naked capitalism

A good article by Clive Crook of the Financial Times discusses the improving fortunes of unions in America. Crook looks at some of the indicators their rising influence (key sign: fawning Democratic hopefuls) and how they can aid as well as impede economic activity.

Even though Crook’s piece is helpful, he somehow seems wide of the mark. He may not understand the roots of the antipathy towards unions in America. Even in their heyday, organized labor was held in less than high esteem, and it wasn’t due as much to their obstructionist role in commerce (America wasn’t in the thrall of corporate interests back then) as to their rampant corruption. Even today, quite a few union members seem ambivalent. While they acknowledge that they do better with the union than they would without, many feel the union extracts too high a toll (in terms of dues) relative to the benefits delivered. In other words, they suspect self-dealing.

And Crook misses why unions have become a more respectable cause. One reason is the widespread disgust with CEO pay. The less sympathetic executives become (and they’ve had plenty of warning that they ought to rein in their behavior, which has gone unheeded), the more measures to clip their wings look justified. If investors can’t pressure a CEO to cut his pay package, perhaps a worker revolt may. Mind you, that isn’t literally what the public is thinking, but the abuse of the power of the office by many CEOs calls for a countervailing force, and labor could credibly step into that breach.

A second reason is the Wal-Martization of workers. Employment at will and America’s weak safety nets seemed viable in a robust economy when employers felt some loyalty toward their workers. But now many companies see them as disposable, a cost rather than an asset. The degradation of job quality and security is producing a pushback.

Third is that some unions are moving away from the traditional reflexive opposition to management and are working to craft win-win situations, in which they work to improve the standing of the industry and also make certain they share in the gains. Andrew Stern, the head of the Service Employees International Union, which is the largest and fastest-growing union in America. A 2005 New York Times article discussed Stern’s approach at considerable length:

Over the years, union bosses have grown comfortable blaming everyone else — timid politicians, corrupt C.E.O.’s, greedy shareholders — for their inexorable decline. But last year, Andy Stern did something heretical: he started pointing the finger back at his fellow union leaders. Of course workers had been punished by forces outside their control, Stern said. But what had big labor done to adapt? Union bosses, Stern scolded, had been too busy flying around with senators and riding around in chauffeur-driven cars to figure out how to counter the effects of globalization, which have cost millions of Americans their jobs and their pensions. Faced with declining union rolls, the bosses made things worse by raiding one another’s industries, which only diluted the power of their workers. The nation’s flight attendants, for instance, are now divided among several different unions, making it difficult, if not impossible, for them to wield any leverage over an entire industry.

Stern put the union movement’s eroding stature in business terms: if any other $6.5 billion corporation had insisted on clinging to the same decades-old business plan despite losing customers every year, its executives would have been fired long ago…..

Having grown up around his father’s small-business clients, and having spent much of his adult life at bargaining tables, Stern had learned a few things about the way business works. He came to embrace a philosophy that ran counter to the most basic assumptions of the besieged labor movement: the popular image of greedy corporations that want to treat their workers like slaves, Stern believed, was in most cases just wrong. The truth was that companies in the global age, under intense pressure to lower costs, were simply doing what they thought they had to do to survive, and if you wanted them to behave better, you had to make good behavior viable for them.

Stern’s favorite example concerns the more than 10,000 janitors who clean the office buildings in the cities and suburbs of northern New Jersey. Five years ago, only a fraction of them were unionized, and they were making $10 less per hour than their counterparts across the river in Manhattan. Stern and his team say they were convinced from talking to employers in the fast-growing area that the employers didn’t like the low wages and poor benefits much more than the union did. Cleaning companies complained that they had trouble retaining workers, and the workers they did keep were less productive. The problem was that for any one company to offer better wages would have been tantamount to an army unilaterally disarming in the middle of a war; cheaper competitors would immediately overrun its business.

The traditional way for a union to attack this problem would be to pick the most vulnerable employer in the market, pressure it to accept a union and then try to expand from there. Instead, Stern set out to organize the entire market at once, which he did by promising employers that the union contract wouldn’t kick in unless more than half of them signed it. (Getting the first companies to enter into the agreement took some old-fashioned organizing tactics, including picket lines.) The S.E.I.U. ended up representing close to 70 percent of the janitors in the area, doubling their pay in many cases, from minimum wage to more than $11 an hour. Stern found that by bringing all of the main employers in an industry to the table at one time, rather than one after the other, he was able to effectively regulate an entire market.

This is a huge departure from the union thinking of old, and the SEIU’s success is likely to bring other unions around to a similar posture.

From the Financial Times:

The US has an unusually low rate of union membership. Barely 10 per cent of its workers are members (and as few as 7 per cent in the private sector), down from about 35 per cent in the 1950s. Whether you see this as a strength or a weakness most likely depends on whether you think the US economy is succeeding or failing. Weak unions make for flexibility and rapid growth in productivity, the engines of US economic pre-eminence. To see what strong unions do for industrial competitiveness, look at GM. But weak unions also squeeze wages at the bottom, worsen inequality and create economic insecurity, the issues that most preoccupy the country and its politicians.

Avidly courting union endorsements in the approaching presidential primaries, all the Democratic candidates are taking a pro-union stance…These are not just rhetorical commitments. All the candidates are supporting legislation promoted by the labour movement that would make it easier for unions to organise…

American workers have often been cool towards unions. In the mid-1990s polls generally found that only about a third of non-union workers wanted to join one. In the past few years, the proportion has risen to more than half. The Democrats’ beefed-up pro-union line is faithfully reflecting this shift in mood. Both spring from the economic strains and insecurity of which so many Americans complain.

But is a recovery of union power a good answer to those problems? GM notwithstanding, the idea should not be dismissed out of hand. Certainly, enough of the wrong kind of union activity can wreck an economy. Britain made that clear in the 1960s and 1970s. But unions need not be so obtusely adversarial and self-destructive. Unions and works councils in Germany and Japan have not impoverished those countries. Unions do raise wages, sympathetic economists point out. When they do, it is usually in industries where product markets are not very competitive and there is a rent for managers to share with labour. When product markets are competitive, there is no rent to divide: the effect of unions on wages is then typically smaller and no economic harm is done.

Pro-union economists also point to evidence that productivity may actually be higher when a union is present, provided that the enterprise is well run to begin with. Perhaps higher wages enable managers to hire better workers, or else encourage companies to invest in labour-saving machinery. This could make for a productive, profitable company with contented workers – although not without losers, one must remember. Because of higher-than-competitive wages, employment is lower than it would have been. The insiders gain, in the best case at little or no cost to shareholders. But outsiders are worse off.

As a rule, though, unions are bad at accommodating disruptive change – the very thing the US does best. The weakness of the country’s unions is surely no coincidence: they are weak because the economy is dynamic, and vice versa. American unionism has modernised lately, but much of what remains is still political and adversarial. Its body language says, we are out to get the bosses. It seeks a voice not just for workers in the office or factory, but for labour in the aggregate. Its agenda is anti-competitive and stridently protectionist, and consequently anti-growth.

The late Rudiger Dornbusch, ever a fount of economic wisdom, was fond of the maxim, protect the worker not the job. Unions are wired to ignore that good advice. Their leaders’ power and pay is bound up with the existence of particular jobs. They are institutionally opposed to creative destruction and economies need a lot of that to thrive. But if workers, not jobs, are to be protected, governments do need to step in. The list is familiar, and has a strongly Democratic flavour: more generous employment subsidies for the low-paid, high-quality education, universal health insurance and help for workers who fall victim to restructuring.

Although I’m not keen about the dollar’s prospects over the next 2-3 years, a Bloomberg story says that it appears to be oversold relative to the euro. However, this view is based on technical analysis, which some dismiss as a close cousin to astrology.

From Bloomberg:

The euro’s record-setting rally may not extend through the end of October, according to analysts who rely on market patterns for their predictions.

No fewer than half a dozen indicators that measure the speed and slope of a currency’s rise and foreshadowed the euro’s three biggest slumps of the past year show the best may be over after it strengthened 4.7 percent last month to its all-time high of $1.4278. Citigroup Inc., the largest U.S. bank, says the euro may drop to below $1.37 unless the currency maintains its momentum.

