naked capitalism

This story on Citi’s further SIV woes has appeared on Bloomberg; we’ll update it when the Wall Street Journal and other financial news sources weigh in.

Citi had roughly $80 billion of SIVs outstanding, but a MarketWatch story that looked to be a a PR plant, put the emphasis not on the rating agency actions, but on the fact that Cit has further reduced the amount of SIVs assets it has outstanding, from $83 billion to $66 billion. Thus the downgrades and reviews of $65 billion of debt involve effectively all of Citi’s’ SIV financing (the $1 billion unaccounted for may represent the lone SIV not on the watch list, Vetra).

The downgrades did not involve primarily subordinated debt, which is either capital notes or medium term notes, not commercial paper. However, the commercial paper for several Citi SIVs has been put on review. The Bloomberg article also lists the rating actions on the non-Citi SIVs

It seems, as we foretold, that the SIV rescue plan, which was about assisting Citi and then anyone else who cared to come along for the ride, is too little, too late (assuming that it ever sees the light of day).

From Bloomberg:

Moody’s Investors Service said $64.9 billion of debt sold by Citigroup Inc.’s structured investment vehicles was cut or placed on review for a downgrade as part of a review of $130 billion of SIV debt…

“In recent weeks, Moody’s has observed material declines in market value across most asset classes in SIV portfolios,” the ratings company said in the statement.

Moody’s cut $14 billion in debt in all, mostly capital notes that rank below commercial paper and medium-term notes and are usually the first to absorb losses, Henry Tabe, managing director in charge of structured finance, said in a telephone interview. The ratings company placed $105 billion of debt on review for a downgrade and confirmed the ratings on $11 billion, Tabe said.

SIV assets on average are 38 percent financial institution debt, 16 percent asset-backed securities and 12 percent collateralized debt obligations, Moody’s said.

The downgrades are “a reflection of the continued deterioration in market value of SIV portfolios combined with the sector’s inability to refinance maturing liabilities,” Moody’s said. Net asset values have slumped to 55 percent from 102 percent in June, Moody’s said, including the NAVs of the three defaulted SIVs….

Citigroup said in a Nov. 5 regulatory filing that it “will not take actions that will require the company to consolidate the SIVs.” The strategy “remains unchanged from the disclosures in the third quarter” filing, spokesman Jon Diat said today in an e-mail statement. “We continue to focus on liquidity and reducing leverage,” Diat said. Citigroup’s SIV assets have dropped to $66 billion from $83 billion on Sept. 30, Diat said.

Centauri Corp., the largest SIV run by Citigroup with $16.9 billion of debt, had its P1 commercial paper rating placed on review for downgrade as well as its AAA medium-term note program, Moody’s said. Centauri’s net asset value dropped to 60 percent from 85 percent since Sept. 5, Moody’s said.

Beta Finance Corp., the second-largest Citigroup SIV with $16 billion of debt, had its senior debt ratings placed on review for downgrade after its net asset value declined to 60 percent from 87 percent, Moody’s said.

Four other Citigroup SIVs, Sedna Finance Corp., with $10.7 billion of debt, Five Finance Corp., with $10.3 billion, Dorada Corp. with $8.5 billion, and Zela Finance Corp., with $2.5 billion, had their P1 commercial paper rating and AAA medium-term note programs placed on review, Moody’s said.

Sedna’s net asset value dropped to 56 percent, Five’s declined to 63 percent, Dorada dropped to 62 percent and Zela’s fell to 61 percent. A seventh Citigroup SIV, Vetra Finance Corp., wasn’t part of the review.

Dorada’s capital note program was reduced to Caa3 from Baa1.

The debacle in Florida, namely a $27 billion short-tern investment fund being frozen after the revelation it held $700 million of defaulted debt (today reported as $900 million) led to $12 billion in withdrawals, is producing a cash crisis at the government entities that hadn’t gotten their money back.

Aside from the troubles this impairment is creating in and of itself, it will feed “run on the fund” behavior if any other government-operated funds encounter similar difficulties.

From Bloomberg:

School districts, counties and cities across Florida are scrambling to raise cash after being denied access to their deposits in a $15 billion state-run investment fund.

Florida’s State Board of Administration, manager of the Local Government Investment Pool, halted withdrawals yesterday at an emergency meeting after $12 billion was pulled out this month from participants. Governments from Orange County, home of Disney World, to Pompano Beach asked for their money back following disclosures that the fund held $1.5 billion of downgraded and defaulted debt.

“The unthinkable and the unimaginable have just happened here in Florida,” said Hal Wilson, chief financial officer of the Jefferson County school district, which kept its entire $2.7 million of cash in the fund. “What we just experienced here is a classic run-on-the bank meltdown.”

Thousands of school districts, towns and fire departments across the U.S. keep their cash in state- and county-run pools. These public accounts, modeled after private money-market funds, are supposed to invest in safe, liquid, short-term debt such as Treasuries and certificates of deposit from highly rated banks.

By freezing the Florida fund, officials left governments without ready access to cash they are accustomed to drawing upon for routine expenditures. The pool was the largest of its kind in the U.S. at $27 billion before the unprecedented withdrawals.

Just 30 miles (48 kilometers) east of the state capitol in Tallahassee, there was no money to pay the 220 teachers and other employees in Wilson’s Jefferson County school district today. Wilson said he trusted the State Board of Administration’s assurances that the money was safe even as other pool participants withdrew billions of dollars.

“We are in the process of working out provisions of a short-term loan with our bank to cover the overdrafts that will occur in our payroll account today,” Wilson said….

