naked capitalism

Martin Wolf, the Financial Times’ highly regarded economics editor, has an usually blunt article today, “Biofuels: a tale of special interests and subsidies.” While the main target is the way special interests are turning biofuels into yet another agricultural pork barrel, he makes a number of important observations: biofuels are only marginally cleaner than conventional energy sources; many of the incentives are counterproductive (witness the discussion of “flexible fuel” vehicles); the policy “rationalisations” are bogus: and of course, biofuels make food more costly.

Wolf also has an important observation buried in the piece, perhaps because it was the subject of a Financial Times editorial, namely, that what is needed is a clear and predictable price for carbon. That would give manufacturers, users, and investors long enough planning horizons to decide themselves among the various options. And perhaps most important, it would put greater focus on energy conservation, which is far and away the most productive near-term step, and less on various schemes that enrich promoters on a current basis and give the public at large the false hope that they can simply switch to a clean energy source and life will continue as before.

From the Financial Times:

Energy security and climate change are two of the most significant challenges confronting humanity. What we see, in response, is the familiar capture of policymaking by well-organised special interests. A superb example is the flood of subsidies for biofuels. These are farm programmes masquerading as answers to energy insecurity and climate change. Not surprisingly, they have the depressing characteristics of such programmes: high protection, open-ended support to producers, and indifference to economic rationality.

Already the support in members of the Organisation for Economic Co-operation and Development costs about $13bn to $15bn a year. But this sum generates much less than 3 per cent of the overall supply of liquid transport fuel. To bring the biofuel share to 30 per cent, as some propose, would cost at least $150bn a year and probably more, as marginal costs rose.

Someone needed to take a close look at the rationality of all these supports. An excellent report from the Global Subsidies Initiative of the International Institute for Sustainable Development does just that*. It does not tell a pretty story.

Policy is extraordinarily complex. It can also be highly irrational. Brazil is, for example, the most efficient supplier of bioethanol, but confronts tariffs of at least 25 per cent in the US and 50 per cent in the European Union. A smaller example is the advantage given to production of “flexible-fuel vehicles” in US corporate average fuel-efficiency standards. Because the fuel-economy credit is biggest for the least energy-efficient models, manufacturers concentrate on sport utility vehicles and light trucks. Yet almost all the drivers of these vehicles use ordinary petrol. The result is greater consumption of petrol, not less.

The cost of support per litre of ethanol varies between $0.29 and $0.36 per litre in the US and $1 in the EU (see chart). Support for biodiesel varies between $0.2 per litre in Canada and $1 in Switzerland. But the cost of petrol, in terms of equivalent energy units, is $0.34 and of diesel is $0.41. Thus, the subsidy to biofuels is often greater than the cost of the fossil fuel equivalent. Not surprisingly, the production costs of subsidised biofuels are also generally much higher (see charts).

Does this costly shift to biofuels at least deliver reductions in net emissions of greenhouse gases? Not by as much as one might suppose, is the answer. The net greenhouse gas emissions of expensive European rapeseed oil-based diesel are a mere 13 per cent less than those of conventional diesel. Similarly, net emissions from US corn-based ethanol are only 18 per cent less than conventional petrol.

This highly subsidised source of demand is also having a big impact on demand for foodstuffs. In 2007, for example, the increase in US demand for corn-based ethanol will account for more than half of the global increase in demand. Much the same is true for US and EU use of soyabeans and rapeseed in biodiesel. The rising price of food is good for producers. It is dreadful, however, for consumers, particularly for those in poor food-importing countries. Increased production of biofuels also adds stress on existing land and water supplies.

Is it possible to justify this cornucopia of complex and expensive subsidies, mandates and protectionist measures? No. But that does not stop people from trying. Indeed, they point to a host of different (and often changing) justifications, as is too familiar from the history of farm policies. Here are just five of them.

Rationalisation one: biofuel subsidies reduce farm support payments. But, in fact, US evidence strongly suggests that these subsidies are being piled on top of existing farm subsidies, not replacing them.

Rationalisation two: mandating biofuels will lower petrol prices. But it is obviously mad to try to lower the price of a commodity by subsidising the production of more expensive alternatives.

Rationalisation three: subsidising biofuel is an efficient way to reduce reliance on risky fossil fuels. But biofuels are, under current technologies, complements to, rather than substitutes for, fossil fuels and are also vulnerable to their own risks of weather and disease.

Rationalisation four: subsidising biofuel is an efficient way to reduce greenhouse gas emissions. According to the report, the cost of eliminating a tonne of carbon dioxide equivalent through biofuels varies from a low of about $150 to as much as $10,000. Even the lower of these figures exceeds almost all estimates of the marginal benefit of reducing a tonne of emissions. It certainly much exceeds the cost of many alternative ways of doing so.

Rationalisation five: subsidies are only needed to establish the infrastructure. But if biofuels are to be competitive, it will be unnecessary to subsidise the infrastructure. Investors can do that for themselves.

This then is a classic farm programme: a costly system of transfers looking for a rationale. Or, as the report puts it: “The bewildering array of incentives that have been created for biofuels in response to multiple (and sometimes contradictory) policy objectives bear all the hallmarks of a popular bandwagon aided and abetted by sectional vested interests.”

So what should be done? Here are some simple negative suggestions: eliminate increasingly popular (because apparently costless) mandates to use specific quantities
of biofuels, since these shift all the risk of fluctuations in demand and supply of foodstuffs on to their use as food; discipline the stacking of subsidies on one another; and eliminate all open-ended supports for production before these become impossible to reverse.

Here, also, are some positive ideas: define the objectives and instruments of policy precisely, in terms of the overall goals of energy security and reductions in emissions of greenhouse gases; create a single global price of carbon that governs all activities; make producers compete for any support that is offered; let the markets decide on sale of flexible-fuel vehicles (and indeed the energy efficiency of vehicles); and, above all, move to free trade in biofuels.

We should at least try to learn from painful experience with a century of farm policies. I know that is naive. But is it impossible to respond to the big challenges of energy policy and climate change by applying a little intelligence, for a change?

*Biofuels – At What Cost? Global Subsidies Initiative, www.globalsubsidies.or

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Famed investor Jim Rogers has been down on the investment banking industry for some time, and thinks there is even more reason to be negative, as a Bloomberg story reports. However, I think George Soros would take exception to the characterization of Rogers as “co-founder” of Quantum. Rogers most assuredly worked for Soros.

Note that we have argued that investment banks are at risk of becoming sufficiently impaired to have larger consequences for the financial system. It takes a lesser degree of conviction to merely dislike their stocks.

From Bloomberg:

Jim Rogers, co-founder of the Quantum Hedge Fund with billionaire George Soros, boosted his bets against U.S. securities firms because of their salary “excesses” and money-losing investments.

Rogers said he increased his year-old short positions in the past six weeks in U.S. investment banks, using exchange-traded funds and bets against individual companies he declined to name. Stocks in the industry, which pays too much in bonuses, may fall as much as 70 percent in a bear market, he said.

“You see 29-year-olds on Wall Street making $10 million to $20 million a year, and they think it’s normal,” Rogers, 65, said in an interview in London today. “There have been lots of excesses,” said Rogers, chairman of Beeland Interests Inc.

The top five U.S. securities firms will probably earn a combined $29.3 billion this year, according to analysts surveyed by Bloomberg, breaking a three-year record streak after Merrill Lynch & Co. reported a $2.2 billion third-quarter loss. Goldman Sachs Group Inc., Morgan Stanley, Merrill, Lehman Brothers Holdings Inc. and Bear Stearns Cos. earned $30.7 billion last year, three times more than their profit in 2002.

Goldman Sachs, Wall Street’s most-profitable securities firm, said Sept. 20 that it set aside $16.9 billion to pay salaries, benefits and bonuses in the first nine months of the year, topping the record amount for all of last year.

A month later, Merrill Lynch reported its biggest quarterly loss amid $8.4 billion of writedowns for subprime mortgages, asset-backed bonds and bad loans. The 12-member AMEX Securities Broker/Dealer Index has fallen 13 percent since the start of June, while the Standard & Poor’s 500 Index was little changed.

“Who knows how bad the balance sheets are,” Rogers said. “They took on gigantic amounts of bad paper.”….

Rogers said he made the investments using his own money. He declined to say how much he oversees.

The slump in the U.S. housing market “still has a long way to go” before recovering, he said. “Market excesses don’t clear themselves out in just four or five months; they take years.”

In keeping, Jeff Matthews gives us Stan O’Neal’s recent golf record.

If you want a vivid illustration of why subprimes have turned out to be the mess they are, the graphic below, courtesy Russ Winter who also supplied this explanation:

The term used here, “DTI proforma” , measures what debt payments to income on 2005 and 2006 vintage subprime teaser loans would have required if the loan were fully indexed, fully amortized, and included insurance and property tax. The results are shocking.

This chart paints a very sorry picture as to how many borrowers can be rescued.