“We are a little more cautious,” said Tom Fitzpatrick, Citigroup’s global head of currency strategy in New York. “Whenever you see acceleration” of this magnitude, “it’s a sign we may have a correction,” he said.

The euro’s appreciation is putting pressure on the European Central Bank to find a way to curb the gains. French President Nicolas Sarkozy and Fiat SpA Chairman Luca Cordero di Montezemolo complain that the rise in the currency shared by 13 European nations is hurting their economies….

The currency may drop as low as $1.367 by the end of October, according to Citigroup and Zurich-based UBS AG, the biggest currency traders after Frankfurt-based Deutsche Bank AG. A Bloomberg survey of 45 banks and brokerages set the euro at $1.40 by January and $1.34 at the end of 2008.

Technical analysis, popularized by Charles Dow, creator of the Dow Jones Industrial Average in 1896, is based on the theory that a chart of the price of any asset or index contains clues about future movements.

Those indicators watched by traders say the euro is becoming too expensive. The currency’s 14-day relative strength indicator reached 80.65, almost double a month ago. The gauge measures the momentum of price changes. Readings above 70 and below 30 indicate a reversal may occur.

The euro dropped 3.2 percent in the five weeks following the last time the index passed 80 in December 2006. It fell 3 percent in the seven weeks after the index exceeded 70 in the last half of April, and the currency tumbled 3.5 percent in the three weeks after it topped 75 in late July.

“Most technical indicators — stochastic, momentum or relative strength — are telling us the euro is extremely overbought,” said George Davis, chief technical analyst at RBC Capital Markets in Toronto. “The prospect for a short-term correction is getting bigger every day the rally is sustained.”….

Trading envelopes, which measure how far from the mean a price has strayed, and commodity channel indicators showing when a currency is overbought also suggest that the euro has reached extreme highs.

Goldman Sachs Group Inc. advised investors last week to sell euros bought since Aug. 16 because indicators show “the probability of consolidation is quite high,” said Jens Nordvig, a New York-based strategist at the firm.

Tanta at Calculated Risk, in one of her usual colorful explanations, tells us the real pitfall of stated income loans, and it’s not one you might expect.

She works through an example of an entrepreneur who doesn’t report all his income (as an aside, she’s not keen to reward that behavior and works through the implications for the bank if issues a stated income loan with the guy claiming just enough income so that his debt-to-income ratio falls within accepted norms, versus a “full doc” which shows his true (according to the IRS) DTI of 68%.

The fully documented loan not only requires more internal sign-offs and regulatory reporting, but it is also a red flag to bank examiners and investors, almost certain to require further explanation.

So this makes the no doc look like a win-win, right? It saves the bank all kinds of hassle and expense, and is easier for the borrower too.

The problem that everyone has been ignoring is that the borrower had better be damned certain he can make good on the loan, because he is assuming liability that the bank ought to be bearing. If the loan goes bad, the borrower can be prosecuted for fraud. As Tanta informs us:

have said before that stated income is a way of letting borrowers be underwriters, instead of making lenders be underwriters. When I say make lenders be lenders, I don’t mean let’s not regulate them. I have no problem with regulatory examinations; far from it. I am someone whose signature (usually, in fact, as that second sign-off) has appeared on exactly these kinds of loans, and whose butt has been on the line for them. We all face having loans we approved go bad; the world works that way. What the stated income lenders are doing is getting themselves off the hook by encouraging borrowers to make misrepresentations. That is, they’re taking risky loans, but instead of doing so with eyes open and docs on the table, they’re putting their customers at risk of prosecution while producing aggregate data that appears to show that there is minimal risk in what they’re doing. This practice is not only unsafe and unsound, it’s contemptible.

We use the term “bagholder” all the time, and it seems to me we’ve forgotten where that metaphor comes from. It didn’t used to be considered acceptable to find some naive rube you could manipulate into holding the bag when the cops showed up, while the seasoned robbers scarpered. I’m really amazed by all these self-employed folks who keep popping up in our comments to defend stated income lending. It is a way for you to get a loan on terms that mean you potentially face prosecution if something goes wrong. Your enthusiasm for taking this risk is making a lot of marginal lenders happy, because you’re helping them hide the true risk in their loan portfolios from auditors, examiners, and counterparties. You aren’t getting those stated income loans because lenders like to do business with entrepreneurs, “the backbone of America.” You’re not getting an “exception” from a lender who puts it in writing and takes the responsibility for its own decision. You’re getting stated income loans because you’re willing to be the bagholder.

And no, this doesn’t particularly do much for my assessment of your business acumen. Frankly, I’d rather see your tax returns and your P&L and hear your story about how investments in the business you have made, with the intent to grow it wisely, have limited your income or made it highly variable, than to see you volunteer to risk prosecution for fraud because, you know, you really need to buy a house. Do you do business with people like that all the time? Are you typically attracted to deals that are claimed to be perfectly legitimate, except that it’s important not to fully disclose certain facts to certain parties? Does that maybe explain some of your accounts receivable problems and your pathetic cash flow? It certainly seems to be explaining some lenders’ cash-flow problems at the moment.

This isn’t just an issue for regulated depositories. All those claims by securities issuers and raters about how we had no idea that gambling was going on in this joint are directly comparable. The tough news for the self-employed “respectable” borrower is that I don’t care if you’re individually willing to play bagholder: you can’t afford to underwrite that collective risk. We have a major credit crisis that’s proving that.

The Wall Street Journal has broken the story that UBS will announce that it is writing down its fixed income book as much as 4 billion Swiss Francs, or roughly $3.4 billion, which will result in losses of 600 to 700 million SFr for its third quarter.

Although this write-off is greater than those taken by other investment banks like Lehman and Morgan Stanley whose quarters end a month earlier, and thus aren’t exactly comparable, UBS may have company soon. As the Journal observed:

Among banks that haven’t yet reported, Merrill Lynch & Co. faces a possible third-quarter write-down of as much $4 billion to reflect losses on mortgage-related securities and buyout-financing commitments, a Wall Street analyst predicted last week.

Part of the Journal’s discussion, however, warrants a bit of further explanation:

The write-downs represent the first big stamp made by UBS’s new CEO, Marcel Rohner, who was named in July after the bank ousted his predecessor in the wake of the shutdown of its internal fund, Dillon Read Capital Management. Mr. Rohner said shortly after taking control of UBS that he would pursue a more conservative strategy, such as limiting growth of UBS’s investment bank. In setting its write-down, UBS is valuing its assets conservatively, people familiar with the matter said. A write-down would also let Mr. Rohner try to ring-fence problems that started before he took the helm.

According to a person familiar with the matter, Mr. Rohner now will personally oversee UBS’s investment-banking division in place of investment-banking CEO Huw Jenkins. The London-based Mr. Jenkins has overseen the division for the past two years, a period in which it grew aggressively, and also took on risks linked to the U.S. subprime-mortgage market at a time when those assets were already beginning to founder. As the damage from the division’s trading strategy began to unfold Mr. Jenkins in early August replaced the bank’s fixed-income chief, but its troubles mounted in the months that followed.

First, Marcel Rohner’s “ring fencing” means he has an incentive to recognize not just actual losses, but any likely losses. It’s in his interest to take one massive, comprehensive hit now, rather than have the Chinese water torture of continuing quarterly write-downs that would reflect badly on him. That means, to the extent that there is any uncertainty in how to mark positions, they will have taken a negative view.

This in turn implies their results are likely not to be comparable to those of other firms, who don’t have cause to get all the bad news out at once. In fact, other Wall Street firms are likely exploiting whatever valuation latitude they have to show a more flattering picture, particularly since some managers doubtless believe (or at least hope) this credit contraction will reverse itself soon.

Query whether the SEC will take an interest in the almost-certain valuation disparity between UBS and its peers.

Another issue is simply one of nomenclature. Because UBS is a universal bank, meaning it is both a commercial and an investment bank, its investment banking division comprises its entire securities operation. That’s a different use of terms than you find in a pure investment bank, whose investment banking operations consist of services sold to corporations, such as corporate finance, M&A, and so on. In these firms, the various trading operations, such as fixed income and equities, are housed in separate units. Thus, the statement “the damage from the [investement banking] divisions’s trading strategy” would make no sense at, say, a Goldman. They don’t have trading operations in their investment banking division.