Standard & Poor’s yesterday said it contacted state officials about whether the fund holds any money for debt service payments by local governments and whether that cash will be made available. The credit-rating company said it hadn’t yet received information and was monitoring the situation….

The board is considering ways to shore up the fund, including obtaining credit protection for $1.5 billion of downgraded and defaulted holdings hurt by the subprime market collapse. In voting for the suspensions, officials sought to stem the flood of money leaving the pool and avoid losses on forced sales of assets…

The fund’s $900 million of asset-backed commercial paper that was downgraded to default amounts to 6 percent of its assets. Another $650 million, or 4 percent, is invested in certificates of deposit at Countrywide Bank FSB, a unit of Countrywide Financial Corp. The bank’s rating was cut to Baa1, three levels above junk status, by Moody’s Investors Service on Aug. 16.

Update 11/30. 6:00 PM: Other states are seeing removals from their cash funds. MarketWatch reports that roughly 10% has been withdrawn from its vehicle.

Bloomberg reports that despite the latest balm to the credit markets, that of offers of emergency funds that would tide banks over the typical end-of-year reduction in liquidity, Libor has nevertheless increased to the highest level since 2001.

The problem, of course, is the the reason funding is tight is that banks are worried about counterparty risk. Cheaper funding is not going to make them assess those exposures any differently. This does not bode well for the efficacy of further rate cuts by the Fed.

From Bloomberg:

Money-market rates rose, driving the cost of borrowing in euros for three months to a six-year high, after central banks failed to quell concerns about year-end cash needs and losses linked to U.S. subprime mortgage defaults.

The London interbank offered rate for euro loans rose 3 basis points to 4.81 percent, the highest since May 2001, the British Bankers’ Association said. The increase came even after the European Central Bank today extended the maturity of a regular refinancing operation through the end of the year. The rates for dollars and pounds also climbed.

The ECB, the Bank of England and the Federal Reserve have all offered emergency funds this week to soothe concerns that credit conditions will deteriorate at the end of the year….

“Central banks don’t have the tools to arrest this rise in Libor because the issue is no longer about liquidity, it’s about credit concerns,” said John Wraith, London-based head of U.K. interest-rate strategy at Royal Bank of Scotland Plc, the second-biggest U.K. bank. “If banks aren’t willing to lend to one another, there’s nothing central banks can do.”

The gap between the rate on three-month interbank euro loans and the ECB’s benchmark rate, which currently stands at 4 percent, is the highest since the central bank took charge of monetary policy in 1999….

Bank of England Governor Mervyn King said yesterday there’s a risk a further drop in asset prices “might impair the balance sheets of the banking system in the U.S., which would lead to a classic credit squeeze.”

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

I am sticking my neck out a bit on this post, since the credit default swaps market doesn’t garner much coverage, so any readers who are involved in this busines are encouraged to comment.

Yes, there are frequent references to what changes in CDS prices mean about the credit-worthiness of particularly names, but there is parlous little attention paid to the health and activity of the market as a whole.

Despite the use of the term “swap,” CDS are really insurance contracts. A protection seller (effectively, the insurer) agrees to make a payment to the protection buyer if specified bad things happen (a “credit event” usually defined as bankruptcy or failure to pay) to a “reference entity” which can be a company (“single name”) or an index. See here for more detail.

Now while it may look like the risk being traded here is default risk, there is a second risk: counterparty risk. CDS are the largest credit derivative product, and they are traded solely over the counter. That means that the CDS agreement is only as good as the protection seller that wrote it.

When Warren Buffet described derivatives as “financial weapons of mass destruction” he wasn’t worried about speculators blowing themselves up, but about counterparty risk:

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).

So why should we be concerned about CDS? Even though they have been around since the mid 1990s, they have grown explosively since 2002, in a (until a few months ago) benign credit environment:

Notice that the notional amount outstanding is $45 trillion. While the economic exposures of derivatives are a fraction of the notional amount, this is still large enough to focus the mind.

Who is standing behind these contracts? As Ted Seides tells us:

Banks are the primary sellers of CDS, totaling 40% of all written CDS and representing notional exposure of $18.2 trillion.[xv] Banks claim to run hedged books, effectively serving as a market-maker in the CDS market. As should be evident from the events in subprime, even the most sophisticated systems are often unable to fully hedge risks of this size and degree of complexity. If printed materials are any indication, banks may be asleep at the switch. The “Counterparty Considerations” section in the Credit Derivatives Primer of market share leader JP Morgan is a single paragraph on the last page of the volume, which proclaims “the likelihood of suffering (counterparty default) is remote.”[xvi] (italics added)

Hedge funds appear to be in over their heads as well. According to printed statistics and consistent with anecdotal evidence, hedge funds are sellers of 32% of all CDS, insuring exposure of $14.5 trillion.[xvii] Recent estimates indicate that the entire hedge fund market is approximately $2.5 trillion in net assets under management. Thus, hedge funds are bearing risk in excess of their ability to pay the piper if anything goes wrong.

Although, as noted above, there is comparatively little reporting on the CDS market, we are seeing some signs of stress.

The last two years have seen the growth of CDS based on asset backed securities and ABS indices, such as the ABX and the CMBX, based on the CMB, an index representing commercial real estate securities. CDS were also one means to achieve credit enhancement in collateralized debt obligations. Given the sharp decline in the ABX indices and downgrades of CDOs, it’s a no-brainer that anyone who wrote protection on them has taken large losses. Case in point: Swiss Re recently announced that it had taken over $1 billion in losses on two CDS referencing mortgage-backed investments.

