumed by anxiety. Today, moreover, as I argued last week, the brain has become active, global and self-confident. Is it also creating huge dangers for the world economy?

Critics would levy three big charges against modern financial capitalism: it is unjust; it is inefficient; and it is unstable. This charge sheet is as old as capitalism itself.

Two objections are made to the rewards gained by financiers. The large one is that making large sums out of speculation, rather than production, is distasteful. But this distinction is arbitrary. What matters far more is whether the activities are economically helpful. A narrower objection is to the fiscal regimes under which successful financiers operate. Yet this, again, raises general questions about fiscal policy, not ones limited to the financial sector. Thus, the charge that there are injustices associated only with financial capitalism is hard to justify.

More interesting, therefore, is the second question: does the financial brain even know what it is doing? In other words, does the financial system add to economic efficiency?

The benefit and risk of finance are two sides of one coin. The benefit is the ability to reallocate resources among people at any point of time and over time. The risk is that the resulting pyramids of promises are vulnerable to fraud, deception and irreducible uncertainty and so to successive fits of optimism and panic.

These are indeed inescapable features of any financial system, to be managed, not eliminated. It is impossible to align the interests of insiders with those of the people they ostensibly serve, let alone with those of the wider public. To take just one salient contemporary example, the least that managers of private equity or hedge funds can earn is the management fee. But their investors – or, more probably, the people who depend on the money their investors manage – may lose everything.

As Professor Dani Rodrik of Harvard university has pointed out in a comment in the FT’s Economists’ Forum, it has proved possible to tame domestic finance, more or less. In the US, the country with the most sophisticated financial system in the world, the financial sector seems to have generated much innovation, along with a reasonable degree of stability. But the evidence on the benefits of liberalisation in emerging economies, though not absent, is not as strong as proponents desire. This is not because there are no benefits. It is, instead, partly because the financial markets are primitive, partly because the interface between global and domestic markets is defective and partly because benefits have been overwhelmed by the costs of crises.

This brings us to the third item on the charge sheet: the ability of the financial brain to generate huge calamities. At present, that possibility looks remote. It is a decade since the Asian financial crisis began to roll across the globe. Today, we see a fast-growing global economy, with low spreads on risky assets, strong corporate balance sheets, easy issuance of debt and, inevitably, declining returns on speculative activity, as well (see charts). Yet, as the Bank for International Settlements points out in its latest annual report, still the best single official analysis of how the financial and monetary systems are evolving, that is the right time to worry. By the time crisis hits it is far too late. It is well before then that people make mistakes. Usually, moreover, it is not those responsible for the mistakes who suffer, but everybody else.

How big are those dangers today? Sizeable, would be my guess. The consensus is for continued, rapid and stable economic growth. But, as the BIS remarks: “It is not difficult to identify uncertainties that could conceivably cause the near-term forecast to come unstuck, or that could result in less welcome outcomes over a longer horizon.”

The risk of inflation is one such uncertainty, as capacity is used up across the globe. The exalted level of housing markets in most high-income countries is another. The continued reliance on US household spending and, more broadly, the elevated level of private consumption in almost all high-income countries is yet another. Not to be forgotten are persistent and massive deficits and surpluses in the global balance of payments and associated capital flows. Moreover, government intervention in foreign currency markets still accounts for a sizeable part of the financing of the US current account deficit.

In addition, we have to consider what is going on in the financial markets themselves. How many investors, for example, are taking equity risks in return for poor bond returns? How many of them are even aware that these risks are being taken on their behalf? As the BIS notes: “There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking…Moreover, should liquidity dry up and correlations among asset prices rise, the concern would be that prices might also overshoot on the downside.”

Is it possible to take advantage of the financial brain’s abilities, while limiting its capacity for irresponsible, short-sighted and destructive behaviour? What are the policy issues that we would be examining if we wanted to do so.

First, for essentially political reasons, we must re-examine the taxation of income and wealth.

Second, we should recognise that emerging and small economies have to manage their involvement with the global financial system cautiously.

Third, we must also realise that the mixture of floating exchange rates with a number of important pegged rates is creating huge distortions.

Fourth, we must look more closely at how monetary policy interacts with the financial sector and asset prices.

Fifth, we should also look once again at how well vast rewards are aligned with risk in financial markets.

Finally, we must encourage regulatory and fiscal authorities to achieve higher levels of co-ordination.

We will have to live with today’s financial markets, since policymakers would seek to curtail them only after a disaster. Even their critics should fear such a disaster. The task is, instead, to exploit the many benefits, while managing the risks. This will never be done perfectly. But it can be done at least tolerably well. The alternative is too awful to consider.

The concept that cheap imports result in job losses should be a no-brainer, but it is still greeted with considerable resistance in some circles.