The story also characterizes UBS’s woes as a result of having expanded its investment banking operations too quickly when the problem appears to have been quite specific:

UBS’s fixed-income division suffered after the bank set up Dillon Read, the in-house hedge fund it started in June 2005, because the unit siphoned off many of the bond team’s best traders.

Losses from Dillon Read widened to 230 million Swiss francs in the second quarter from 150 million Swiss francs in the first quarter, UBS said. Shutting it down cost the bank $314 million in the second quarter to cover restructuring, severance payouts and write-downs of unused rental space for the traders.

The latest losses are, in part, a result of continued costs of writing off Dillon Read’s soured mortgage bets, but they are also a result of other securities held by the fixed-income division.

Whether or not UBS’s bond traders were decent traders (note that trading on a day-to-day basis and acting as a proprietary trader, which is more or less what hedge funds do, are two very different skills), they weren’t very successful at running a hedge fund. And it has now become evident that UBS didn’t have the bench depth in its fixed income unit to support a major exodus of talent. Leaving a major trading operation in unseasoned hands is a prescription for disaster.

The coverage in the Financial Times echoes the Journal’s concerns about earnings at other investment banks:

But in recent days, analysts have become more concerned about the prospects for some of the banks whose quarter ends in September. Deutsche Bank shares were hit last week amid concerns that it will take big writedowns. Analysts have also dramatically reduced their forecasts for Merrill Lynch with William Tanona at Goldman Sachs predicting it will have barely broken even because of multi-billion-dollar mark-to-market losses on leveraged loans and collateralised debt obligations.

The prolonged disconnect between the debt and equity markets is bizarre. Historically, credit market corrections precede equity downturns; once in a while, as in 1997-1998, they send a false positive, so equity investors feel justified in not taking every blip in the credit markets to heart. (And we aren’t the only ones to think along these lines, witness this post by Michael Panzner).

But although there is a good deal of variability, in the stone ages, the typical lag between a tighter credit and an equity decline was four months, and the tendency has been for it to shorten. If you put the beginning of the credit downturn at June 7, when ten year Treasury bond yields jumped upwards, breaking a long-established historical pattern that traders saw as a sign of the long decline in interest rates, the equity markets still have some time before a correction looks overdue.

Of course, the reason for the cheer in stock-land is that the Fed rode in to the rescue on September 18 with its 50 basis point cut in the Fed funds rate. But did that work as well as the bulls would have us believe?

We noted Friday that the commericial paper markets were still rocky, and the Financial Times reported Saturday the credit markets look weak:

Markets and the world economy are in a no-man’s-land 11 days after the US Federal Reserve’s dramatic half-point interest rate cut….conditions in the interbank money market and other troubled corners of the financial system remain far from normal….

If the US economy does deteriorate severely from here, sickly credit markets would have to absorb another shock: this time from rising expected defaults on a wide range of US assets. That could put the market healing process into reverse.

Even before Friday’s distress sale of Net Bank, a US internet bank, Fed officials were wary of assuming that the crisis is past.

Fed policymakers do see a welcome change in tone and sentiment since their rate cut, with investors starting to differentiate much more between assets and investment vehicles.

The effects of this have been most marked in the asset-backed commercial paper market (ABCP), where stress is now more tightly confined to paper backed by problem mortgages and special investment vehicles (SIVs) that are not backed by strong banks. Credit spreads have also narrowed.

The market for leveraged buy-outs is starting to re-open and spreads between agency conforming and non-conforming mortgages have tightened a little.

But Fed officials still believe markets are fragile. They are a little concerned by the slow progress in the non-conforming mortgage market.

While interbank lending spreads as well as rates fell in the aftermath of the rate cut – much to the relief of Fed policymakers – spreads have moved up again.

“There is still a clear dislocation in money markets and the new high in Euribor is a genuine worry,” said Dominic Konstam, head of interest rate strategy at Credit Suisse. “Volumes in the market are running at 10 per cent of normal activity.”

Officials blame the latest uptick in interbank spreads on quarter-end and year-end husbanding of liquidity. They see that big banks are still hoarding cash owing to uncertainty about how many assets currently held in investment vehicles will come back on balance sheet.

With mostly smaller and weaker banks seeking to borrow, interbank lending rates have been pushed up by so-called “adverse selection”.

Policymakers do not expect markets to recover rapidly, in part because of the overhang of securities. Weak SIVs unable to obtain financing may have to liquidate their portfolios, while banks still have a huge portfolio of leveraged loans to distribute.

Most investors still lack valuation models capable of evaluating the most complex credit products.

The Fed rate cut “does not cure the ills of the liquidity crisis”, said Jim Caron, co-head of global interest rate strategy at Morgan Stanley. Many institutions have had to rely on shorter-term funding in recent weeks, making them vulnerable to bad news….

It is possible for improvement in market functioning to co-exist with increasing concern about the economy – but not for long. Either the economic data will point upwards, in which case the market healing process should speed up, or they will point downwards and then markets are likely to take another turn for the worse.

Dennis J Snower at VoxEU reaches a similar conclusion via a different route. He believes a mere continuation of the credit crunch will hurt growth. Worse, given that the pullback was the result of overvalued US housing, and many other economies have real estate that is even more overpriced than ours was, he is worried about the possibility of housing contagion.

From VoxEU:

For years economists and policy makers have worried about the fragility of the US economy, and particularly about the un-sustainability of the US housing boom, but when the shock finally occurred, everyone – central banks, commercial banks, hedge funds, private investors – appears to have been unprepared. The big surprise was the nature of the shock. Suddenly banks stopped lending to one another, except on punitive terms. Liquidity dried up, threatening the existence of otherwise well-functioning banks and businesses. The crisis of confidence jumped across US borders with ease, as the recent run on Northern Rock has shown. How will this financial turbulence affect the world economy?….This is my purpose – not to make a forecast, but to warn of possible dangers ahead.

Investors tend to imagine that the world will continue to be approximately like it is now. Before the US Federal Reserve reduced the benchmark interest rate by one-half percentage point on Tuesday, September 18, financial markets were in despair; afterwards they were euphoric. Such myopia is dangerous. So far, economic activity – production, employment, consumption, investment and trade – have remained largely unaffected by the credit crunch. Many seem to believe this will continue. Equally dangerous.

If the credit crunch persists, there can be no doubt that economic activity will suffer. The Fed’s interest rate cut will not prevent US home foreclosures, nor will it eliminate the glut of unsold homes. If US house prices continue to fall and unemployment continues to rise, consumers will doubtlessly reduce their spending, and the fall in demand will aggravate the rise in unemployment, hurt the US stock market, and thus lead to a further fall in spending.

Meanwhile, it is worth keeping in mind that the US is not the only country where house prices have risen much faster, on average, than national incomes. On the contrary, house prices in Australia, Britain, Denmark, France, Ireland, Spain, and Sweden have all increased faster, over the past ten years, than in the US. Of course the US is a special case on account of its subprime mortgage lending towards the end of its housing boom. There, mortgage lenders with poor credit records could buy houses at virtually interest-free for a few years, before the rates were adjusted steeply upwards. But the danger of international contagion remains. The US housing slump may well lead investors in Europe to reassess the value of their properties. If that happens, then consumption spending is likely to fall in the countries listed above, leading to weaker labour markets.

This could happen at a time when the Chinese economy has overheated and will need to slow down, and when the Japanese economy is stagnating. There are no other countries to take-up the slack, to serve as a “motor” for the world economy, as the US has done for so long.

The New York Times’ Grectchen Morgenson, in “Can These Mortgages Be Saved?” looks at Countrywide’s loan modification operation (in typical bureaucratic doublespeak called HOPE: “Helping homeowners, Offering solutions, Preventing foreclosures and Envisioning success”) and finds it wanting.

Unlike some recent Morgenson pieces, this article is remarkably free of snide remarks or swashbuckling prose. Instead, Morgenson offers some examples of homeowners who were given the runaround by Countrywide when they tried to get their loans modified. These vignettes are intespersed with Countrywide’s defenses of its practices (which are remarkably unconvincing) and comments from organizations who work with delinquent borrowers, all of whom confirm that Countrywide is the less willing than other mortgage servicers to mod loans, and by a considerable margin.