Consider another troubling development: banks are already worried about counterparty risk in the money markets, as witnessed by the uncharacteristically large spread between T-bills and Libor. It seems inconceivable that banks wouldn’t have similar worries about CDS exposures. We have indirect confirmation via this story in the Financial Times, “Trading in derivatives slows to a trickle“:

Liquidity in some of the world’s biggest derivatives markets has dried up this week amid increasing fears over the health of the international financial system.

Over-the-counter trading in derivatives of equities, credit and interest rates have all seen much lower volumes as problems in financial markets have prompted investors to sit on the sidelines…

Analysts said flows had slowed to a trickle this week – even lower than in the summer when the credit squeeze was at its peak – as investor appetite for risk had diminished amid talk of potential bank defaults…

David Brickman, head of European credit strategy at Lehman Brothers, said: “Generically, trading volumes [in credit derivatives] are a lot lower than they were in the summer.

“The theory is that if people can’t trade bonds, they’re going to go to CDS [credit default swaps]. But in an environment like this you can’t get liquidity on single-name CDS either. That just leaves the indices.”

And a more colorful confirmation comes from a reader:

To remind you we have been short the ABX CMBX and CDX since last January. To keep this short I will summarize my points.

1. Our counterparties are Bank of America and Barclays. We only have ~20 million in equity and were allowed to go short the market 150M notional by posting 3% margin. Presumably the numbers are similar for someone who wanted to go long (should be a little higher).

2. After July hit we were no longer allowed to take ‘new’ short positions. We were originally told that we are allowed to close out our shorts at any time but not allowed to open a new one. So we couldn’t roll into the on-the-run series or move our shorts up the capital structure as the environment continued to deteriorate.

3. My original thought was that they wanted to artificially prop up the market because the market makers may have too much of a net long exposure – and they are extrememely concerned – or they have someone on the proprietary desk that got themselves into a pickle. So I thought this would pass in a few weeks and we could move our position around.

4. Today I still cannot open a new position. In the past few months a few friends have been let go from some of the larger banks and have shed light on the topic. The reality is that they are concerned about collecting from hedge funds that were long. Although this is just hearsay from friends – it completely matches my own experience. To further the point – working with the collateral team at BOA in pay as you go contracts – they are a mess. They are overdrafting accounts – forgetting to pull money when its due – they can’t reconcile a mistake in less than 8 weeks. It’s a debacle.

Conclusion:
The credit teams for these banks may have been allowing hedge funds to trade at excessive leverage without enough controls. They most likely were basing margin requirements on the volatility of the security (or contract). I am a firm believer that this type of analysis blinds analyst to real risk and gives them unjustified confidence in how ‘secure’ they are – but that’s another story. I am not going to pretend I can estimate these losses or give accurate numbers to even shed light – but this is definitely and ‘unknown unknown’ with a high potential impact. As Nassim Taleb would say – this has the makings of a Black Swan.

What seems odd, given all the foregoing, is that Swiss Re, admittedly a new player but one with a small book, is the only concern to have reported CDS losses. Someone has to be on the other side of the eyepopping trades entered into by Paulson & Co. and for that matter, Goldman, which has been short mortgage-related credits. That raises the question of how much latitude financial firms have in marking their derivative books (and auditors have no hope of getting to the bottom of their economics).

The other open question is what happens to the CDS market as banks continue to shrink their balance sheets? CDS have become integral to the way a lot of players measure and manage credit risk, but if the market becomes illiquid, there will be a lack of reliable price information and a dearth of protection sellers to write new contracts.

If you’d like to worry even more about CDS, this post from “CDS: Phantom Menace” from Sudden Debt is insightful.

Do we see a pattern here? The much-covered, little-loved SIV rescue program (formally known as the Master Liquidity Enhancement Conduit and informally called the Entity or Super SIV) was announced prematurely, didn’t clearly solve the problem it was meant to address, involved a lot of failing around to try to resolve irreconcilable interests (those of the SIV sponsors versus the investors who would eventually fund it) and appears to be stillborn (despite the expectation that a structure would have been announced and syndication of the credit enhancement would be underway, we’ve heard nada, presumably because HSBC’s decision to rescue its own troubled SIVs has put a damper on the MLEC plan).

Paulson seems unable to learn from his own experience. He is swinging for the fences with another Big Scheme That (Purports To) Fix The Problem With A Master Stroke. His track record here is not encouraging.

According to Bloomberg, he had a one hour meeting today:

…. with federal regulators, bankers and lobbyists. Executives of Citigroup Inc., Wells Fargo & Co. and Washington Mutual Inc. attended, said a person present….

“One of the roles of Treasury is to say `come on, let’s get together and see what we can do,”’ said Wayne Abernathy, executive director of financial-institutions policy at the American Bankers Association in Washington and a former Treasury assistant secretary. “You’re likely to come up with something that will work both in the marketplace and honor the sanctity of the contracts involved.”

This was effectively a kickoff meeting to bring relevant parties together to discuss possible approaches to the subprime mess. Yet how is this treated in the Wall Street Journal? It’s a page one story, “U.S., Banks Near A Plan to Freeze Subprime Rates.” And in more MLEC deja vu, we have the too often repeated mantra,

Details of the plan, which could be announced as early as next week, are still being worked out.

Now either Bloomberg is wrong, or the Journal is wrong, but that telltale sentence says the Treasury has again let the press get too far out in front of the story.