Do the math. Even using the teaser rates, and the phony affordability mortgage servicing burden figures, 65% were devoting over 40% of their income to their mortgage and related costs. 40% is usually considered the max for prudent lenders. That number rises to over 80% with the correct computation. Oh, and that assumes the “income” part of the equation is accurate. Remember that a high proportion of subprime mortgages were stated income loans, and for those, income was typically exaggerated by a considerable degree.

Bottom line: very few subprime teaser borrowers can be saved, even with the heroics of keeping them at their starter rates. No wonder the servicers aren’t trying to do mods. In most cases, there isn’t any point.

One of my pet peeves is lousy research, and even worse is lousy-with-intent pseudo-research. The airwaves are filled with fake factoids crowding out real information.

I was once tempted to write a post on what it takes to do good survey research, simply because surveys are widely cited and most people probably mistakenly think they deliver reliable findings. In fact, it takes quite a lot of work and testing to devise a good survey instrument, and most people sponsoring studies don’t want to spend the time and money.

John Kay of the Financial Times has taken aim at the same topic, for different reasons: too many surveys these days are done for public relations purposes, to stir up some noise, and were never even undertaken as serious research.

The more the public starts to be skeptical of pronouncements based on surveys, the happier I will be. From the Financial Times:

This is the age of the bogus survey. I woke up recently to the news that 95 per cent of children in Britain had been victims of crime. Of course they had. From a legal perspective, pushing a classmate or taking a pencil without the intention of returning it is a crime. School playgrounds are hotbeds of crime and always have been.

The difference between the bogus survey and real research is that real research has the objective of yielding new information, while bogus surveys are designed to generate publicity. The organisation that had undertaken this bogus survey – I forbear from mentioning its name – did not disguise that it had done so in order to draw attention to the problem of abuse of children.

Statistics about the incidence of real criminal activity against and among children are hard to come by and hard to interpret. We do not really know whether things are getting better or worse, or by how much – at least not without careful research and analysis, which would be hard to explain on television. Programme producers will not ask you to appear to spell out these complexities, but will allow you to horrify viewers and listeners with alarming news.

Public relations professionals understand these triggers, to such an extent that commissioning a bogus survey is now a standard element in the pitch they present to potential clients and conducting these surveys is an increasingly large part of the activity of market research organisations.

The agencies appreciate, although they are normally too polite to spell it out to their clients, that Universal Widgets is not a very interesting company, widgets are not a very interesting product, and Nigel Snooks, the chief executive, is not a very interesting man. But a survey that shows that two-thirds of men have contemplated hitting their wives with a widget will produce many media slots in which Mr Snooks of Universal Widgets can recount the findings.

There is even a term for this kind of activity. It is called “thought leadership”. That term illustrates the problem. It probably does not matter much that the bogus survey is used to generate spurious news. The danger is that opinion polls designed to produce eye-catching answers displace serious thought and analysis. The organisation that announced that 95 cent of children had been victims of crime judged, correctly, that its survey better served its needs than serious research into the problems with which it was concerned, that had not been done.

The study of business is afflicted by confusion between the results of a survey of what people think about the world and a survey of what the world is really like. At another recent meeting I heard a platform speaker announce that 40 per cent of books would be electronically published by 2020. A pesky academic asked exactly what this number meant and what evidence it was based on. The speaker assured the audience that the number had been obtained in a survey by eminent consultants of the opinions of the industry’s thought leaders.

I imagine most of the thought leaders had no more idea than anyone else what the question implied, or what the answer was, and did not devote more than the briefest consideration to their response, so I am not surprised that the median answer was close to a half. If you want to know the future of publishing, you will learn more by peering into a crystal ball. It will at least give you time to think.

Newspapers, broadcasters and consultants will start to distinguish bogus surveys from substantive knowledge only when their audience demonstrates that it knows the difference. Academics and think-tanks need to be reminded that generating publicity is not a legitimate research objective. The column in The Week magazine called “what the scientists are saying”, a compendium of silly claims from scientists trying to attract attention, is as embarrassing to the cause of real science as Private Eye’s Pseuds’ Corner is to real literature.

When you are asked for your opinion in your role as thought leader, put the phone down. You will be serving the public interest as well as saving your time.

Robert Rubin spoke out against policies that weaken dollar, from the commonsense perspective that a cheap dollar lowers the US standard of living. That’s a bit simplistic, since the impact of a weak currency on citizens depends on how dependent a country is on imports, and critically, to what degree domestic goods could substitute for imports. However, he is right to point out that trashing the dollar isn’t the best fix for our economic woes.

A Bloomberg story yesterday provides another indicator of the dollar’s diminished status:

Bargaining while buying some trinkets in the Maldivian capital, Male, recently, I heard most unexpected words: “You can keep your dollars.”

This tiny nation of 1,200 islands has long accepted U.S. currency out of convenience for visitors and financial sobriety. The dollar tended to do better in global markets than the local monetary unit, the rufiyaa. That may be changing and it’s a bad omen for the world’s reserve currency.

“My dollars aren’t as popular here as they’ve been in the past,” says Moyez Mahfouz, 51, who has visited the Maldives from Bahrain with his family once or twice a year for a decade. “More and more on this trip, I’m being asked for rufiyaa.”

From Bloomberg:

Former Treasury Secretary Robert Rubin said relying on a falling currency to stoke exports isn’t a “sound approach” and urged economic policy changes that would strengthen the dollar.

“The lower the exchange rate, the less that we receive in exchange for what we produce, and that lowers our standard of living,” Rubin said in an interview after attending a conference in Washington. “Our objective ought to be to have a strong currency based on sound policy.”

Policy makers aren’t pursuing solutions to the country’s economic deficiencies and looming budget deficits, said Rubin, who served under Bill Clinton, a Democrat. By contrast, Treasury Secretary Henry Paulson and other Republicans have lauded the U.S. economy as “healthy” and hailed demand for American exports as a boon for growth.

Policies should be focused on curbing government spending, raising revenue and addressing the soaring cost of government programs such as Social Security and Medicare, said Rubin, now chairman of Citigroup Inc.’s executive committee. Improving education, research and infrastructure are critical to increase productivity, he said.

“You put it all together and I think we can do very well economically and then we can have a strong currency,” said Rubin, who served as the chief economic adviser to President Bill Clinton. “We’re certainly not on those policy tracks right now.”

The dollar traded at $1.4438 per euro at 3:24 p.m. in New York, after dropping as low as $1.4438 yesterday, the weakest since the European currency’s debut in January 1999.

The slide “seems to have helped with respect to exports,” Rubin said. At the same time, “a much weaker dollar” could have “inflationary effects,” he said, while declining to predict the U.S. currency’s direction.

The dollar has declined in four of the past five years, and is down 7.5 percent so far in 2007 against a broad index of world currencies. During Rubin’s tenure at the Treasury from 1995 to 1999, the same index increased 24 percent.

Record exports helped trade contribute 1.3 percentage points to economic growth in the second quarter, outweighing the impact of the decline in home construction.

Treasury Secretary Henry Paulson earlier today reiterated his support for a “strong” U.S. currency during a trip in India. “I am strongly committed to a strong dollar,” he said.

I had wondered why, given the swift and brutal contraction of the commercial paper market in August and September, that there weren’t more apparent signs of distress. Outstandings fell an eyepopping $368 billion.

Commercial paper is short-term borrowings, maximum 270 days, but typically much shorter. If a borrower can’t roll his commercial paper but still needs the dough, he has to either find other sources of funding pronto or sell other assets. And given that the contraction was almost entirely in the asset backed commercial paper market, meaning CP supported by mortgages, car loans, credit card receivables, one would have expected to see a change in borrowing terms in those markets.

Now the mystery has been unraveled. It turns out many mortgage-related ABCP issuers have gone to a lender of last resort, namely the Federal Home Loan Banks, which have extended $163 billion of loans to them. Like Freddie Mac and Fannie Mae, they are considered to be government sponsored enterprises. Even though the Federal Home Loan Banks are technically a cooperative of private banks, the Federal government is sufficiently involved in their oversight (for example, their board is appointed by the President and approved by the Senate) that they are regarded as enjoying government support and fund at favorable rates. Worryingly, and again like Fannie Mae and Freddie Mac, they have had accounting issues, but legislation mandating tougher oversight stalled in the Senate.

So risk has been passed from institutions that could have been permitted to fail (or at least suffer) to one too big too fail. We’ll learn all too soon whether this was a move that we will regret.

From Bloomberg:

Banks shut out of the market for short-term loans are finding salvation in a government lending program set up to revive housing during the Great Depression.

Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

To meet the sudden demand, the institutions sold $143 billion of short-term debt in August and September, according to the FHLBs’ Office of Finance. The sales pushed outstanding debt up 21 percent to a record $1.15 trillion, an amount that may become a burden to U.S. taxpayers because almost half comes due before 2009.