But mortgage mavens will still likely find fault with the piece. Even though Morgenson gives specific details about how and when the borrowers got in trouble and how their overdue amounts escalated, she doesn’t give as much information as one would like as to how things spun out of control. It sounds as if she did, or could easily have, gotten documents from the victims. She could have put them to better use.

In addition, in one of Morgenson’s examples, it sounds as if the borrower was defrauded. Countrywide charged one Shannon Rivas-Spivey for flood insurance for reasons that turned out to be bogus, yet it appears Rivas-Spivey never got the charges reversed. Something doesn’t add up, and Morgenson didn’t get to the bottom of it.

Nevertheless, some of the quotes and factoids are compelling:

Countrywide strongly disagrees. Last week, it described its efforts on behalf of troubled homeowners. “Our No. 1 priority is to help borrowers stay in their homes,” said Steve Bailey, a Countrywide executive, in a news release. The company said it has saved 39,582 mortgages from foreclosure so far this year….

Even so, the workouts that Countrywide boasted about last week include two types of deals that wind up forcing borrowers from their homes. Almost 14 percent of its homeownership preservation efforts involved borrowers who agreed to sell their homes for less than their loan amounts, called a short sale, or involved homeowners turning over their deeds to Countrywide to prevent a foreclosure. Countrywide did not disclose in its news release that such arrangements were included in its workout figures.

“When you look under the surface, they are counting deeds-in-lieu as a modification,” said Martin Eakes, chief executive of the Center for Responsible Lending, a nonprofit and nonpartisan research organization. “When you’ve taken someone’s house, even without the foreclosure process, to count that as a modification is worse than fiction.”….

Even as Countrywide maintains that helping its borrowers modify their loans is its top priority, its investors have heard a slightly different story. In a conference call with analysts and investors in late July, Kevin Bartlett, Countrywide’s chief investment officer, counted about 2,000 loan modifications done in June. Most of those, he said, involved deferring overdue interest or adding the past due amount to a loan. The company rarely provides workouts that reduce interest rates on loans, Mr. Bartlett told investors.

Yet reducing rocketing interest rates is exactly the relief that many borrowers are seeking because, consumer advocates say, that is the only way they can afford to stay in their homes. Loan experts say that when workouts involve deferring overdue interest or tacking amounts owed onto the back of a loan, borrowers often wind up in trouble again in just a few years.

Mr. Bailey said that while Countrywide has historically done few interest rate reductions, it will be doing more. “Right now we have just about 1,000 loans facing interest rate reductions,” he said. “The pendulum is swinging that way.”

But Mark Seifert, executive director of Empowering and Strengthening Ohio’s People, a consumer advocacy group in Cleveland, is dubious. He said his experience with Countrywide, one of the dozen or so lenders and servicers with whom he works on behalf of borrowers, has been unsatisfactory.

For the first eight months of this year, he said, his group took in 132 cases in which Countrywide was the loan servicer. Of those, two ended up in what he called “very good” workouts from the company. One involved forged documents when the original loan was made, Mr. Seifert said, and the other involved a borrower who received her deal from Countrywide the day before she was set to testify before Congress last July about her problems with the company.

“We have experience with Citi, Chase and a whole litany of other lenders,” Mr. Seifert said. “Some are better than others, but we are successful more than half the time with all of them. Except Countrywide.”….

Bruce Marks is founder of the Neighborhood Assistance Corporation of America, a nonprofit advocacy and mortgage company that helps troubled borrowers get new, low-cost loans. He sees problem mortgages from across the country and works with a variety of lenders. He said that his organization has resolved 3,500 cases for imperiled borrowers this year, and that none have had to leave their homes.

Mr. Marks, too, characterizes Countrywide as the lender most unwilling to help borrowers.

“Homeowners who are desperate to keep their homes are trying to restructure the mortgages to the payment before the rates reset,” he said. “Countrywide demands their last dollar and their retirement funds to stop a foreclosure on unaffordable loans.”

You cannot make this stuff up….From the US Patent and Trademark Office:

Outsourcing of services

Abstract

A method for identifying human-resource work content to outsource offshore of an organization. The method is provided on a computer readable medium and includes the steps of identifying at least one task being performed by an organization; associating each identified task with a functional group within a plurality of functional groups related to the organization; determining information about individual human resources spent on each task; determining task information about human resources spent on the plurality of tasks, the task information based on the determined information about individual human resources spent on each task; using the determined task information to determine a value of each task; and outsourcing tasks having a value lower than a predefined limit to at least one of offshore and to a low cost supplier….

Assignee Name and Address: International Business Machines, Armonk, NY.

It seems peculiar indeed that a sea change in the world economy, namely, the decline of the international funds flow generally called “global imbalances,” has gotten so little attention.

“Global imbalances” refers to capital flows from high savings countries such as China, Taiwan and Japan, funding current account deficits (meaning consumption) in the US. They have become as fundamental to the operation of the world economy as the Gulf Stream is to the climate, and changes in it would produce a similar level of disruption.

This topic has garnered comparatively little attention in the financial press relative to its importance. There was a sobering discussion by Martin Wolf at the Financial Times recently. But for the most part, the discussion, even by Serious Economists, is on the decline of the dollar, and it seems for the most part to be considered in isolation. An exception that proves the rule is a comment by Paul Krugman (in keeping, on his blog, not in his New York Times column) that points to a recent paper of his that addresses the issue but frames it in terms of a possible “dollar plunge”:

There is little doubt that the dollar must eventually fall from current levels. Trade deficits on the current scale cannot continue forever – and we are all fond of quoting Stein’s Law: ‘If something cannot go on forever, it will stop.’ Closing the trade deficit will require a redistribution of world spending, with a fall in US spending and a rise in spending abroad. One occasionally hears assertions that this redistribution of world spending can lead to the required change in trade deficits without any need for a change in real exchange rates – a view John Williamson once felicitously described as ‘the doctrine of immaculate transfer’. In fact, however, a redistribution of world spending will require a fall in the relative prices of US-produced goods and services, because US spending falls much more heavily than the spending of other countries on those US-produced goods and services. So there must, eventually, be a real depreciation of the dollar. But this depreciation could be gradual, a few percent per year or less. Why should it take the form of a discrete drop?

There has actually been surprisingly little discussion of this question, even in papers that can seem, on a casual reading, to be about the prospects for a dollar plunge. For example, the widely cited work of Obstfeld and Rogoff about dollar adjustment, continued in their 2005 Brookings paper, is often cited as reason for alarm. But their framework is designed to estimate the size of the dollar decline needed to eliminate the current account deficit; it sheds little light on whether that decline will happen quickly, as opposed to a gradual adjustment over the course of a number of years.

The closest any paper in the 2005 Brookings symposium came to addressing that question directly was Edwards (2005), whose view is echoed less clearly in a number of discussions. The basic idea can be summarized as follows: there has been an
upward shift in the proportion of US assets that foreign investors want to hold in their portfolios. As long as foreign investors are still in the process of moving to this new, higher share of dollars in their wealth, their actions generate a large capital flow into the United States. But the capital flows needed to maintain an increased dollar share in portfolios are much smaller than those required to achieve that share. So once the desired holdings of US assets have been achieved, the argument goes, capital flows into the United States will drop off sharply, leading to an abrupt decline in both the current account deficit and in the dollar.

Note that the scenario that Krugman describes above, that foreign investors will reach a target level of dollar holdings and then become much less keen about buying more dollars to keep funding US deficits, leading to a fall of the dollar. That process appears to be underway. As we have noted before (see here and here for examples), foreign central banks, which have been the biggest buyers of the US currency, have begun to diversify away from the greenback.

A post by Michael Pettis on Brad Setser’s blog (which does a very good job on the currency beat) takes a different angle than Krugman: he anticipates that an end of global imbalances will lead to a prolonged economic slowdown, with or without a sharp correction of the dollar:

As I said in an earlier post I believe that the recycling of the US trade deficit has been the main factor underpinning the recent globalization cycle. If so, and when the current cycle ends, if history is any indication the adjustment from the insanely happy days of too much liquidity (with its attendant surge in risk appetite) to a more “normal” level of liquidity will be a very difficult one and can result in significantly reduced global growth lasting many years – especially for those countries that begin the slowdown with the weakest and most rigid financial systems.