Of course, unlike the MLEC plan, there is a precedent of sorts here that could serve as a blueprint for the Federal effort. In California, four mortgage sevicers have agreed to extend teaser rates for certain borrowers for five years. However, there has been a remarkable lack of detail about how this will work or how many people it will help. Borrowers have to be current on their payments and they need to “prove” that a rate increase is beyond their means. We have seen that state programs to salvage troubled borrowers have achieved very little in the way of tangible results. The California program may fall into the same camp.

Ironically, if the California plan and any state or federal programs along similar lines do help a lot of borrowers, they could run into a second set of problems: investor lawsuits. It isn’t at all clear that the servicers can enter into loan modifications like this unless they will help, or at least not hurt, the investors. It’s hard to establish that with blanket programs, which is what these are intended to be. Remember, the servicers have no legal obligation to the borrower beyond those specified in the mortgage, and those agreements are pretty one-sided. We’ve gone on at greater length elsewhere why we regard the “fix the initial rate” concept as problematic. Indeed, as the Bloomberg story points out,

Mortgage-industry lobbyists have argued an across-the-board solution is difficult to apply. Rewriting contracts also risks moral hazard — encouraging borrowers to take on more debt in the expectation of being bailed out if needed later.

“It is really an indiscriminate procedure that would violate the terms of the contract that provide for loan-by-loan decision making,” George Miller, executive director of the American Securitization Forum, said in an interview this month. A broad approach would “significantly disrupt the reasonable expectation of investors” in the $7.1 trillion market for bonds backed by mortgages.

Back to the Paulson initiative. As noted initially, the Bloomberg report makes clear that the plan, if it even can be called that, is at a preliminary stage:

Paulson was joined yesterday by Federal Deposit Insurance Corp. Chairman Sheila Bair, Comptroller of the Currency John Dugan and Office of Thrift Supervision Director John Reich. Also represented was the American Securitization Forum, which lobbies for investors, traders, underwriters, accounting firms, ratings companies and other institutions involved in the creation and sale of mortgage-backed securities.

Bair has proposed letting borrowers with adjustable-rate subprime mortgages, who are living in their homes and unable to afford resets, get extensions on the starter rate for at least five years. They could also be offered 30-year fixed-rate loans. Reich prefers a three-year freeze…

Jennifer Zuccarelli, a Treasury spokeswoman in Washington, declined to discuss the meeting in detail. “We are encouraged progress is being made,” she said…

Regulators still lack reliable estimates on the extent of the subprime mortgage crisis.

Three months after they asked banks to modify loans for borrowers at risk of default, agencies have little comprehensive data on what lenders and loan servicers have done, officials say.

The Treasury has urged the Mortgage Bankers Association to gather precise data on loan modifications.

The Journal’s coverage, by comparison, was breathless:

The Bush administration and major financial institutions are close to agreeing on a plan that would temporarily freeze interest rates on certain troubled subprime home loans, according to people familiar with the negotiations…. People familiar with the talks say the individual members have agreed to follow any agreement reached by the coalition, which is called the Hope Now Alliance….

In general, the government and the coalition have largely agreed to extend the lower introductory rate on home loans for certain borrowers who will have trouble making payments once their mortgages increase…

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

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

Among the holdouts have been investors, who typically hold securities backed by mortgages. If interest rates are frozen, they would lose the potential benefit of higher payments. But investors have cautiously moved toward cooperation, likely on the grounds that it’s better to get some interest than none at all.

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

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

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

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

Note that the American Securitization Forum seems to be playing both sides of the street at the moment, and as a lobbying organization, its actions are not binding on its members. Recall also that hedge fund Paulson & Co. threatened to sue Bear Stearns during the unwinding of its hedge funds. It was never entirely clear what the issues were, but it appeared to involve “class warfare” or actions that had the (perhaps unintended) effect of aiding one tranche in a securitization at the expense of another. In other words, fairly arcane issues can be grist for litigation.

Consider finally that any plan is not legally binding and is merely a set of guidelines for the industry, so interpretation is likely to vary. As with the state rescue plans, it may turn out that too few borrowers meet the criteria set forth for the program to have much impact.

Even if the dreadfully named Hope Now Alliance comes up with a remedy for borrowers, don’t assume it can’t be contested as an illegal breaching of contractual rights.

Update 11/10, 6:15 PM: Paul Kedrowsky provides further detail as to why this idea is problematic. First he cites the Financial Times:

Industry executives, market participants and several analysts said implementing any plan would be complicated and riddled with technical and political problems, including possibly encouraging otherwise stable borrowers to miss payments. “If you are a borrower in the group that gets left behind by this scheme, you have a set of perverse incentives to default in order to get the break. It has moral hazard written all over it,” said Don Brownstein, chief executive of Structured Portfolio Management, a hedge fund.

Several mortgage experts also said categorising borrowers would be difficult, given that their financial information might never have been collected before.

Note that the moral hazard comment is based on a misunderstanding of the proposal. It is for borrowers who have made their payments but likely won’t be able to, at least consistently, once the reset hits. Remember, the program is supposed to help only the Deserving Poor. But other plans have found it is hard to get borrowers who are current on teasers thorough an application process before the reset hits. Most turn to relief post reset, when they are in trouble, and thus they are screened out.

He also quotes an Institutional Investor story that points out that the lenders/servicers aren’t within their rights to modify any securitized subprimes, and unhappy investors who were looking forward to a reset-created uptick in payments may sue.

Who was it who said money is too important to be taken seriously?

I came across this video courtesy Dave Iverson at Economic Dreams – Economic Nightmares. Enjoy!