The government is “taking a lot of risks through the Federal Home Loan Banks that are unnecessary,” according to Peter Wallison, a fellow at the American Enterprise Institute, a Washington-based organization that analyzes public policy, and general counsel at the Treasury Department from 1981 until 1985.

The home loan banks, known as FHLBs, are increasing risks to taxpayers by assuming the role as a lender of last resort, said Wallison. That’s the job of the Federal Reserve, he said.

A loss of confidence in the companies could prompt investors to dump FHLB debt, potentially causing the collapse of one or more banks, according to Wallison and lawmakers including Representative Richard Baker of Louisiana. If others were unable to meet the liabilities, taxpayers would be on the hook, they said.

U.S. lawmakers need to ensure “the institutions don’t blow up in the taxpayer’s face,” Representative Christopher Shays of Connecticut, a Republican on the House Financial Services Committee that is responsible for oversight of the system, said in an interview.

The FHLBs are cooperatives created by President Herbert Hoover in 1932 to spur mortgage lending. The system’s 8,100 owners and customers range from New York-based Citigroup Inc., the largest U.S. bank, to the single-branch Custer Federal Savings & Loan in Broken Bow, Nebraska. Their government ties support top AAA ratings from Standard & Poor’s and Moody’s Investors Service.

They borrow in the bond market and lend the money to their members. Federal Home Loan Bank obligations, when combined with the $1.5 trillion debt and $4.7 trillion in bond guarantees of Washington-based Fannie Mae and Freddie Mac in McLean, Virginia, are 46 percent more than the $5.04 trillion of Treasury debt held by the public.

Lenders turned to the FHLB as two main sources of funding, short-term IOUs backed by mortgages and mortgage-bond sales, began to dry up in August. That’s when losses on securities tied to subprime home loans began to spread throughout the credit markets and investors retreated to the relative safety of Treasuries and their equivalents.

Asset-backed commercial paper outstanding fell 25 percent to $883.7 billion as of last week from $1.18 trillion on Aug. 8, data compiled by the Fed show.

Sales of mortgage bonds, excluding those issued by Fannie Mae and Freddie Mac have tumbled by 66 percent to a monthly average of $39 billion from $115 billion in 2006, according to Friedman Billings Ramsey Group Inc., a securities firm in Arlington, Virginia.

The home loan banks “were the only game in town for a lot of borrowers,” said Jim Vogel, head of agency debt research at FTN Financial a securities firm in Memphis, Tennessee. They are “like an old watch your grandfather left you years ago, and you pull it out of the drawer and find it’s the only timepiece you have.”

In July, lenders could raise funds by issuing one-month asset-backed commercial paper that yielded 1.8 basis points less on average than the one-month London interbank offered rate. A basis point is 0.01 percentage point.

In September, the asset-backed commercial paper, when it was available, cost as much as 51 basis points more than Libor. At the same time, the Federal Home Loan Bank of New York offered one-month funds at an average of 48 basis points below Libor, making their loans more attractive.

The FHLB’s outstanding discount notes rose to a record $311 billion in the first three quarters, the most since 2001, according to data compiled by Zurich-based Credit Suisse Group.

FHLB loans probably will continue to grow in the next few months, though at a slower rate than during August and September, said Margaret Kerins, an agency debt strategist at RBS Greenwich Capital in Greenwich, Connecticut.

“Each day we seem to have new financial institutions announcing losses and so this probably isn’t over,” she said.

The home loan banks can lend at below-market rates because their government charter enables them to borrow more cheaply than other financial institutions. The ties to the government suggest the U.S. will bail them out in times of trouble.

The system sold $3 billion of two-year notes on Oct. 26 at a yield of 4.26 percent, or 46 basis points more than Treasuries of similar maturity. Stamford, Connecticut-based General Electric Co., also rated AAA, has $1 billion of notes due a month later that yield 4.6 percent.

Some lawmakers said they are concerned the FHLBs are taking on too much debt after they were unable to account properly for their own risks.

Five of the banks, including the Atlanta and Pittsburgh branches, restated earnings from 2001 through 2004, while the Chicago and Topeka branches corrected mistakes from 2001 through 2003. All of them fixed accounting errors for financial contracts used to protect against swings in interest rates.

The mistakes at the home loan banks, as well as those at Fannie Mae and Freddie Mac, prompted Republican lawmakers to spend the past four years pushing for legislation to create a tougher regulator for the government-chartered enterprises. While the House passed legislation in May, the Senate Banking Committee has yet to do so.

The failure to create new laws “is predicting disaster,” Baker, a Republican on the financial services panel, said in an interview. The FHLBs “have the potential for adverse economic impact if not properly administered,” he said.

The banks require borrowers to put up mortgages, mortgage bonds and other assets as collateral. None has experienced “a credit loss on an advance to a member, ever,” Ronald Rosenfeld, chairman of the Federal Housing Finance Board, the Washington- based regulator of the FHLBs, said in an e-mail.

The New York bank looks at detailed data on each asset when deciding how much to extend against it and doesn’t accept delinquent loans or non-AAA rated bonds as collateral, Paul Heroux, its head of member services said in an interview.

“The home loan banks are extremely low-risk institutions,” Allan Mendelowitz, one of five directors of the Federal Housing Finance Board, said in an interview. “There is probably no contingent risk to the taxpayer.”

Investors said the same about mortgage securities, which had home loans as collateral and were given top AAA ratings by S&P and Moody’s. Then defaults soared for loans to people with poor credit and some securities fell as much as 80 cents on the dollar.

A collapse would create “tremendous pressure to have the taxpayer bear the cost of a bailout,” said Representative Ed Royce, a Republican from California on the House Financial Services Committee.

The FHLBs have $276 billion of bonds maturing in 2008 and $174 billion in 2009, according to data compiled by Bloomberg. The system last week began to refinance about $144 billion of its so-called discount notes sold in August and September with maturities ranging from eight to 12 weeks, FTN’s Vogel said.

Borrowing from the system during that period was probably a record for a two-month span, Vogel said. The FHLBs disclose their borrowing at the end of each quarter.

Calabasas, California-based Countrywide, the largest U.S. mortgage lender, almost doubled borrowings from the Federal Home Loan Bank of Atlanta to $51 billion during the quarter, the company said in a statement last week.

Countrywide began to use the FHLBs in August as analysts at New York-based Merrill Lynch & Co. raised the possibility that the company could go bankrupt after it had trouble raising funds in the commercial paper market. Countrywide later sold a $2 billion stake to Charlotte, North Carolina-based Bank of America Corp., the second-biggest in the U.S. after Citigroup.

“You don’t want to use the phrase `going out of business’ in the press, but they would be in a much, much worse liquidity position if they didn’t have the Federal Home Loan Bank system sitting out there,” said Paul Miller, an analyst at Friedman Billings Ramsey Group Inc., a securities firm in Arlington, Virginia.

Washington Mutual, the largest U.S. savings and loan, boosted its borrowing from the FHLBs by $31 billion, the company said this month.

The Seattle-based lender’s “funding flexibility” put it in “a much stronger position to withstand the market disruptions of the third quarter,” Chief Financial Officer Thomas Casey said on a Oct. 17 conference call with investors. Washington Mutual spokeswoman Libby Hutchinson declined to comment further.

Paramus, New Jersey-based Hudson City Bancorp, the third- largest thrift in the U.S., borrowed $800 million from the FHLBs in the third quarter, 25 percent more than a year earlier, said Chief Executive Officer Ronald Hermance.

“Even AAA rated credits were having a tough time issuing paper,” Hermance said. “It took everybody back to the Federal Home Loan Banks.”

This blog generally features less than cheery news on the environment/species loss/global warming front, mainly because there isn’t a hell of a lot positive to report.

So we wanted to pass along a wee positive development about wee creatures, namely frogs. As readers may know, frog populations have been falling, and one of the culprits appeared to be a nasty fungus.

It turns out a surprisingly inexpensive and effective treatment has been found. From the BBC:

New Zealand scientists have found what appears to be a cure for the disease that is responsible for wiping out many of the world’s frog populations.

Chloramphenicol, currently used as an eye ointment for humans, may be a lifesaver for the amphibians, they say.

The researchers found frogs bathed in the solution became resistant to the killer disease, chytridiomycosis.

The fungal disease has been blamed for the extinction of one-third of the 120 species lost since 1980.

Fearful that chytridiomycosis might wipe out New Zealand’s critically endangered Archey’s frog (Leiopelma archeyi), the researchers have been hunting for a compound that would kill off the disease’s trigger, the fungus Batrachochytrium dendrobatidis.

They tested the chloramphenicol candidate on two species introduced to New Zealand from Australia: the brown tree frog (Litoria ewingii) and the southern bell frog (L. raniformis).

“We found that we could cure them completely of chytrids,” said Phil Bishop from the University of Otago.

“And even when they were really sick in the control group, we managed to bring them back almost from the dead.”

“You could put them on their back and they just wouldn’t right themselves, they would just lie there. You could then treat them with chloramphenicol and they would come right,” Dr Bishop explained.