In previous cycles, financial systems, which during the good times had evolved into greater risk-taking activity and more-tightly-stretched asset-liability structures, were suddenly caught short by the secular change in risk appetite. In many cases their ability to intermediate the flow of capital slowed considerably, and what followed often involved considerable economic slowdown.

My evidence is largely anecdotal, but it seems to me that those countries with the highest levels of financial risk-taking and the least flexible financial systems were the ones that did most poorly – the United States in the 1930s, with its reliance on thousands of small banks with rigid deposit bases, a weak and inexperienced central bank, and an investment banking industry in shock, of course did among the worst, although there were plenty of other non-financial factors that exacerbated the problem (by the way, it is worth remembering that in 1929 the US had, after several years of very high trade and capital account surpluses, very high levels of reserves, which in the end didn’t help).

The reputation of drug companies has taken a beating in recent years. Their prices have risen much faster than inflation (except for last year, when generics had some impact), makes them almost universally suspect. The industry’s claim that its fat margins are warranted by its investment in research doesn’t bear much inspection. 45% of drug R&D is government funded. Moreover, Big Pharma spends more on marketing than on research. Can you think of another business that is profitable enough to warrant in person selling to small businessmen, which is what most doctors are?

One would expect the major drug companies to be particularly image conscious these days. An industry on the defensive seldom takes pot shots at one of its main regulators. Yet that is precisely what Novartis has chosen to do. From the Financial Times:

The Food and Drug Administration has become over-cautious in its assessment of new medicines following political pressure arising from safety controversies, Dan Vasella, chief executive of Novartis, said on Friday.

Mr Vasella, the only chief executive from one of the big pharmaceutical groups to attend the three-day Clinton Global Initiative in New York this week, said the medicine regulator had gone too far in seeking to evaluate drugs on criteria beyond their safety and efficacy.

“The FDA has become subject to politics,” Mr Vasella said. “If they are assailed like they are now, the best thing to do is nothing.”

Novartis has felt the sting of the FDA’s increasing focus on safety that sprung partly from US drugmaker Merck’s withdrawal of painkiller Vioxx owing to heart risks three years ago. Two drugs in Novartis’s pipeline, Galvus for type II diabetes, and painkiller Prexige, have met significant regulatory delays with the FDA.

Both Prexige and Arcoxia, Merck’s successor to Vioxx, have been denied approval by the FDA in spite of receiving approval around the world. The US safety issue has shaped their assessment to include a broader discussion of their place in the market and alternative treatments.

“The discussion on what this [drug] brings over and above what’s on the market is a question that’s being asked. The FDA doesn’t seem to trust the physicians any more,” Mr Vasella said.

Novartis is taking an interesting gambit, in claiming that it is the true defender of consumer interests and (by implication) the FDA is a bad guy by withholding useful medicines. (I imagine that the FDA has come to regret its change in policy in 1997 to allow direct to consumer advertising, which has given drug companies another channel to influence public perceptions. Note that the US and New Zealand are the only two advanced economies that permit it).

But Vasella’s charges don’t stand up to scrutiny. in reverse order, the FDA shouldn’t trust physicians. This isn’t a matter of trust, but of findings in properly designed studies. In addition, your average MD doesn’t have the time to keep up on medical research. And very few have expertise in study design or methodology. That’s precisely why they can be manipulated by drug detailmen. So implying that physicians are in a better position to judge efficacy and safety than the FDA is bogus.

The grist of Vasella’s argument is that two drugs, his Prexige and Merck’s Arcoxia that have been approved “around the world.” The FT should have examined that claim rather than treating it as fact.

I didn’t have to look far to find problems with both drugs. I started with Australia and hit pay dirt.

Australia and New Zealand have banned Prexige. From the Australian announcement:

Prexige was withdrawn on 10 August 2007 by the Therapeutic Goods Administration because of a small number of cases of serious liver side effects. If you take Prexige, stop taking it immediately and see your doctor to discuss an alternative to this drug and to arrange any tests you may need.

New Zealand was slightly more forgiving, allowing use only in very low doses:

The New Zealand Ministry of Health’s medicine watchdog Medsafe has withdrawn the supply of 200mg and 400mg Prexige tablets.

The anti-inflammatory drug has been blamed for the deaths of two people and for two others requiring liver transplants in Australia.

Medsafe spokesman Stewart Jessamine said its medicines adverse reactions committee (MARC) discussed the overall risks and benefits of the use of Prexige with regulators in Australia, Singapore and the United Kingdom.

“This increased risk of liver damage for Prexige outweighs any of the potential benefits claimed for the 200mg and 400mg dose,” Jessamine said.

The 100mg Prexige tablets would stay on the market, though would be closely monitored.

Similarly, Australia did not approved Etoricoxib, the chemical name for Merck’s Arcoxia in its initial review in 2004, citing safety concerns. After the Vioxx scandal in the US, the Therapeutic Goods Administration decided that it would be approved only for very limited use:

It is proposed to greatly limit the approved uses of two other Cox-2 inhibitors which have not yet been marketed in Australia. They are etoricoxib and lumiracoxib. In both instances, ADEC was not sufficiently assured of the safety of these drugs for anything other than short term use in patients without increased cardiovascular risk.

So the idea that the US is tougher than other drug regulators is exaggerated. And by happenstance, a story in the New York Times yesterday depicts an FDA not only grossly understaffed in the area that oversees clinical trials, but also strongly inclined to downgrade any problems found:

In a report due to be released Friday, the inspector general of the Department of Health and Human Services, Daniel R. Levinson, said federal health officials did not know how many clinical trials were being conducted, audited fewer than 1 percent of the testing sites and, on the rare occasions when inspectors did appear, generally showed up long after the tests had been completed.

The F.D.A. has 200 inspectors, some of whom audit clinical trials part time, to police an estimated 350,000 testing sites. Even when those inspectors found serious problems in human trials, top drug officials in Washington downgraded their findings 68 percent of the time, the report found. Among the remaining cases, the agency almost never followed up with inspections to determine whether the corrective actions that the agency demanded had occurred, the report found.

“In many ways, rats and mice get greater protection as research subjects in the United States than do humans,” said Arthur L. Caplan, chairman of the department of medical ethics at the University of Pennsylvania.

So Vasella is 100% correct. Politics have a great deal to do with drug approvals. My FDA lawyer buddies tell me that the FDA enforcement area is understaffed precisely because its budgets have been cut by Congress.

But those politics already operate very much in favor of the drug industry.

A couple of stories confirm that, despite the peppy response of the equity markets and the return to more-or-less upbeat reporting in the financial media, the Fed’s 50 basis point cut has not restored normalcy to the sector most in need of aid, namely, the money markets.

Central bankers have limited and for the most part, crude tools. One of the concerns voiced in the run-up to the September FOMC meeting was that the credit market crisis was, as UCSD economist James Hamilton put it, “bank run on non-banks.” Thus, measures designed to shore up banks, like the use of the discount window, would have no impact, and a general rate reduction might or might not help the battered sector (a rate reduction won’t help problems related to transparency, and will have only a marginal impact on solvency) but would increase prices of asset classes that benefit from lower short term rates.

One sign of the limited impact of the Fed’s move: commercial paper outstandings are continuing to shrink. While the rate of decline has moderated, if the Fed’s intervention has worked, CP outstandings would instead be rising.

From Bloomberg:

The decline in the U.S. commercial paper market slowed last week, after the Federal Reserve cut interest rates to shore up confidence in the credit markets.

Debt maturing in 270 days or less fell by $13.6 billion in the period ended yesterday to a seasonally adjusted $1.86 trillion, including a $17.3 billion decline in asset-backed commercial paper, according to the Federal Reserve in Washington.

The amount outstanding has fallen by $368.1 billion, or 17 percent, over seven straight weeks to the lowest since August 2006 as some issuers were shut out of the market. The decline is smaller than the previous week’s drop of $48.1 billion, a sign that the credit crunch in short-term debt markets may be subsiding following the Fed’s half-percentage-point reduction in its benchmark rate on Sept. 18.