Today’s GDP release showed third quarter growth at 4.9%. That number was such a howler that it promptly elicited the contempt it deserved. From Barry Ritholtz, in “GDP=4.9% (also, I have a bridge for sale in Brooklyn)“

This 4.9% number is one of the more “fanciful” government releases you will see in your lifetime, (outside of the state run media that exist only within totalitarian dictatorships).

Did this past quarter feel like the strongest growth quarter in 4 years?

Let’s begin with what we know about Q3 prices: They saw significant increases — yet the price index deflator was a 9 year record low of 0.9%. Rex Nutting observed: “Because of the way in the price index is constructed, it likely understates real-world inflation, and thus overstates real growth.”

Residential fixed investment, the GDP component that includes spending on housing, plunged by 19.7% in the third quarter (but Investments in structures increased 14.3%).

Profits for the 3rd quarter flipped negative, dropping 8.5%.

We have seen consumer spending falter, with the crucial opening salvo of the holiday weekend down 3.5%. That’s no surprise, given that second-quarter wages were revised lower by $44.8 billion. As a result, real disposable incomes fell 0.8% in the second quarter, instead of rising 0.6% as the Commerce Department had previously reported.

~~~

Question: How can Q3 GDP be 4.9% with corporate earnings, housing and retail sales so awful? Forget Goldilocks, this fairy tale sounds more like Cinderella . . .

The more anodyne Wall Street Journal’s Real Time Economics Blog also took issue, and pointed to other measures that showed far less robust growth:

According to the latest gross domestic product revision, the U.S. economy swelled at nearly a 5% clip last quarter, almost double the economy’s noninflationary limit.

Or did it?

Gross domestic income – a lesser-known gauge that the Fed has highlighted in the past as perhaps a better alternative — increased less than 2% last quarter, well below the economy’s potential. The first estimate of GDI is released with the second GDP estimate because it incorporates data that isn’t available earlier. (See line 11 on this chart.)

GDP counts economic activity based on expenditures, while GDI bases it on income. In theory, they should add up the same, though the often diverge — albeit not as much as they did last quarter.

Earlier this year when the Fed was trying to reconcile slower GDP growth with still-strong labor markets, it noted that GDI “might better capture the pace of activity.” GDI was running hotter than GDP at the time.

But the tables appear to have turned since early in the year. GDI has grown more slowly that GDP over the first three quarters of 2007 as a whole.

The main difference between the two gauges last quarter was corporate profits, which GDI includes and GDP excludes. Corporate profits from current production fell last quarter. GDI also doesn’t explicitly include net exports and inventories, as GDP does. GDI, in contrast, relies more heavily on employee compensation data.

But when there are differences, Fed officials may lean towards GDI, especially when it comes to signaling economic downturns. Fed economist Jeremy Nalewaik wrote in a March paper that GDI “has done a substantially better job recognizing the start of the last several recessions than has real-time GDP.”

Now even Ritholtz’s post acknowledges that a big contributor to the seemingly exaggerated GDP figures is the way inflation is treated, and GDI isn’t skewed by that. So we seem to have a culprit.

However, what is troubling is that this isn’t the only instance of dubious statistical releases by the government. Ritholtz, Michael Shedlock, Dean Baker, and Floyd Norris have remarked repeatedly on suspect birth-death adjustments to the Bureau of Labor Statistic’s monthly jobs report. Needless to say, the birth-death adjustments have led to increases in jobs allegedly created, and this pattern has persisted for months.

Similarly, Ritholtz, Wolfgang Munchau, and others have been critical of reliance on the consumer price index as the metric of inflation (it is one thing to say that the non-core elements, particularly food and energy, are volatile, but in this case, they’ve been unidirectional).

Ritholtz, Shedlock, and Nouriel Roubini haver also criticized previous GDP releases, and Shedlock in particular has written on the seldom-considered practice of using hedonic adjustments to GDP. They allow for the fact that computers are becoming more powerful at lower costs. In essence, the US grosses up the price of computers in its GDP reports to adjust for the fact that computer prices are dropping.

These adjustments have been going on since 1980 and the US is the only OECD country to use this approach. Shedlock obtained some data from the Bureau of Economic Advisers that indicated that hedonic index-related adjustments had added $2.257 trillion to 2005 GDP. That’s 22% of the total.

Why does this bother me? As Ritholtz suggested at the outset of his comment on the latest GCP release, this is banana republic behavior. I did a wee bit of work in Mexico a while ago, and then you couldn’t rely on a single government supplied statistic. it made any analysis an exercise in informed guesswork, and made it hard for businesses and individuals to plan. But it seems this nation is more interested in feel-good than in reality.

Update 11/30, 2:00 PM: Jim Hamiltion at Econbrowser provides an analysis of the GDP release. An increase in inventories apparently contributed 1% of the 4.9%, which is not a good sign, but he found the news that exports were another source of growth to be encouraging.

Yesterday, Bloomberg reported that a state-run investment fund in Florida witnessed $8 billion of redemptions out of a total fund size of $27 billion because its investors learned the fund held $700 million of defaulted paper. The fund froze the remaining fund assets today. Apparently withdrawals continued yesterday after the Bloomberg story was released, since the latest coverage says that the fund had another $3 billion of redemptions today before the state shut the window.

The latest report comes from Bloomberg:

Florida officials voted at a special meeting to suspend withdrawals from an investment pool for schools and local governments after redemptions reduced assets by 44 percent in the past month.

The pool had $3 billion of withdrawals today alone, putting assets at $15 billion, said Coleman Stipanovich, executive director of the State Board of Administration. The board manages the pool along with other short-term investments and the state’s $137 billion pension fund.

“If we don’t do something quickly, we’re not going to have an investment pool,” said Stipanovich at the meeting in the state capitol in Tallahassee. The fund was the largest of its kind, managing $27 billion before this month’s withdrawals.