The researchers tried using chloramphenicol as both an ointment, applied to the frogs’ backs, and as a solution.

They found that placing the animals in the solution delivered the best results. The team has admitted it was surprised by the outcome.

“You don’t usually expect antibiotics to do anything to fungi at all. And it does. We don’t understand why it does, but it does,” said Russell Poulter.

Professor Poulter, the molecular biologist who hunted down chloramphenicol, added: “It’s also got the great advantage that it’s incredibly cheap.”

The scientists are now making their research widely known ahead of formal publication in a science journal because of the pressing need for a safe and effective treatment for the chytrid disease.

The blow that chytrid has dealt to the frog population is already immense.

The disease has probably accounted for one-third of all the losses in amphibian species to date, says Professor Rick Speare, an expert in amphibian diseases who works with the University of Otago’s frog research group.

These losses are huge – and this is in addition to other threats such as habitat destruction, climate change, pollution and hunting.

Since 1980, more than 120 amphibian species have disappeared; and according to the World Association of Zoos and Aquariums, in the near future many more species are in danger of vanishing.

“We are losing an awful lot of these creatures now and if we don’t do something intelligent, then we’re going to lose an awful lot more,” said Professor Poulter.

But a hopeful finding is that the introduced frogs that have been infected with chytrids are now more resistant to further infections.

“We haven’t quite understood how that could happen,” said Dr Bishop. “It might be a natural thing; if a frog survives a chytrid infection then it is resistant when it gets attacked again.”

The researchers believe that zoos now will have more options, either to be able to control an outbreak or to rescue infected frogs from the wild, knowing that they can be cured.

The next challenge the research team has set itself is to find a treatment that will work in the wild.

“I would really feel quite satisfied if we could say, 10 years from now, that you have to be careful walking around [Australia's] Kosiuszko National Park or you might tread on a corroboree frog because they’re all over the place,” said Professor Poulter. “I would take real satisfaction from that.”

I have a picture of science classes rounding up wild frogs, dipping them and releasing them……

Despite the widely-held view that the Fed will lower the Federal funds rate another 25 basis points this Halloween, some continue to argue against further reductions.

We’ve taken that position here before, and will recap some of the reasons. The 50 basis point cut in September was a pre-emptive strike, based not on evidence of slowing growth but out of concern for the deteriorating housing market and fragile conditions in the money market.

While the Fed’s action gave a nice boost to the stock market, and reduced Libor spreads and credit default swap prices somewhat, it also led to a rise in long-term rates based on increased inflation expectations, and higher long rates are a negative for house prices. And it appeared to do almost nothing for the continuing crisis in the money markets. Commercial paper outstandings continued to fall after the cut, and the SIV market is still in trouble, as witnessed by the announcement of the Citigroup-JP Morgan-Bank of America-sponsored rescue plan, and the restructuring of some failed SIVs (Cheyne and Cairn).

In addition, the dollar has continued to fall against most currencies, and further interest rate cuts could lead to a rapid decline, which would also be destabilizing.

The Fed has only a hammer, in this case monetary actions (interest rate moves and liquidity increases or reductions) and therefore the current economic woes look like a nail. But the ailing housing and money markets will not be cured by looser monetary policy. Their problems are lack of transparency and insolvency. A 25 basis point cut, or even a 200 bp cut, isn’t going to put more cash in the pocket of someone who can’t make his mortgages payments, or make money market investors suddenly trust SIVs that hold mortgage-related paper.

The experts argue that the Fed has to cut rates this week because the markets expect it. Since when is making the markets happy the Fed’s job? (Whoops, I know the answer to that question: since Greenspan).

The role of the Federal Reserve, as William McChesney Martin put it, is to take the punchbowl away when the party starts getting good. In other words, one of its responsibilities is to deny the industry what it wants, because what it wants isn’t necessarily in its best interest.

Further consider that the Fed feels pressured to act because Fed fund futures have a rate cut priced in. Maybe the Fed needs to look at other markets to gauge the likely efficacy of its actions.

The markets have already discounted a rate cut, meaning they are well nigh certain it will happen. Yet the ABX indices, which are a increasingly reflect sentiment about the housing market have been deteriorating rapidly at the very time when confidence in a Fed cut this month has been rising (see yesterday’s update). If this free fall doesn’t prove the irrelevance of a Fed funds cut to the housing market, what does?

Both the Financial Times and Mark Thom’s Economist’s View provide insightful views. The Financial Times comment, by Manuel Hinds and Benn Steil is as close to snarky as the FT gets and ominously (and quite seriously) draws parallels between the US and developing countries that suffered financial crises (shades of our Banana Republic Watch), specifically, the combination of modest inflation in consumer goods and bubbles in investable assets.

Thoma features fellow University of Oregon prof and Fed watcher Tim Duy. Interestingly, at the beginning of October, Duy was predicting further rate cuts, even though he was opposed to the idea. He thinks they are unlikely for now based on GDP growth. He also shows that the Fed has communicated its views pretty clearly, but the financial media has turned a deaf ear.

First, from the Financial Times:

The Federal Reserve’s dramatic 0.5 per cent interest rate cut on September 18 was greeted with euphoria in the stock market, which soared 5 per cent in the two weeks that followed. This fact itself was hailed as vindication for a Fed that felt Jim Cramer’s pain, and gave the world the cheaper dollars the market guru shrieked for in CNBC’s (and YouTube’s) most memorable “Mad Money” segment ever.

To those who worry about inflation, the Fed could point to crunching credit as a danger to growth, and ipso facto a force for disinflation. Waiting for the numbers to prove it would just be reckless dithering.

We have sympathy for Ben Bernanke, Fed chairman, and company. The job of a price fixer is never easy. What should money cost? For most of human history this was easy: once you fixed a conversion factor with gold, you just sat back and let the forces of supply and demand do their stuff. But since the collapse of the Bretton Woods currency regime (the last vestige of thousands of years of commodity money), discretion has been the watchword. Nine smart folks at the Fed board have taken over the job of deciding what the price of money should be. If the hagiography and hatred showered on Mr Bernanke’s predecessor, Alan Greenspan, is any indication, that price should be wisely wiggled down to make jobs, up to prick bubbles and now, apparently, back down to offset losses on millions of bad credit decisions.

So, are our cheaper dollars now at the right price? In the coming months, all eyes will be on the consumer price index for the answer.

Unfortunately, there are circumstances in which excessive monetary creation can destabilise the economy while the rate of CPI inflation remains low. These tend to be present when the danger of monetary destabilisation is at its highest because people have lost faith in the ability of money to keep its value through time.

As one of the great monetary economists of the last century, Jacques Rueff, pointed out in the late 1960s, people react to the “growing insolvency” of a reserve currency, such as the dollar, by acquiring “gold, land, houses, corporate shares, paintings and other works of art having an intrinsic value because of their scarcity”. Sounds familiar? Indeed, this is the story of our present decade, one in which alternatives to the dollar as a store of value have soared even while the CPI has remained subdued.

This phenomenon is well-known in developing countries, where asset booms combined with low CPI inflation have preceded monetary and financial crises. In Mexico, for example, share prices rose 12-fold between January 1989 and November 1994, while inflation fell from 35 per cent to 7 per cent. Inflation then soared as the Tequila crisis exploded.

Prices of shares and real estate more than doubled from 1993 to 1996 in Indonesia and South Korea while CPI inflation rates were declining. In May 1997, just weeks before the currencies collapsed, inflation was only 4.5 per cent in Indonesia and 3.8 per cent in South Korea.

The same symptoms have been visible in many other monetary crises in developing countries. They seem to be visible today in the US. Following the 2001 dotcom crash, resources flowed into real estate, foreign exchange and commodities, while CPI inflation remained modest. In 2007 the housing bubble finally burst, causing credit to crunch as the market struggled to out the owners of dud mortgages and mortgage-linked contracts. The Fed reacted with cheaper dollars, which did precisely nothing in that regard. Credit risk fears remain unabated. But the market duly dumped dollars for harder assets, pushing the euro, shares, oil and gold to record dollar prices.

Gold, having been global money for the better part of 2,500 years, and therefore the commodity most sensitive to expectations of macroeconomic in stability, provides the best measure of the extent of the rush towards inflation-proof hard assets.

Between August 2001 and August 2007, the dollar price of gold soared 144 per cent, while the CPI rose only 17 per cent. The last time such a substantial and sustained appreciation of gold was observed was in the 1970s, on the heels of America’s loose money policy and balance of payments deterioration in the 1960s and Rueff’s warnings regarding “the precarious dominance of the dollar”. There were two episodes, from 1971 to 1975 and from 1977 to 1980. In both, the increase in the price of gold and other commodities presaged substantial increases in CPI inflation as well as significant falls in the international value of the dollar.

The dollar sustained its role as the international standard of value because of good fortune on two fronts. First, the Fed under Paul Volcker hammered out inflationary expectations with a painful but necessary period of high interest rates. Second, there was no viable alternative.