“The commercial paper market is not deteriorating as fast as it was in August, but as long as outstandings continue to fall, it is not out of the woods yet,” Christopher Low, chief economist at FTN Financial in New York, wrote in a note to clients.

Note that in the acute phase of the credit contraction in August, CP outstandings fell by roughly $90 billion a week for two weeks running, then $60 billion the week after that.

John Authers of the Financial Times tells us that pricing also indicates that the commercial paper market is still traumatized:

Markets have had more than a week to digest the dramatic cut in the Fed Funds rate to 4.75 per cent. Has it worked?

It has stimulated equities…Intriguingly, it has also made money for commodity investors. The S&P GSCI non-energy commodity index is up a cool 16 per cent since the Fed cut the discount rate in August.

But the Fed was not acting for these people. It wanted to relieve the crisis of confidence in money markets, where doubts about the quality of collateral had sent soaring the rates at which banks could raise funds.

Here, there are two ways to look at it. The dollar Libor rate, at which banks lend to each other, fell by the full 50 basis points. Having touched 5.725 per cent, it is now 5.23 per cent.

In asset-backed commercial paper 90-day paper rates reached 6.25 per cent and have come back down to 5.37 per cent.

So the rate cut reduced the cost of finance, bringing it back down to the levels before the crisis. This is important.

But there is a second way to look at it. Normally Libor and commercial paper are closely tied to Fed Funds. Both tend to be only slightly higher than Fed Funds, reflecting only slightly higher risks. When those spreads suddenly widened, it signalled a crisis of confidence.

Those spreads are as wide as they were before the rate cut. In July, commercial paper traded at only 4bp above Fed Funds. That spread is now 62bp. Three-month Libor usually trades at 10 or 11bp above Fed Funds: that spread is now 45bp.

So the rate cut euphoria has not flushed the underlying lack of confidence out of the system. The money market shows banks are still fearful of ugly surprises in the next few months. Maybe that should temper the roaring equity and commodity markets.

Bloomberg Magazine, in “Unsafe Havens,” reports that money market funds run by Bank of America Corp., Credit Suisse Group, Fidelity Investments and Morgan Stanley owned over $6 billion of CDOs with subprime debt in June.

The reason this is a serious issue is that money market funds have a $1 NAV, meaning “net asset value” rule. The funds are required by the SEC to invest conservatively. In practice, they always to maintain principal value. But as the article explains, this sort of investment puts the funds at risk of breaching the $1 NAV requirement.

What this article tells us, in effect, is that investors weren’t completely nuts to have dumped money market funds for Treasuries in August. Of course, they probably should have called the fund manager first, since most large fund management firms, such as Vanguard, correctly see this sort of paper as in appropriate for a money market fund.

The article is quite long but very much worth reading in its entirety; we’ve excepted the juicy bits. From Bloomberg Magazine:

Unbeknownst to most investors, some of the largest money market funds today are putting part of their cash into one of the riskiest debt investments in the world: collateralized debt obligations backed by subprime mortgage loans….

Money market funds with total assets of $300 billion have invested in subprime debt this year….

Under SEC rules, money market managers must invest in securities with “minimal credit risks.” Joseph Mason, a finance professor at Drexel University in Philadelphia and a former economist at the U.S. Treasury Department, says subprime debt in money market funds is far from safe.

“This creates tremendous risk for today’s money market investors,” says Mason, who wrote an 84-page report on CDOs this year. “Right now, I’m not comfortable investing anything in CDOs.”….

On Aug. 9, BNP Paribas SA, France’s biggest bank by market value, froze withdrawals on three investment funds with assets of 2 billion euros because the bank couldn’t find a way to value its U.S. subprime bonds and other assets. CDOs aren’t bought and sold on exchanges and their trading has little transparency….

Bruce Bent, who in 1970 created the first money market fund, The Reserve Fund, says no money market fund should invest in subprime debt.

“It’s inappropriate,” Bent, 70, says. “It doesn’t have a place in money market funds. When I created the first money market fund, I said you have to have immediate liquidity, safety and a reasonable rate of return. You also have to have a situation where you’re not giving people headline risk.”

Investors have sought safety during the subprime meltdown by moving their holdings to U.S. Treasuries and money market funds. On Aug. 8, just after the Bear Stearns hedge funds filed for bankruptcy protection, U.S. money market fund total assets reached a record high of $2.66 trillion, with investors pouring $49 billion into such funds in one week, according to the ICI.

As a sign of stability, money market funds never allow their share price to rise above or fall under $1 for each dollar invested.

A money market fund that invests in subprime debt increases the risk that its share price could drop below $1. If 5 percent of a fund’s holding is subprime debt, and in a worst-case situation that asset collapses, then the value of the fund could drop to 95 cents.

Even if a fund’s value dropped below a dollar, banks and fund companies wouldn’t allow investors to lose money, says Peter Crane, founder of Crane Data LLC, the Westborough, Massachusetts-based publisher of the Money Fund Intelligence Newsletter.

“Fund companies will support the funds,” he says. “They won’t let them break $1 a share. The odds of money market funds breaking the buck are virtually nil.”

Just once has a money market fund failed. In 1994, a fund run by Community Bankers Mutual Fund of Denver invested in securities that defaulted. Investors were paid 96 cents a share, and the fund was liquidated.

The fund had invested 27.5 percent of its assets in adjustable- rate securities, whose values were tied to interest rate changes, the SEC found. The fund lost money as interest rates increased….

Lynn Turner, chief accountant of the SEC from 1998 to 2001, says the SEC will likely look into money market funds investing in CDOs, particularly because the value of subprime collateral of CDOs can collapse suddenly….

Commercial paper pays relatively low interest rates, which averaged about 5.3 percent in June and July, because it rarely defaults. There have been occasional exceptions, such as paper issued by Enron Corp. and WorldCom Inc., both of which filed for bankruptcy earlier in this decade.

CDO commercial paper, often loaded with subprime debt, pays higher returns than corporate paper, and it paid as much as 6.5 percent in August.

This year, CDOs have sold more than $11 billion in the form of investment-grade commercial paper to money market funds, SEC filings show. The paper has the highest credit rating because Fitch Ratings, Moody’s and S&P give AAA or Aaa ratings to the top portions of CDOs, which are the source of all CDO commercial paper.

Satyajit Das, a former Citigroup Inc. banker and author of 10 books on debt analysis, says those ratings are very misleading. “I don’t think the typical money market investor, in his wildest dreams, would assume he has exposure to the risk of subprime CDOs,” he says. “They may be in for an unpleasant surprise.”

Money market managers buy CDO commercial paper even when prospectuses warn of the risks.

Zurich-based Credit Suisse, Morgan Stanley in New York and San Francisco-based Wells Fargo are among money market managers that poured more than $1 billion into commercial paper issued by the Buckingham series of CDOs managed by Chicago-based Deerfield Capital Management LLC.

“Reliable sources of statistical information do not exist with respect to the default rates for many of the types of collateral debt securities eligible to be purchased by the Issuer,” say both the 2005 and 2006 CDO prospectuses backing commercial paper held in the funds.

Deerfield’s three Buckingham CDOs have directed $1.5 billion, or 40 percent of their $3.8 billion in assets, into subprime debt, according to their trustee reports. Billionaire Nelson Peltz’s Triarc Cos. agreed to sell Deerfield in April.

Morgan Stanley spokesman Mark Lake and Wells Fargo’s John Roehm declined to comment.

Tim Wilson, head of Credit Suisse’s cash management portfolio desk, says he’s comfortable with CDO commercial paper because it has the highest credit ratings and because his funds hold the debt for only one to three months.

“We don’t have any concerns these are going to have any defaults in 90 days,” he says. “We’re obviously watching.” The paper matures within three months, and after that the fund doesn’t hold any subprime debt, unless Wilson decides to buy more.

Vanguard Group Inc., the second-largest mutual fund company in the U.S., has a policy of never buying CDO commercial paper for its $90 billion in money market funds or $325 billion in fixed- income mutual funds.

“It really gets down to transparency questions,” says John Hollyer, risk management director at Valley Forge, Pennsylvania- based Vanguard. “Can you understand what you have? And can you measure it appropriately? We haven’t been comfortable that we could.”