Local governments including Orange County and Pompano Beach that use the pool like a money-market fund asked for their money back after the State Board of Administration disclosed in a report earlier this month that holdings in the fund were lowered to below investment grade.

The board met today to consider ways to shore up the pool, including obtaining credit protection for $1.5 billion of downgraded and defaulted holdings hurt by the subprime market collapse. In voting for the suspensions, officials sought to stem the increasing flood of money leaving the pool and avoid losses on forced sales of assets.

“We need to protect what is there in the interim,” said Governor Charlie Crist, a Republican and one of three trustees of the State Board of Administration along with Florida Chief Financial Officer Alex Sink and Attorney General Bill McCollum.

The pool has invested $2 billion in structured investment vehicles and other subprime-tainted debt, state records show. About 20 percent of the pool is in asset-backed commercial paper, Stipanovich said at the meeting today.

“There is no liquidity out there, there are no bids” for those securities, he said.

Stipanovich raised the possibility of having the state pension fund shoulder the risk of some of the troubled securities with a credit-default swap, through which the retirement fund would guarantee the debt in exchange for an insurance premium. Sink immediately rejected the idea.

“We would, in effect, be bailing out one fund, to which we have no legal obligation, with the star fund of Florida, our pension fund,” she said. “I think we have to be very careful about transferring this risk into our pension fund.”

The board also considered adopting a more conservative investment policy and seeking a top credit rating for the pool from Standard & Poor’s.

The New York Times is having a good week. Today, in “Lenders’ Belt-Tightening Stifles Growth in Economy,” Peter Goodman examines the recent sharp fall in credit extension to commercial enterprises, particularly small businesses. It’s a solid piece of reporting, and reading it, one wonders why the Federal Reserve’s Vice Chairman Donald Kohn didn’t allude to the contraction in lending in his widely-covered remarks at the Council on Foreign Relations yesterday. Bloomberg quoted him:

‘`Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well,” Kohn said.

The Times story tells us that “could induce” is the wrong characterization. Banks are tightening their purse strings now.

Nevertheless, there were a couple of places in this otherwise informative piece where Goodman missed some important nuances. Let’s start with the top of the article:

Credit flowing to American companies is drying up at a pace not seen in decades, threatening the creation of jobs and the expansion of businesses, while intensifying worries that the economy may be headed for recession.

The combined value of two leading sources of credit — outstanding commercial and industrial bank loans, and short-term loans known as commercial paper — peaked at about $3.3 trillion in August, according to data from the Federal Reserve. By mid-November, such credit was down to $3 trillion, a drop of nearly 9 percent.

Not once in the years since the Fed began tracking such numbers in 1973 has this artery of finance constricted so rapidly. Smaller declines preceded three recessions going back to 1975; at other times such declines tended to occur in conjunction with an economic downturn.

The contraction in the commercial paper market has occurred primarily in the asset backed commercial paper sector, which consists of CP supported by residential mortgages, auto loan receivables and credit card receivables. Since Detroit has become addicted to financing consumers as a way to move metal, the contraction in ABCP has a direct impact on the auto industry. Otherwise, the shrinkage of ABCP affects commercial borrowers indirectly, via its impact on banks (most importantly, the fact that some are having to extend credit when affiliated entities can’t roll maturing ABCP, which ties up their credit capacity, and that banks are now leery of lending to each other) and the housing market (the loss of ABCP shuts off another securitization outlet).

In fairness, traditional commercial paper, where companies sell their short-term IOUs to investors, has also witnessed a fall in outstandings over the last three weeks, and the latest drop was noteworthy, but modest compared to the decline in ABCP. Nevertheless, this is a new and troubling development.

Although the Times made it sound as if the Fed was aware of and worried about the fall in commercial credit (likely true), the story also indicated that Kohn commented on it. In fact, his speech focused on the mortgage markets and the turbulence in the financial markets, and treated the consequences for the real economy as an open question:

We are following this trajectory closely, but key questions for central banks, including the Federal Reserve, are, What is happening to credit for other [non-mortgage] uses, and how much restraint are financial market developments likely to exert on demands outside the housing sector?

The article also indicates that the Fed may cut rates to address this problem. While that is accurate, it is unlikely that a rate cut, or even quite a few cuts, will change the psychology of lending officers. When defaults start to rise, banks tighten their lending criteria, and they tend not to loosen them again until the economy show signs of strengthening. Thus a rate reduction is unlikely to do much for the small businesses interviewed in this story.

Back to the Times:

For now, though, the situation is looking bleaker for many businesses. Already, companies in everything from furniture manufacturing to Web site design are tightening their belts, delaying expansion and scrambling for other sources of cash.

“This is a very big deal,” said Andrew Tilton, a senior economist in the United States Economic Research Group at Goldman Sachs. “You’re basically crimping the growth of the more vulnerable companies. If they can’t borrow the money, their options are much more limited. They’d have to have less ambitious hiring plans, buy less machinery and cancel projects.”

Two years ago, in what now seems like another era, Carmen Murray easily borrowed $100,000 from a local bank to finance her company, Rodeo Carpet Mills, which makes high-end rugs in an industrial stretch near Los Angeles. Getting a check was as simple as returning a mass-mailed flier.

Today, Ms. Murray is seeking a fresh loan from the bank to finance an expansion to supply Las Vegas hotels with floor coverings. She needs new machinery and 15 more workers, bringing the total work force to 45. If she manages to get the money, it will not come easily.