It may not be so lucky this time. Today, not only does the euro wait in the wings as understudy, but gold banks have risen in tandem with the dollar’s decline and offer the world a viable private alternative that has permanent intrinsic value.

As the Fed debates whether the world is truly crying out for even cheaper dollars, it would be wise to heed the lessons of monetary history.

Below, Tim Duy focuses on the fundamentals, as he argues the Fed will, and finds they do not justify a rate reduction:

The Fed begins a two-day meeting today, with market participants widely expecting a rate cut. I am mentally prepared to be on the wrong side of this call, joining the lonely few, but I just can’t tease another rate cut out of the incoming data.

In my mind, the argument for a rate cut hinges on one crucial assumption – that the market is expecting a rate cut, and the Fed will not want to disappoint…..

The problem with this view is that Fed Chairman Ben Bernanke does not believe it is his job to lead markets around by the nose like his predecessor. I think under the new regime, the Fed expects their comments to be taken at face value. And I think they are pretty effectively communicating their view on the economy: Outside of housing, there is minimal spillover, and whatever spillover exists is completely expected. From Bernanke on October 15 (italics mine):

Since the September meeting, the incoming data have borne out the Committee’s expectations of further weakening in the housing market, as sales have fallen further and new residential construction has continued to decline rapidly. The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year. However, it remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions. We will be following indicators of household and business spending closely as we update our outlook for near-term growth. The evolution of employment and labor income also will bear watching, as gains in real income support consumer spending even if the weakness in house prices adversely affects homeowners’ equity. The labor market has shown some signs of cooling, but these are quite tentative so far, and real income is still growing at a solid pace.

A week later, Chicago Fed President Charles Evans reiterated the outlook:

Indeed, on balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast.

Such comments – that the economy is roughly in-line with the Fed’s forecast – are essentially ignored by commentators. Has anyone noticed that the data flow has steadily caused 3Q07 estimates of growth to be raised above 3%? Think about it – the Fed cut rates 50bp during a quarter in which growth topped 3%, just after a quarter with almost 4% growth.

The Fed is never that proactive. Never.

Yes, I know, forecasts for 4Q07 are low on the potential impact of the August market turmoil. But note that we have almost no data on the 4th quarter to assess the quality of those forecasts; largely some volatile data on consumer confidence and jobless claims. Moreover, the Fed expects weakness, and is trying to look through it to mid-2008. And the Fed already cut 50bp because they knew that they would not have any good data on which to assess the 4th quarter at their October meeting. Nor would they normally commit to policy with only a single month’s data. The month is not even over! That was the “risk management” portion of their decision to cut 50bp in September. How many rate cuts do you take as insurance?

And, on risk management, Fed Governor Frederick Mishkin, one of the architects of 50bp move, sees financial conditions improving:
‘

‘Market functioning has certainly not yet returned to normal,” Mishkin said in a speech at a seminar commemorating the 1907 U.S. financial panic, which led to the Fed’s creation. Still, Fed actions ”have helped improve conditions in several short-term funding markets and instill confidence in investors that liquidity would be available if needed,” he said.

They did not expect conditions to return to normal overnight; they are simply looking for things to be moving in the right direction. And they are – notice that the ABX market is coming unglued again, as documented by Calculated Risk, but the impact on financial markets is considerably more muted than this summer.

I also believe that this latest jump in oil prices will cause Fed policymakers to question their confidence in the inflation outlook more so than the growth outlook (if economic activity was really coming unglued, oil consumption should be slowing). And notice that despite a softer near term outlook for the economy, FedEx is still prepared to boost its air rates 6.9% next year, following this year’s 5.5%. They must be pretty confident of their pricing power. In my mind, the entire commodity complex is a worrying signal about the path of inflation, but I doubt the Fed is as concerned. Likewise the Dollar; I still have trouble believing the Fed has completely written off the Dollar, but continued rate cuts would signal that the Greenback remains a one-way bet…..

If the Fed decides they are unwilling to defy the market, or that “risk management” requires additional rate cuts, I would have to conclude that regardless of what the statement says, that one must expect a series of multiple rate cuts. They will be responding to the deteriorating housing market, and I simply expect no stabilization in that market in the near future….

Bottom Line: I believe the Fed intended to take a pass in October with the 50bp rate cut. I believe market participants were correctly reading the data until they got caught up in the risk management story. I think the Fed has been explaining past actions, not future policy. For that, you need to look at their forecast. On the basis on the data alone, the Fed is already so far in front of the curve it is hard to justify another cut at this point. I absolutely do not expect the Fed to cut 50bp.

This is the most contrarian call I have made; I simply believe that the case for a rate cut is much weaker than market participants appear to believe.

As most readers probably know, subprime mortgage broker/lender Countrywide Financial’s CEO Angelo Mozilo, which posted a massive loss for its third quarter, predicted a return to profit this quarter. Not only did the stock rise 32% that day, but CFC’s announcement was perceived to be such good news that it gave the stock market a boost.

I will confess to not having given the Countrywide forecast much thought beyond considering it to be not credible. Now CFC could have deliberately over-reserved, and it therefore relying on being able to reverse those reserves if results don’t meet its cheery prediction. However, the ABX indexes are continuing on as close as you can get to a vertical trajectory downward, so it looks pretty likely that any cushion will be consumed by increases in delinquencies and foreclosures (remember, a foreclosure puts an end to servicing revenues). CFC has announced a borrower salvage program that is unlikely to help its profits. I don’t see much factual underpinning for the idea that CFC has turned the corner.

Now my view is based simply on the continuing-to-deteriorate fundamentals for housing and my belief that anything that comes out of Mozilo’s mouth has to be taken with a handful of salt. But Michael Shedlock and Accrued Interest, who have thought about CFC more deeply, are also dubious.

Shedlock points out that the spike-up in the stock price was due to a short squeeze and then turns to substantive matters. First he gives us some juicy bits from Mozilo’s pronouncement that I somehow missed:

Countrywide said borrowers were behind in payments on 29.08 percent of subprime loans it services as of September 30, up from 23.71 percent in June. The delinquency rate rose to 5.76 percent from 4.56 percent on prime home equity loans, and to 4.41 percent from 3.35 percent on conventional first mortgages.

That trajectory does not speak well for capital returning to the market. When losses start piling up, lenders tend to over-learn their lessons and become stringent often at precisely the time when reducing credit availability can have knock-on effects.

Shedlock’s comments:

It appears that Countrywide attempted to throw in everything but the kitchen sink into those “one time losses“. But even with that strategy it is premature for Countrywide to be acting as if the “perfect storm” is over. Those increases in delinquencies are going to translate into increased foreclosures and increased REOs (Real Estate Owned) sometime down the line.

One has to laugh at the statement that the third quarter represented an “earnings trough.” After all, a $2.85 per share loss is quite a “trough”. The estimate was a loss of $1.65 per share. It’s quite amazing to see a $1.20 per share earnings miss be treated as such magnificent news.

In addition, Countrywide appears to be bragging about securing another $18 billion in “highly reliable” credit lines. Instead investors ought to be worried about the possibility that Countrywide will again need those credit lines.

Accrued Interest, by contrast, was willing to consider the possibility that Countrywide was correct and might show profits soon, and the tone of the post was neutral. However, the arguments do not bode well for CFC.

AI posits that mortgage lending could become more profitable by virtue of a shift in the supply/demand balance. Continuing demand for mortgages versus a withdrawal of lenders and investors suddenly means more pricing latitude on the part of lenders, and almost certainly margin improvement. He also points out that most salvageable of the current subprime borrowers facing resets will be refinanced, either by CFC itself, or Wamu, the FHA, or various state-sponsored programs. His conclusion:

So back to Countrywide. I don’t think they are in a good position to take advantage of higher loan margins. I think actual banks with actual balance sheets and better access to emergency liquidity are in stronger position to realize new opportunities in mortgage lending. On the other hand, if we assume that Countrywide underwrites nothing other than easily securitized stuff, and has indeed written down all its assets (including both loans and servicing rights) to their true value, then there is no reason why they shouldn’t be profitable to some degree in the near future.

The big IF in the previous paragraph is the true value of their assets. By that I mean not the market value, but what those assets really turn out to be worth. We are living in a world where determining the value of mortgage assets is extremely difficult. We know that there are assets currently priced at 50 cents on the dollar which will eventually pay off in full. And we know there are assets similarly priced which will turn out to be worthless. If Countrywide has written down all their risky assets to x cents on the dollar, and on average, that’s what those assets eventually pay out, then everything will be fine. If they realize x-y, then it may be several quarters before they’re back in the black.

Finally, the thing that I don’t like about Countrywide is their access to non-market capital. A bank can go to the Fed or to the Home Loan Banks and get emergency capital. So if WaMu or Fifth Third or US Bank or some other large retail bank were to have sudden trouble with securitization, they’d have options. Countrywide Bank is too small to consider it a realistic option to fund Countrywide’s overall operation, and as we saw in August, Countrywide is subject to liquidity problems.