Bank of New York Mellon Corp.’s Dreyfus unit has banned CDO commercial paper from its $110 billion in money market funds because it has found that analyzing subprime holdings in CDOs is too difficult.

The firm’s money market investment committee decided in 2005 that such paper was too risky, Dreyfus spokeswoman Patrice Kozlowski says. “The committee questioned the fundamental structure of commercial paper of CDOs,” she says. Dreyfus has never purchased CDO commercial paper, she says.

CDOs create what is supposed to be a safety net for buyers of their commercial paper. CDO managers reach agreements with banks to purchase their paper when nobody else will, so the CDO can pay off debt when it’s due.

Some fund companies, including Dreyfus, say those contracts don’t reassure them because they’re conditional and they aren’t guarantees. “The banks can refuse to fund,” Kozlowski says.

CDO paper has other risks, former banker Das says. “CDO commercial paper has a lot more moving parts than other kinds of commercial paper,” says Das, who wrote “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives” (FT Prentice Hall, 2006).

“There’s a lot more that can go wrong,” he says. Das says that because so much subprime debt is held by CDOs, there is constant risk that the value of the investment can drop or collapse….

Two money market funds run by AIM have gotten the message. They stopped buying CDO commercial paper. “In today’s market, you really can’t trust any ratings,” says Lu Ann Katz, AIM’s director of cash management research.

As recently as June, two AIM money market funds owned $2.64 billion of CDO commercial paper that was invested in subprime debt. The debt made up 10.2 percent of the AIM STIT-Liquid Assets Portfolio and 4.5 percent of AIM STIT-STIC Prime Portfolio.

Katz says she’s stopped buying CDO investments because she doesn’t trust credit ratings and she thinks CDO paper in money market funds is too risky. AIM’s funds had included more than $1 billion of CDO commercial paper issued by CDOs managed by Bear Stearns before its hedge funds collapsed….

Money market managers are required to determine that their investments are safe and have high credit ratings, according to Rule 2a-7, a 1997 addition to the Investment Company Act of 1940.

“The money market fund shall limit its portfolio investments to those United States dollar-denominated securities that the fund’s board of directors determines present minimal credit risks,” the rule says.

Money market managers buy CDO commercial paper to boost returns and make their fund more attractive to investors, which in turn increases their income, money market fund inventor Bent says. “The higher rates sell more easily,” he says. “They’re doing it to suck the people in.”…

While CDOs aren’t regulated by the SEC, mutual funds –including money markets — are. The SEC disclosed in June it’s begun looking at some CDO investments, without releasing further details.

Former SEC Chief Accountant Turner says investors have cause to be concerned about money market funds’ holding subprime debt.”It does

n’t make you feel real good in the gut,” Turner says. “This stuff takes on a life of its own when it starts going south.”

A few days ago, we said we were willing to eat a bit of crow. Even though we had acknowledged some time ago that Bear might not survive the subprime mess as an independent firm, we also thought that no one with any sense would take a strategic position (taking a speculative bet is an entirely different matter). Investment bank acquisitions have a terrible track record, and a minority stake, even with a preferred return and other contractual protections, isn’t a great position to be in either. Bear’s rough, highly entrepreneurial culture makes it particularly unsuitable for a strategic suitor.

At least for the moment, crow-consumption appears to be premature. It turns out that the rumors of Bear talking to possible investors appears to have been just that, mere rumors. From CNBC.com:

Investment bank Bear Stearns doesn’t appear to be holding talks about selling a stake to Warren Buffett or any other investors, contrary to earlier reports.

Shares of Bear Stearns rose sharply after the New York Times reported Wednesday that the company was in serious talks with Buffett and several other investors, including Bank of America, Wachovia and two Chinese banks.

But people have told CNBC that at present, Bear Stearns isn’t holding talks with anyone.

Citing unnamed people briefed on the discussions, the Times said the talks involved the sale of up to a 20 percent stake in Bear Stearns…

Analysts who follow Bear Stearns have expressed doubts about the deal.

“I’m not certain why Bear would want to sell a piece of itself at an impaired value,” Brad Hintz, an analyst at Sanford C. Bernstein, told Reuters Thursday.

“This management team has gone its own way for too many years to suddenly decide it wants to sell out at a low valuation. It’s a fine franchise that just went through a very difficult environment, but fixed-income problems don’t last forever.”

Is the iPhone the beginning of the end of Apple’s days as a company who can do no wrong?

In retrospect, the change of the name of the company from “Apple Computer” to “Apple” may have been the tip-off. It made official the Cupertino company’s shift in orientation from being a personal computer company to a consumer electronics business, a 21st century version of Sony in its heyday.

The problem is that Apple had carved out two very lucrative niches, its hardware (which observers have noted achieve vastly better margins than other PC makers) and its iPod. It appears to have underestimated its ability to compete effectively in fields where competition is keen, product life cycles are short, and having good partners is key to success.

Today, the New York Times and ZD Net (among others) bemoan the latest flat-footed Apple iPhone move, namely providing software updates that terminally damage (aka “brick”) iPhones that have been unlocked to work on other carriers’ networks. This is popular (aside from the general geek pursuit of making hardware do new tricks) because AT&T isn’t a great cell phone service and the contracts themselves have some undesirable features (such as horrific international roaming charges). Both bemoan this move as a PR disaster, again, like the sudden price drop, alienating Apple’s most loyal customers.

But worse, as we discuss later, this “bricking” of the phones is flat out illegal. Once title has passed, owners have certain rights, and modifying their goods is one of them. Voiding the warranty is one issue (there are ways Apple could to that within the law) but breaking devices that you don’t own isn’t kosher. Legally, this is tantamount to disabling the transmission of a car because you don’t like tires someone put on them.

What has enabled Steve Jobs to reincarnate himself and his company is his dedication to superior, user friendly technology. Even his commercial failures put him ahead. The NeXT computer was far and away the best operating system on the market at the time, and was the darling of derivatives firms who needed a platform that would both allow for fast development yet be rock solid stable in running mission critical apps in a high transaction volume setting. The old NeXT OS is the guts of the Mac OS X, which also runs on the iPhone.

But Jobs now appears to be reverting to the sort of behavior that one associates with Bill Gates: putting commercial considerations ahead of consumer needs and innovation. Is that the price of market leadership?

From ZD Net:

Apple is clearly in a war with hackers over the iPhone and its most loyal fans could take a few hits. How Apple performs through these battles will determine the company’s overall reputation going forward.

Today’s angst over iPhones becoming iBricks because they were modified is really just the beginning. There are a few reports of non-hacked iPhones going dark following Apple’s latest firmware update. Adrian Kingsley-Hughes and others note that Apple has a PR problem on its hands. These issues could affect how Apple is perceived in its core markets.

The iPhone issues are really just a side effect of a much larger issue. As Apple grows it increasingly loses that feel-good underdog image. It starts looking like every other large company. Apple even starts to look like a bully–even to large media players that merely want to try different pricing schemes on iTunes. To make matters worse Apple is alienating its base. Add it up and customer service declines. Customer service declines won’t happen overnight, but Apple will have issues simply based on numbers–the more customers it has the more people it can annoy. Steve Jobs is treated as a messiah able to leap over options scandals and create a never-ending stream of delightful products, but that won’t last forever.

There is something futile about the way Apple appears to be fighting some of its most ardent fans, those who want to use the full capabilities of the iPhone.

Saul Hansell of the New York Times also focuses on the damage to Apple’s image and creation of barriers to innovation. One man’s hacker is another’s freedom fighter:

Thursday afternoon, Apple released the scheduled update to the iPhone software. And the gadget blogs confirm that it does, as Apple threatened, wreak havoc on modified iPhones. Some phones have indeed been “bricked.” In others, unofficial applications have been disabled. And there are worries that hacking the updated phone will be harder.

The result: Serious hackers will keep finding new ways to break in. Less technically inclined may well find themselves chastened into technological submission, assuming they can get their pricey toys to work at all. Will Apple really refuse to help people with iBricks?….