Let’s be clear on a few points: while open trade in theory creates benefits to all parties, the system we have isn’t open trade, but managed trade. Most other countries negotiate trade treaties with an eye to achieving a trade surplus and protecting their workers; our approach is to favor the interest of our corporations, wherever they choose to produce their goods. William Greider made this point in a New York Times op-ed, “America’s Truth Deficit“:

The United States’…weakening position in the global trading system is obvious and ominous, yet leaders in politics, business, finance and the news media are not willing to discuss candidly what is happening and why. Instead, they recycle the usual bromides about the benefits of free trade and assurances that everything will work out for the best.

Much like Soviet leaders, the American establishment is enthralled by utopian convictions — the market orthodoxy of free trade globalization….

An authentic debate might start by asking heretical questions: Why is the United States one of the few advanced economies that suffers from perennial trade deficits? Why do new trade agreements, despite official promises, always leave the United States with a deeper deficit hole, with another wave of jobs moving overseas? How do the authorities explain the 30-year stagnation of working-class wages that is peculiar to America? Are we supposed to believe that everyone else is simply more competitive or slyly breaking the rules? In the last three decades, American policymakers have succeeded in closing the trade gap with only one event — a recession….

American political debate is enveloped by the ideology of free trade, but ”free trade” does not actually describe the global economic system. A more accurate description would be ”managed trade” — a dense web of bargaining and deal-making among governments and multinational corporations, all with self-interested objectives that the marketplace doesn’t determine or deliver. Every sovereign nation, the United States included, uses its vast arsenal of policies to pursue its national interest.

But on the crucial question of how policy makers define ”national interest,” Washington stands alone. Western Europe, whatever its problems, manages economic policy to maintain modest trade surpluses. Japan manages to insure far larger surpluses in recessions (its export income subsidizes inefficient domestic employers). China strives to acquire a larger, more advanced industrial base at the expense of worker incomes and bank profits. Germany and Japan, despite vast differences, both manage to keep advanced manufacturing sectors anchored at home and to defend domestic wage levels and social guarantees. When they do disperse production and jobs overseas, as they must, they do so strategically.

By contrast, Washington defines ”national interest” primarily in terms of advancing the global reach of our multinational enterprises. Elites are persuaded by the reigning orthodoxy that subsidiary domestic interests will ultimately benefit too.

Greider’s views are gaining increasing acceptance. Princeton economist Alan Blinder, once a die-hard free trade suporter, has come to the conclusion that the downside of free trade is likely greater than previously estimated. Harvard’s Dani Rodrik has looked at the analyses that seek to quantify the gains from open trade and has declared the estimates to be “grossly inflated.” In addition, even economists who are staunch supporters of free trade are increasingly willing to admit it creates losers and winners (before the belief was that a rising tide would lift all boats). It’s becoming respectable to advocate training and other subsidies to workers who lose jobs due to trade-induced industry restructuring (one of many examples: Timothy Geithner, President of the New York Fed).

So this short article by Robert Scott, “Wal-Mart’s reliance on Chinese imports costs U.S. jobs,” gives a little more dimension to the heretofore underreported costs of our current trade regime. Only when we understand both sides of the equation, costs and benefits, can we make sound policy decisions.

From Scott:

China’s entry into the World Trade Organization was supposed to improve the U.S. trade deficit with China and create good jobs in the United States. But those promises have gone unfulfilled: the total U.S. trade deficit with China reached $235 billion in 2006. Between 2001 and 2006, this growing deficit eliminated 1.8 million U.S. jobs (Scott 2007). The world’s biggest retailer, U.S.-based Wal-Mart was responsible for $27 billion in U.S. imports from China in 2006 and 11% of the growth of the total U.S. trade deficit with China between 2001 and 2006. Wal-Mart’s trade deficit with China alone eliminated nearly 200,000 U.S. jobs in this period

The manufacturing sector and its workers were hardest hit by the growth of Wal-Mart’s imports. Wal-Mart’s increased trade deficit with China eliminated 133,000 manufacturing jobs, 68% of all jobs lost. Overall, the Wal-Mart trade deficit displaced and 308,100 jobs in 2006. On average, 77 U.S. jobs were eliminated for each one of Wal-Mart’s 4,022 U.S. stores in 2006. (See The Wal-Mart Effect for more details.)

Wal-Mart’s huge reliance on Chinese imports illustrates that many powerful economic actors in the United States benefit from China’s policy of maintaining an undervalued yuan, its abuse of labor rights, and other fair-trade norms. Wal-Mart’s benefit, however, is not the country’s gain, as these policies have contributed directly to the ever-growing trade deficit that imperils future economic growth.