In terms of the market overall, both in credit and stocks, you’d hope that Countrywide delivers on their promise. If not, I think there will be a very negative reaction in both markets.

Monoline insurers, such as MBIA, Ambac, and FGIC, are in the business of providing financial guarantees. And one of the products they got involved in guaranteeing was mortgage-related structured credits, much to their peril, as we noted back in August.

As subprime losses have mounted, so too have worries about the ability of these guarantors to maintain their AAA ratings. The Wall Street Journal on Friday pointed out that their funding costs were rising, a sign of concern about credit strength:

Financial institutions and bond insurers were targeted by cautious investors. The cost of credit protection on insurer American International Group Inc. and bond insurers such as Ambac Financial Group Inc., rose while their stock prices tumbled as worries about their exposure to the subprime mortgage market mounted.

Today, the Financial Times went so far as to suggest that the monolines might suffer serious mortgage-meltdown damage. This would bode ill for the local governments, since these firms are the main source of credit enhancement for municipal bonds.

From the Financial Times:

Investor worries are mounting that the next big casualties from the credit squeeze might be the specialist companies that act as guarantors for bond issuers.

These companies, which write insurance to boost the credit ratings of various kinds of bonds, have seen their share prices pummelled and the cost of protecting their debt against default soar. Over the past week, sector leaders such as MBIA, Ambac, XL Capital Assurance, Radian and MGIC have all been hit hard.

In recent years, these companies, known as monolines, have moved away from their role of guaranteeing, or wrapping, bonds issued by US municipalities towards writing business related to structured asset-backed finance deals, such as mortgage-backed bonds and collateralised debt obligations.

Following the turmoil in structured credit markets, this business has turned sour, which could affect the cost of borrowing for the local US authorities who rely on their guarantees.

“Our conclusion is that MBIA and the rest of the financial guarantors are facing a prolonged period of stress,” said Rob Haines, an analyst at CreditSights, a research house.

Standard & Poor’s said it was reviewing new data on bond insurers to determine the companies’ ability to weather any further subprime-related storms.

The sector suffered last week, particularly after it produced a string of disappointing third-quarter results, which included hefty writedowns on the value of the insurance contracts written on structured bonds.

MBIA reported earnings on Thursday and saw its shares finish the day 14.9 per cent lower at $46.99. They had recovered to $47.47 on Monday, well off their 12-month high of $76.02.

The cost of protecting $10m of MBIA’s debt against default in the credit default swap market has soared from about $22,000 annually for a five-year contract back in February to more than $231,000 last week, said data provider CMA Datavision.

MBIA and its peers believe the market has overreacted and expect to see the writedowns recovered as the bonds they have insured regain their market values and mature. Michael Grasher, an analyst at Piper Jaffray in New York, concurred that the recent weakness in the financial guarantors was an overreaction: “The market is betting that management has fallen asleep at the wheel. We don’t agree.”

Bernanke is hoist on his own petard. He and the members of the FOMC had hoped that their dramatic cut in the Fed funds rate in September would be enough of a balm to the markets to give them more policy latitude in later months. Instead, the markets took it as a signal that Uncle Ben is their best friend, and they are lobbying for more, via the expectations signaled in futures prices. Now the FOMC is hostage. If they do what they think is right for the economy, they might roil the markets.

I wish we had Volcker back. He was more willing to inflict short-term pain for long-term benefit. A further rate cut will do nothing to shore up the areas of the market where the troubles lie, such as SIVs and CDOs. Certain types of mortgage-related assets are either not trading at all, or would trade only at distressed prices, due to problems of credit quality and transparency. A rate cut will not fix either problem.

From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke and his colleagues sound as if they’d prefer to just say no to an interest-rate cut this week. The financial markets may not let them.

Policy makers from Bernanke on down have avoided signaling they want to reduce benchmark lending rates at their Oct. 30-31 meeting, ever since lowering them by a larger-than-anticipated half percentage point in September. Instead, Fed officials have stressed how uncertain the outlook is and, in words Bernanke used twice in a single week, how “challenging” it is to make policy.

Traders don’t agree. They consider the chances of a rate cut this week as a cinch, judging from federal funds futures prices at the end of last week. If the Fed disappoints them, it risks upsetting still-fragile markets and hurting the economy.

“The Fed is reluctant to ease,” says Louis Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP LLC, a unit of ICAP Plc, the world’s largest broker for banks and other financial institutions. “But it also doesn’t want to unsettle the financial markets unnecessarily.”

The likely rationale if the Fed cuts: a desire to prevent the worst case, in which renewed market tumult, rising oil prices and falling home values drive the U.S. economy into recession.

The Fed, though, may combine such a move with an open-ended statement that doesn’t promise further cuts. Its goal would be to dissuade investors from anticipating a series of reductions, an outlook that could further weaken the dollar and revive inflation concerns….

“The markets are yo-yoing all over the place,” says former Fed Governor Lyle Gramley, now a senior economic adviser at Stanford Group Co. in Washington. “The Fed ought to have a cooler head.”….

Anecdotal information the Fed has gathered from business contacts, which has more weight in uncertain times, shows the economy expanding, albeit at a slower pace than when the central bank’s Federal Open Market Committee met last month….

Policy makers, including San Francisco Fed President Janet Yellen, have also highlighted the economy’s ability to weather financial turmoil in the past as reason to avoid overreacting to the latest market squall.

They cite 1998, when stocks slumped and credit costs rose after the collapse of hedge fund Long Term Capital Management in September. Helped by three rapid-fire rate cuts by the Fed, the economy barreled ahead, growing by 6.2 percent in the fourth quarter….

The Fed tried to avoid a similar situation last month with its half-point cut, says Laurence Meyer, a Fed governor from 1996 to 2002 and now vice chairman of Macroeconomic Advisers LLC of St. Louis. Instead, it once again faces calls for another cut. And traders are betting it will comply once more, if only to short-circuit a renewed increase in borrowing costs in credit markets.

Update, 10/29, 4:45 PM: Further observations from the Nattering Naybob:

No cut on Oct 31st means BIG disappointment. Cut?? Initial glee, but then we could see a redux of Jan 31, 2001 rather than the 1998 scenario.

Between June 99 and May 00, the Fed raised to 6.5%, then held for 7 months. During which the Dot.com implosion began the stock market slide in Mar 2000.

In a surprise meeting 01/03/01 the Fed cut 50 bps, the markets rocketed to the upside for 4 weeks.

At the regularly schedule meeting on 01/31/01; The Fed cut another 50 bps. The market initially jumped up then closed down that day.

Looking at a chart it appears after raising, then holding, the 2nd cut reinforced lower economic expectations and a weaker dollar, which sent the market into a 3 year tail spin.

An economic-risk index compiled by Citigroup suggests that credit costs are rising after dropping in the aftermath of the initial 50 bps September rate cut.

At Vox EU, Shang-Jin Wei argues in “Don’t over-sell the benefits of a change in the Chinese exchange rate policy,” that the upside of an end to the dirty float of the yuan (or as he prefers, the renminbi), has been overstated. His analysis is elegant and persuasive, and the piece is colorfully written as well.

He argues for the savings deficit hypothesis, that as long as Americans have a lousy-to-non-existent savings rate, our balance of payments won’t get better. And he finds, empirically, that there is no evidence that a floating exchange rate speeds up a current account adjustment.

Wei also believes that while a more freely floating currency will be a net plus for China, he doesn’t perceive the benefits to be large. I am a bit surprised that he does not address the argument commonly made, that the massive dollar purchases are playing a major role in domestic inflation (it has gotten so severe that China has imposed price controls). One would think that that would be a selling point.

From Vox EU:

Those urging China to adopt a more flexible exchange-rate regime sell the policy advice on the ground that it will substantially speed up the adjustment of global current accounts and that it will also substantially enhance the effectiveness of China’s domestic macroeconomic policies. Both supposed benefits may be exaggerated.

The Chinese renminbi (RMB) has come under intense scrutiny in the last five years, and calls for its revaluation have found receptive audiences amongst economists, politicians and the popular press. Many have advocated that China move to a more flexible exchange rate in order to alleviate global imbalances and improve its own macroeconomic management. But the benefits of an exchange-rate regime change for China and for the world may have been over-sold in policy circles. I say so on two grounds. First, the role of a flexible exchange-rate regime in facilitating current account adjustment may be vastly exaggerated. Second, the virtue of a flexible RMB exchange-rate regime in enhancing the effectiveness of China’s macroeconomic stability may also be over-rated.

Would a flexible exchange rate really speed up current account adjustment?

I ask this question not just due to the fact that a country’s current account imbalance is the difference between its national savings and national investment, that the large US current account deficit is a reflection of its large saving deficit, and that the US bilateral deficit with China is only part of its overall deficit with the rest of the world. All these are true.