On Monday, Apple had issued a press release warning of “irreparable damage” to iPhones that have been modified or unlocked from the AT&T network. It also threatened users that “the permanent inability to use an iPhone due to installing unlocking software is not covered under the iPhone’s warranty.”…

Apple may well be justified using tough tactics against people who modify their phones so they no longer use the AT&T network. Apple stands to receive several hundred dollars for each phone over the course of two years from AT&T’s service fees.

Some people—actually a lot of people—don’t much like AT&T. Or they don’t want to pay AT&T’s roaming fees overseas and would rather use a local cellular company. And these people will always be looking for ways to defeat Apple’s locking system. The simple way to defuse this fight, of course, would simply be for Apple to sell an unlocked iPhone for, say, $300 more than the locked version.

But this gets at Apple’s propensity for control. The phone is, in some ways, a better experience on AT&T because of its links to voice mail and so on. But does that mean if Apple’s way is better it should always prevent people from using its products in some less optimal way?

Since the iPhone is a very sleek, capable handheld computer, people are going to want to run programs on it. They are going to want to hack and see what they can build. It’s a law of nature. And Apple might as well be fighting gravity…

Apple essentially has two choices. Either it exposes most of the iPhone’s capabilities to developers. Or it will have to gird for an ever escalating war in which it will have to send ever more electronic brick-bombs to its best customers who don’t follow its strict rules.

In an earlier post, we discussed how Apple’s program of damaging modified iPhones is clearly against the law, specifically the Magnuson-Moss Warranty Act:

The second question of updates from Apple damaging unlocked iPhones, is much more complicated. If an update can, unintentionally, do damage, is again a question Apple must answer before rendering iPhone’s warranty void. And, Apple is legally required to prove it… at least on the civil grounds of more-likely-than-not. If Apple will release an update that intentionally detects the baseband modification, and then does damage iPhones that have it is more simple to answer; they could, but it’s illegal for them to do so. Magnuson-Moss prevents Apple from intentionally voiding the warranty based on the presence of a modification. Extrapolating from that, it also prevents them from damaging other components of iPhone (such as Boot ROM or baseband components) simply because the modification has been detected (which an updater can detect by checksumming the baseband).

The post, citing an article in PhoneNews, also states that contractual provisions in the sale agreement cannot override Magnuson-Moss.

Today, the BBC and the Telegraph, among others, discussed the proposal of James Lovelock of Oxford and Chris Rapley, former head of the British Antarctic Survey, to reduce CO2 levels by pumping it into the deep ocean. Note that this is a type of carbon sequestration.

Lovelock and Rapley believe this action is necessary because climate change is progressing rapidly and current programs to reduce greenhouse gas emissions won’t to the job fast enough. However, as some of the commentary on this idea, and a related op-ed piece in the New York Times note this approach is not without risk. Disturbingly, they promote an idea that will increase the acid level of the ocean, when acidification is already leading to the death of coral reefs and shellfish. This idea may simply substitute one problem for another.

From the Telegraph:

[Lovelock and Rapley] believe the answer lies in the oceans, which transport much more heat than the atmosphere and, covering more than 70 per cent of the Earth’s surface.

They propose that vertical pipes some 10 metres across be placed in the ocean, such that wave motion would pump up cool water from 100-200 metres depth to the surface, moving nutrient-rich waters in the depths to mix with the relatively barren warm waters at the ocean surface.

This would fertilise algae in the surface waters and encourage them to bloom, absorbing carbon dioxide greenhouse gas while also releasing a chemical called dimethyl sulphide that is know to seed sunlight reflecting clouds.

“Such an approach may fail, perhaps on engineering or economic grounds”, they say, adding that the effects on the acidity of the ocean also have to be factored in.

In an earlier post, we discussed the dangers posed by rising acid levels in the ocean:

But there are side effects to our love affair with CO2 that are not often mentioned. In fact, whether the earth cools or warms is absolutely irrelevant to these effects. I repeat: Absolutely irrelevant.

One of the most startling effects is the acidification of the oceans. Since 1750, the oceans have become increasingly acidic. In the oceans, CO2 forms carbonic acid, a serious threat to the base of the food chain, especially on shellfish of all sizes. Carbonic acid dissolves calcium carbonate, an essential component of any life form with an exoskeleton. In short, all life forms with an exoskeleton are threatened: shell fish, an important part of the food chain for many fish; coral reefs, the habitat of many species of fish….

The formation of carbonic acid does not depend upon temperature. Whether the oceans warm or cool is irrelevant. Of concern only is the amount of CO2 that enters the oceans….

According to one estimate, between 1750 and 1994, oceans absorbed 118 billion tons of CO2—and we were just starting serious CO2 production. As anyone with a fish tank knows, as the Ph falls, the water becomes more acidic. Fish life becomes more and more problematical.

This absorption has made the world’s oceans significantly more acidic since the beginning of the industrial revolution. Research published last year by Mark Jacobson, an assistant professor of civil and environmental engineering at Stanford University, indicated that between 1751 and 2004 surface ocean pH dropped from approximately 8.25 to 8.14. James Orr of the Climate and Environmental Sciences Laboratory further estimated that ocean pH levels could fall another 0.3 – 0.4 units by 2100.

In fact, by 2050,

…there may be too little carbonate for [in the Pacific] organisms to form shells as soon as 2050.

Since 1990 alone, Ph levels in the Pacific have dropped .0025. Such a drop may not seem significant until one understands Ph levels.

Today, in a New York Times op-ed, Viaclav Havel points out one of the fallacies of reasoning like Lovelock’s and Rapley’s: that extreme measures to counter greenhouse gas emissions also move the equilibrium:

The effects of possible climate changes are hard to estimate. Our planet has never been in a state of balance from which it could deviate through human or other influence and then, in time, return to its original state. The climate is not like a pendulum that will return to its original position after a certain period. It has evolved turbulently over billions of years into a gigantic complex of networks, and of networks within networks, where everything is interlinked in diverse ways.

Its structures will never return to precisely the same state they were in 50 or 5,000 years ago. They will only change into a new state, which, so long as the change is slight, need not mean any threat to life.

Larger changes, however, could have unforeseeable effects within the global ecosystem. In that case, we would have to ask ourselves whether human life would be possible. Because so much uncertainty still reigns, a great deal of humility and circumspection is called for.

As rating agencies came into renewed focus this week as a result of Senate Banking Committee hearings on their role in the structured credit mess, one suggestion appears to have been gotten little play in the financial media.

Yesterday, the Financial Times reported that Eric Mindich, CEO of Eton Park Capital and newly appointed head of a government advisory panel on hedge funds, said rating agencies needed to be split up to reduce their conflicts of interest. This idea parallels the post-Enron requirement that accounting firms separate their consulting business from their audit function.

For the rating agencies, the analogy is to separate the rating function from advisory services. And what is interesting is that the proposal comes from a senior member of the financial services industry, rather than, say, an academic.

From the Financial Times:

Credit ratings agencies need to separate their rating and advisory functions because of conflicts of interest in their relationship with Wall Street, the newly appointed head of a high-level government advisory panel said yesterday.

Eric Mindich, who was named on Tuesday as head of a private sector group advising the White House, said investor confidence in the ratings agencies had been “severely damaged” and that their business model had inherent “serious -conflicts”.

“I do not think that the market can discipline ratings agencies sufficiently,” said Mr Mindich, chief executive of Eton Park Capital and a former colleague of Hank Paulson, the Treasury secretary, at Goldman Sachs, the investment bank.

Mr Mindich said he was concerned that agencies issue ratings and also advise issuers of securities on how to secure better ratings. He suggested it might be necessary to separate those functions or require agencies to provide detailed disclosure of their contact with clients.

Lawmakers and investors criticised the companies for giving high ratings to subprime securities and failing to act quickly when borrowers began defaulting on loans backing the bonds.

Ratings agencies publish their judgments on credit-worthiness to help assess the risk of investments. Their performance has been criticised in the wake of the credit squeeze that has hit capital markets. Last month the European Commission announced an investigation into their slow reaction to the subprime crisis….

Larry Summers, the former US Treasury secretary, said there were obvious conflicts of interest in the ratings industry: “If you are hired by someone at twice your regular fee to work collaboratively with their people to design a security that will receive a triple A rating from yourself” you are likely to deliver certain results. “There needs to be a lot of cleaning up in this area.”