“They want this; they want that,” Ms. Murray sighed. “I got the sense that I have to start all over again. They need to know who I am and all about my business.”

A survey of bank loan officers conducted by the Federal Reserve in October found that about one-fifth of lenders had tightened lending requirements for commercial and industrial loans for large and midsize businesses over the previous three months. A slightly smaller proportion reported tightening lending to small companies.

By themselves, commercial bank loans have actually surged: large companies have tapped prearranged lines of credit to weather the financial chaos that has accompanied the unraveling of the American real estate market.

But this source of finance has been nowhere near enough to compensate for the virtual shutdown of the short-term commercial paper market. Much of this debt had been pledged against the value of mortgages, making them effectively radioactive in markets around the globe.

In recent years, a lot of commercial lending was inspired by an upward spiral of enrichment: banks made new loans, then swiftly sold them off for profit, using the proceeds to extend still more. But with much of the financial world unnerved by the mortgage meltdown, buyers for commercial loans are scarce.

“Since the resale market went away, major banks have had much less availability to make loans,” said Mark A. Sunshine, president of First Capital, a private commercial lender. “Absolutely, credit is much less available.”

Some of the drop reflects the subsiding in the run of mergers, diminishing the demand for credit by companies buying other companies. Some can be explained by what many economists view as a healthy return to the skeptical scrutinizing of prospective borrowers by banks. But lenders and borrowers from northern Virginia to southern Arizona confirm that the credit tightening has already begun to cut money reaching healthy companies as well, affecting their spending and hiring.

What loans are being extended are going primarily to companies with longstanding relationships with banks. Lenders are reluctant to bet their increasingly scarce capital on riskier, less-established companies in a time of economic anxiety. That leaves many of those companies on a limb.

“Small businesses are just inherently more risky, and banks are going to be more conservative in protecting their assets,” said Jody Keenan, who chairs the board of the Association of Small Business Development Centers in Burke, Va. “We’re starting to see a tightening already, particularly for very small companies. We’re talking about real impacts in local communities.”

A slowdown among smaller companies could be especially costly to the economy in terms of jobs. More than half of American jobs are at companies with fewer than 100 workers, according to Moody’s Economy.com.

In recent months, smaller companies have been adding jobs even as larger firms have been shedding workers, according to the ADP National Employment Report, which tracks changes at companies with payrolls overseen by ADP. From May to October, 276,000 of the 378,000 jobs added were at companies with fewer than 50 employees, the report found.

To be sure, the strongest companies with property to put up as collateral and years of profits they can point to are still able to borrow, often at increasingly favorable terms.

The downturn in the housing market has made banks reluctant to sink money into anything related to real estate, from title companies to bathroom tile manufacturers.

But lenders have sought refuge in more vibrant areas — notably agriculture, which has benefited from the rise in global demand and the sudden boom in ethanol production.

Richard Brown, president and chief executive of the Krause Corporation, which makes soil-tilling equipment at its factory in Hutchinson, Kan., relies upon lines of credit from banks to smooth out the seasonal nature of the business. Though it sells its products mostly in the spring and fall, the company must make them year-round.

Mr. Brown said banks had been calling him relentlessly to offer new loans.

“They’re trying to maintain their business and get past the subprime debacle, and where can they go?” Mr. Brown said. “Agriculture in this country is very strong.”

But in other parts of the economy, notably the auto industry, access to credit has tightened considerably, as banks steer their limited capital away from companies with declining sales.

A year ago, when he needed new machinery, Doyle Hayes, president and chief executive of Pyper Products, an auto parts maker in Battle Creek, Mich., went back to the local branch of Comerica bank, where he has been doing business for years. He borrowed $300,000.

Last week, when Mr. Hayes needed $140,000 for a new robot, he did not even bother to inquire at the bank. “We knew what the answer was going to be,” he said, meaning the bank would have turned him down. “When the auto industry goes down, anything that has four wheels becomes suspect.”

Still, Mr. Hayes did not put off the purchase. “You can’t save yourself into prosperity,” he said. He managed to borrow the money instead from Battle Creek Unlimited, a nonprofit economic development arm of the city.

In Arizona, Dennis Long, president of Enterprise Resource Group, which manages computer networks for businesses in the Phoenix area, is keen to expand, particularly by picking up work from the federal government. But that requires hiring a sales representative, and he lacks the capital to go beyond his $100,000 line of credit from Wells Fargo Bank.

“The bank says we’re maxed out,” Mr. Long complained. “It just seems like before they were a little more ‘Let me see what I can do,’ where today I just get ‘no.’”

In Los Angeles, Ms. Murray, too, has grown accustomed to a less-than-exuberant reception from the bank. Having started at the rug factory as a receptionist some 25 years ago, she now owns the company. A Mexican-American entrepreneur, she hopes to capture contracts that are set aside for minority-controlled companies.

She may eventually try an alternative source of finance aimed at small lenders, with the state guaranteeing her loan. Curiously, at one such institution in Los Angeles, Pacific Coast Regional Small Business Development Corporation, the volume of lending has slowed considerably in recent months, said Mark Robertson, the firm’s president and chief executive.

It may be that the effects of the credit tightening are still unfolding, he suggested. Eventually, a parade of would-be borrowers may show up at his door. His business tends to move in the opposite direction of the economy: when times are bad, more people need help to qualify for a loan. Perhaps things just have not gotten bad enough.

But Mr. Robertson thinks another factor may be at play. Business prospects are so uncertain that smaller entrepreneurs have lost their nerve for risk.