Beyond these, many economists and policy wonks take it as self-evident that a flexible exchange-rate regime must deliver a faster current account adjustment. Many IMF statements also reflect this supposition. There is in fact no systematic evidence supporting it. I call this a faith-based initiative, something widely assumed to be true and actively peddled to countries as policy advice, but with little solid supportive evidence.

In a systematic analysis of this issue, Menzie Chinn and I find absolutely no support in the data for the notion that countries on a de facto flexible exchange-rate regime exhibit faster convergence of their current account to the long run equilibrium.1 This is true when we control for trade and financial openness; and this is true when we separate large and small countries.
To be sure, the current account does have a tendency to revert to its long-run steady state. This is clearly reflected in our empirical work. However, the speed of adjustment is not systematically related to the degree of flexibility of a country’s nominal exchange-rate regime.

Should we be surprised by this finding? Perhaps not. The current account responds to the real exchange rate, not the nominal exchange rate. If the real exchange rate adjustment does not depend very much on the nominal exchange-rate regime, then the current account adjustment would not depend very much on the nominal exchange-rate regime either. Menzie Chinn and I therefore go on to check whether the nature of a country’s nominal exchange-rate regime significantly affects the adjustment process of its real exchange rate. After looking at enough regressions, we conclude that the answer is no: the real exchange-rate adjustment is not systematically related to how flexible a country’s nominal exchange-rate regime is. If anything, there is slight, but not very robust evidence that less flexible nominal exchange-rate regimes sometimes exhibit faster real exchange-rate adjustment.

Just to be clear, if one could engineer a real appreciation of the renminbi, it could have some effect on China’s trade or current account balance. Indeed, in a separate research project that I am doing with Caroline Freund and Chang Hong, using China’s bilateral trade data and separating processing from non-processing trade, we find evidence that bilateral trade volume clearly responds to changes in bilateral real exchange rate, especially for non-processing trade.2 But a more flexible exchange rate does not promise a faster current account adjustment or resolution of global current account imbalances.

If China does opt for a more flexible exchange-rate regime today, its real exchange rate will most likely appreciate on impact. However, given China’s still-shaky financial sector and the credit crunch in advanced economies, it is certainly possible for the real exchange rate to go the other direction the day after tomorrow. After all, today’s expectation of an RMB undervaluation is a relatively recent phenomenon, emerging in late 2003. As clearly shown in Figure 1, taken from a paper with Jeffrey Frankel, until October 2003, the market actually expected a RMB depreciation, as measured by the non-deliverable forward rate.3 But the expectation shifted in late 2003 when US officialdom and scholars at prominent think tanks started to up the volume in the call for an RMB revaluation.

The very high speed of China’s foreign reserve accumulation really took off within the last four years, as seen in Figure 2. It may very well be responding to a shift in market expectation on the RMB movement, or at least the reserve accumulation and the exchange rate speculation feed on each other. However, if it took only four years for China’s FX reserve to triple in value, it may take only another four years for it to lose 60% of the value once the exchange rate expectation starts to reverse itself. Economic history books are full of examples of seemingly sudden shifts in market sentiment. A tight credit market in developed countries, such as the one we are seeing today, has in the past engendered a reversal of global capital flows, and a concomitant shift in the valuation of emerging market currencies.

Would a flexible regime vastly improve the effectiveness of China’s macro policies?

To appeal to China’s self-interest, advocates of a more flexible exchange-rate regime say it will greatly enhance the effectiveness of China’s domestic macroeconomic policy. A more flexible regime, as the logic goes, would free the domestic interest rate to serve as an instrument for domestic macroeconomic stability, and may benefit other policy objectives as well, such as financial reform and addressing future shocks. While I agree that a shift to a more flexible exchange-rate regime is a net positive for China, I would caution that the benefits of doing so for China should not be overrated.

First, China’s current monetary policy still has room for maneuver. Fundamentally, China’s capital controls, while leaky, are binding at the margin. The gap between lending and deposit rates can be widened further. The required reserve ratio might also be raised if desired.

Second, China’s fiscal policy still has room for maneuver. True, there are a lot of contingent liabilities that should and may show up on the country’s balance sheet. On the other hand, state-owned firms collectively are making a profit that is not currently counted in the government budget. The state may require these firms to pay up more dividends to augment existing fiscal management tools.

Third, to the extent that the de facto dollar peg constrains the conduct of China’s monetary policy, it may not be a bad thing. The most important goal of a good monetary policy is to maintain price stability. The de facto peg to the US dollar has served China well – beyond its role in promoting exports – as it has provided an anchor for its monetary policy. Once the country switches to a substantially more flexible exchange-rate regime, it will by definition lose this nominal anchor. One might prescribe an inflation targeting framework. But one could question how faithfully China will follow such a framework.

China’s recent monetary history has clear bouts of double-digit inflation, as shown in Figure 3. So resisting political pressure to deviate from maintaining price stability isn’t necessarily a strong suit for the central bank. The current leadership at the Central Bank, Governor Zhou Xiaochuan and his deputies, happens to be superb. But leadership at the central bank could change, and a look at the recent history doesn’t inspire absolute confidence that an inflation-targeting framework will be faithfully followed. So a less stable domestic price is a risk that cannot be easily ruled out if and when the country shifts to a more flexible exchange-rate regime.

Conclusion

I have stressed two points. First, the notion that a flexible exchange-rate regime would facilitate a faster current account adjustment is in fact not well supported by empirical evidence. Second, the virtue of a flexible exchange-rate regime in enhancing the effectiveness of China’s macroeconomic policy may also be overrated.

I still think that the benefits of moving to a more flexible exchange-rate regime likely outweigh the costs for China. On the other hand, China faces many challenges in its economy, including environmental degradation, rising income inequality, pervasive corruption, mining production safety, food production safety, and a constant threat of massive unemployment, to name just a few. In the grand scheme of things, when ranking all the reforms to do on the basis of benefit to cost ratio, how much priority this particular reform – the shift of the exchange-rate regime – should be given is a separate question.

Nouriel Roubini is a bit self-congratulatory in his latest post, and one can’t begrudge him. He took a lot of heat for his early prediction that the housing market would deteriorate badly and pull down the broader economy.

So far, since growth has slowed only somewhat, some economists still hold out hope that the impact of housing on GDP will be limited. Roubini, in “The Recessionary Macro Effect of the Worst U.S. Housing Bust Ever,” argues that the data coming in continues to support his earlier, grim forecasts.

He also notes that mortgage rates would have to fall 200bp to make current housing prices viable, and argues that the Fed was hoping that its September rate cut would be a step in that direction. But as most readers are well aware, long bond rates, which are the basis for pricing fixed rate mortgages, rose rather than fell based on higher inflation expectations.

From Roubini:

A friend of mine who is a senior professional in one of the largest financial institutions in the world has sent me privately – and confidentially – the following email messages. Like me, he predicted a year ago that this would be the worst housing recession in US history and described a bust process that would go through 4 phases. Here is the way he is putting it:

It appears that we are now entering phase 2 on the timeline for the housing bust:

Phase 1: rising mortgage defaults, homes prices start falling, sale volumes falls, housing starts and permits decline.

Phase 2: home-builders’ bankruptcies, housing starts and permits crash, substantial layoffs in construction and real estate-related fields (mortgage brokers, mortgage lenders, etc.).

Phase 3: substantial price declines in major metro areas, large rise in defaults of prime but low-equity mortgages.

Phase 4: large-scale government intervention to help households going bankrupt. This is a political phenomenon, so the timing and nature of this cannot be reliably forecast.

Evidence of financial distress and default among homebuilders in phase 2:

Public builders in trouble….

I fully agree with him with one caveat: we are not just at the beginning of phase 2 but most likely already at phase 3 as most of the aspects of phase 2 have already occurred by now and some elements of 3 are already on their way (home prices are falling sharply in some major metro areas, we are seeing the rise in defaults in near prime and prime mortgages and some near prime and prime lenders are in trouble). And we are getting close to phase 4 as over a dozen proposals to rescue 2 million plus households on the way to default and foreclosure are now being debated in Washington.

Next, this senior colleague sent me the following additional message – after my latest blog revisiting my predictions – on the macro impact of the worst housing bust in US history:

Follow-up to your blognote today…

Even more interesting is that the current view has not substantially changed from that of a year ago. The evidence is now overwhelming and consensus admits what they denied last year: that we will experience at least a severe housing downturn — in price action unlike anything since the 1930′s, probably also in rates of foreclosure.

But consensus opinion remains unshaken that there will be only minor macro effects. This seems extraordinary to me. A 70 year record decline in what is perhaps the largest private asset class, the collateral for the majority of household debt, whose leverage is at an all-time record high. A downturn – perhaps crash – in the construction and real estate industries (18% of 2005 total metropolitan area GDP).

Perhaps the most astonishing aspect of this event is the refusal to recognize the possible dimensions, the impact, of what is coming.

Indeed, the soft landing consensus is increasingly delusional in believing that the biggest housing recession in US history will not have severe macro effect. Most of the consensus now recognizes that, after the spurt in growth in Q3 (probably a little above 3%) the economy is now rapidly decelerating and Q4 will be weak: for example one of the most bullish houses – JP Morgan – is now forecasting a Q4 growth of only 1%, fully in the growth recession territory (Bloomberg consensus for Q4 is an optimistic 1.8%). But this consensus next goes to assume and predict that Q4 will be the bottom of the US growth slowdown and that economic growth will recovery in soft landing territory (2.5%).

What is the basis for this alleged 2008 growth recovery? Mostly wishful thinking as the economic and financial shocks leading to falling demand (a worsening housing bust; anemic capex spending; slowdown in commercial real estate demand; sharp private consumption slowdown) and weak supply (weakening ISM; slowing down employment; glut of supply of new and existing homes, auto/motorvehicles, consumer durables; a capacity overhang; an excess inventory buildup) will fully persist into 2008. Indeed, as David Rosenberg, the chief US economist for Merrill Lynch put it in his most recent report:

We think a miracle is needed to avoid recession. With domestic demand growth struggling to stay above a 1% run-rate, if we manage to avoid a recession with another huge down-leg in homebuilding activity and home prices, we think it will be a miracle.

A miracle to avoid a recession! Indeed it seems that many of the soft landing optimists are now in wishful thinking mode, if not hoping for a miracle. As Ed Leamer showed in his Jackson Hole paper, six of the last eight housing recessions have ended up in a economy-wide recession; and this housing recession will end up being more severe than all of the former eight ones. The only two exceptions of a housing recession not leading to economy-wide ones were those during the Korean War and the Vietnam war when a massive fiscal stimulus rescued the economy. What we spent – or waste – on Iraq is not sufficient to get that fiscal stimulus; we would need another equivalent of $200 billion fiscal stimulus to do the job. A war with Iran is such an option: but a war in Iran would lead to an overnight doubling of oil prices to $200 per barrel plus and would lead to a certain U.S. and global recession.

Home prices will have to fall by 20% to bring back home affordability to semi-normal levels; or mortgage rates would have to fall by 200bps to get the same result. Chances of the latter happening are zippo as long rates went up after the Fed eased on September 18th. So the adjustment will occur via a painful and deflationary 20% fall in home prices that will trigger an economy wide recession as any mainstream macro-econometric model shocked with a 20% fall in home prices shows.

No wonder that Mishkin – in his Jackson Hole paper – went through a benchmark scenario where home prices fall by 20%; do you think that Bernanke had not read Mishkin’s paper before the Jackson Hole meeting? And the implication of the Mishkin paper was that the Fed needed to start with a 200bps Fed Funds cut to try to attempt to counter this home price shock alone; even that would not be enough as long rates and mortgage rates are likely to fall less than otherwise hoped by the Fed.

So no surprise that Marty Feldstein urged at Jackson Hole the Fed to cut rates right away – to start with – by 100bps. But, at best, the FOMC will give us another 25bps as a Halloween Treat on Wednesday, not the 200bps implied by the Mishkin analysis. So, what the Fed does is – again – too little too late. The consensus among the independent academic luminaries at Jackson Hole (Feldstein, Leamer, Shiller, and even implicitly, Mishkin) was that this was the worst housing bust ever and that the macro effects would be severe with a high risk of a recession. So why is the Wall Street consensus and the Fed not getting it?

What does the macro econometric model used by the Fed imply if you shock it with the worst US housing recession, 20% fall in home prices, collapsing HEW, a severe liquidity and credit crunch, a rise in investors’ risk aversion and uncertainty, and oil at $90? Would someone at the Fed let us know? And – based on that model – which cut in the Fed Funds rate it will take to avoid a recession? Hopefully someone at the Fed may have that answer and provide it to the public.

At this juncture, the question of “Whither Merrill?” is largely rhetorical. We won’t know for certain until the fourth quarter results come in, and for all firms, those are likely to be telling. However, consider the following:

Some securities analysts already estimate that based on further deterioration in the mortgage markets since September 30, Merrill is now sitting on an additional $4 billion in losses.

Although these charts are for ABX BBB and AAA indexes, which are proxies for the subprime paper (there are no proxies for CDOs), these charts, courtesy Calculated Risk, give an idea of the recent trajectory:

ABX-HE-BBB- 07-2

ABX-HE-AAA-07-2

As of the end of the second quarter, Merrill owned $32.1 billion of collateralized debt obligations, reportedly AAA, and $8.8 billion of subprimes. A combination of sales and writedowns has whittled those figures to $15.2 billion and $5.7 billion, respectively.

However, CDOs have tremendous embedded leverage. Their prices are far more sensitive to changes in the performance of their underlying assets, than, say, subprime RMBS. That is why we have had the spectacle of rating agencies downgrading them, not by the normal grade or at worst two that you see for corporate bonds, but by huge amounts. Now that the rating agencies have gone through a process of reviewing ratings on various mortgage securities, Moody’s is turning to CDOs, and some issues have already gone from AAA to junk. That rapid a downgrade is impossible in the corporate bond world in the absence of fraud.

In addition, while Merrill has sold more than half of its earlier CDO inventory, it’s almost a given that what was most saleable was their better paper. What remains is more vulnerable. And with the subprime market taking, CDOs are sure to follow, both due to their direct exposure (a lot of subrprime paper went into CDOs, but many are subprime free) and to the knock-on effects on confidence.

With SIVs restructuring this quarter, which will entail some selling of mortgage related paper, there will be more stress on these markets. Between market deterioration and downgrades, it’s not hard to imagine Merrill taking 50% losses on its remaining CDO inventory. That would mean further writedowns in excess of $7 billion.

Hedge funds charge vastly higher fees than other money managers because they allegedly deliver better investment returns. Yet when you look at most hedge fund indices, they don’t look much better, and are sometimes worse than simple long-only strategies. And remember these indices almost certainly overstate performance, since they exhibit what is called “survivorship bias.” Funds that die are not included in the index, and since the mortality rate among hedge funds is higher than among mutual funds, it produces a greater gap between the returns reported in the indices versus those earned by a typical investor.

There are other distortions in results shown by hedge fund indices: the hedge funds report voluntarily, and they tend not to report poor results; the figures they submit are not audited; the results can include the best results from funds being incubated with small amounts of money.

The result of these distortions in aggregate is significant. A 2003 study, “A Critical Look at the Case for Hedge Funds,” by Richard M. Ennis and Michael D. Sebastian published in the Journal for Portfolio Management, found that from 1992-2002, the Hedge Fund Research Composite Index’s reported an average return of 11.3%. Yet the Hedge Fund Research Fund of Funds Index, which gives the results earned by investors in funds of hedge funds, showed returns over the same period of only 7.1%. And remember funds of hedge funds are supposed to allocate capital to the winners. This return also fell short of the performance of S&P 500 Index and the Lehman Aggregate Bond Index over this time frame.

Yet one rationale for hedge funds still persists: some hedge funds produce superior returns repeatedly. Unlike mutual funds, where mean reversion rules out, various studies have found that some top performers remain top performers.

Even that defense of hedge funds may have bitten the dust. A new study claims that the earlier research was based on faulty methodology.

Remember the logic for the exorbitant hedge fund fees. Investors are paying for “alpha,” that is, the excess return (meaning the return in excess of the “market” return). Investors are willing to pay for alpha because it is considered to reflect an investment manager’s skill, and managers who can regularly outperform the market are rare indeed.

The new paper, “Hedge Funds: Ability Persistence and Style Bias,” by Matteo Belleri and Marco Navone (hat tip All About Alpha) tells us that the past research on this topic is largely bunk:

…the vast majority of the relevant contributions is focused on the persistence of funds total return. Only a small number of articles try to analyze the persistence of fund managers ability measured as the difference between fund return and the performance of an index of hedge funds with the same strategy.

The authors found something sneaky: while a few managers did outperform repeatedly in their reported strategy, when they reran the numbers, defining the strategy based on a three year regression of returns, they found no persistence in superior performance.

What does this result suggest? Style drift. Hedge fund managers are supposed to adhere to a certain program, say global macro, market neutral, distressed investing, emerging markets, commodities. What the authors’ findings suggests is that hedge fund managers cheat. If their strategy is going cold, they dabble in something else.

Now if you an old-fashioned hedge fund investor, meaning a wealthy individual, you’d applaud someone who behaved like that. All you care about is absolute, or perhaps inflation-adjusted, return.

But institutional investors have become the dominant force in the industry, and they care not only about the alpha a fund generates, but also its “alternative beta.” The fact that a particular hedge fund does global macro means it has a profile of returns that may not be correlated with other investments the fund has, and is attractive for that reason. Thus, if a fund deviates from its style, it won’t deliver the type of alternative beta it promised. That is a major no-no for the hedge fund consultants who serve as the gatekeepers for institutional investors.

The study by Belleri and Navone is a major challenge to conventional wisdom about hedge funds. It will be interesting to see what sort of additional research it provokes.