“Any business owner that is experiencing less traffic to their establishment is not willing to take on more debt,” Mr. Robertson said. “Everybody has kind of a wait-and-see, hold-off sort of attitude.”

In the interest of (occasionally) balanced reporting, I thought to include this post from Willem Buiter, currently a Professor of European Political Economy at the London School of Economics, blogging at the Financial Times, on whether the credit crunch will damage the real economy. This piece makes for an interesting contrast to the New York Times story today on the contraction in US commercial lending.

There are some useful factoids in Buiter’s article. For example, ten-year Treasuries are trading at spreads over Bunds similar to “highly indebted, fiscally fragile countries like Greece and Italy.” Frankly, that sounds about right.

Still, I differ with his conclusion: “It is still likely, in my view, that the economic fall-out from the financial crisis will be contained mainly within the financial sector and the residential construction sector,” I believe he has underestimated the extent of this credit bubble and the number of asset classes it has distorted. Buiter argues that problems are concentrated in the housing market, and therefore misreads the degree of damage that financial institutions will sustain (he sees their pain as overreported in the press). He also believes that sovereign wealth funds will ride into the rescue, but how much help they render remains to be seen.

Nevertheless, he makes an additional interesting observation:

From the point of view of the efficient allocation of resources in the medium and long term, the relative (probably even absolute in the short run) contraction in the size of the financial sectors of the advanced industrial countries is a desirable development, as for a number of years now, the private returns in the financial sector have exceeded the social returns by an ever-growing margin. Too much scarce analytical and entrepreneurial talent has been attracted into activities that, while privately profitable and lucrative, were socially zero-sum at best. In the short run, this cutting down to size of ‘Wall Street’ and ‘the City’ will inevitably have some negative side effects for Main Street also. However, the entire financial sector in the UK accounts for only about 7.5 percent of GDP, and the banking sector for no more than five percent of GDP. A sectoral depression will be painful, but of limited macroeconomic significance. In the medium and long term, moreover, a more balanced sectoral allocation of the best and the brightest will be beneficial.

I couldn’t agree more here.

From Buiter:

The financial crisis that erupted in earnest on August 9, 2007, has not yet run its course. The correction of the global underpricing of risk from 2003 till early 2007, will manifest itself beyond the US subprime residential mortgage markets, the instruments backed by these mortgages and the institutions exposed to them. Higher-rated residential mortgages in the US and in Europe will suffer similar corrections. So will commercial mortgages and securities backed by them, securities backed by car loans and credit card receivables, and unsecured consumer credit of all kinds. Unsustainable construction, housing market and residential lending booms occurred not only in the US, but also in the UK, Spain, Ireland, the Baltic states and other CEE countries like Bulgaria…

In the past couple of weeks, equity markets in most of the industrial world have given up all of their earlier 2007 gains and many are now trading in negative territory. No doubt some further equity market corrections are due, in the advanced industrial countries and certainly in some of the more bubbly emerging markets.

There remains pervasive uncertainty about the value of the credit ratings granted to complex structured products during the period 2003-2006, and about the value of the various enhancements the issuers grafted onto these products, including the credit risk insurance provided by the ‘monolines’.

Sovereign risk too is beginning to be repriced. Even within the Eurozone, the spread of 10-year Treasury bond yields over Bunds has increased from the 10 bps to 20 bps range to the 30 bps to 40 bps range for highly indebted, fiscally fragile countries like Greece and Italy. These spreads are likely to widen further when the budgetary positions of these countries worsen as the Eurozone goes into a cyclical downturn.

Emerging market risk continues to be underpriced. This holds for non-sovereign emerging market risk almost everywhere, including hot favourites like China. It holds for sovereign market risk at longer maturities for emerging markets without massive foreign exchange reserves, without significant production and export capacity in natural resources and with a history of weak fiscal discipline and populist policies. Argentina would be an example. This underpricing of emerging market risk is also due for an early correction.

So much for the bad news.

There are, however, also signs that the outline of a systemic stabilisation and recovery sometime in the second half of 2008 is beginning to take shape. Leading commercial banks are beginning to put their off-balance-sheet off-spring back on their balance sheets. HSBC’s announcement on November 26, 2007, that it was taking on its balance sheet $45bn of debt, much of it mortgage-linked, owned by SIVs it manages is, I believe, a harbinger of things to come.

The apparent failure of the Single Master Liquidity Enhancement Conduit, aka ‘Superfund’, proposed by Citigroup, JPMorgan Chase and Bank of America, with the active verbal encouragement of the US Treasury, to get off the ground, is another positive sign, because it supports the view that it is no longer acceptable or possible for private financial institutions to avoid the recognition of capital losses on assets held in SIVs, conduits and other off-balance-sheet vehicles, by selling them to each other at sweetheart prices. The enforced revelation of where the losses are, will reduce the uncertainty and fear about counterparty risk that have been killing liquidity in so many markets.

Money from the ‘New Global Moneybags’ – sovereign wealth funds from the Gulf and from other emerging markets – is beginning to find its way into some of the depressed financial markets and shaky financial institutions. Citigroup announced on November 26, 2007, that it had raised $7.5bn in new capital from the Abu Dhabi Investment Authority, albeit at near-‘junk’ rates of 11 percent. More deals like this will follow.

The monetary authorities that matter have learnt their lessons and are ready to provide liquidity on a large scale should the need arise. The announcement in late November 2007 by the Fed about its plans for year-end liquidity are an example of this greater official preparedness.

Most importantly, the credit boom of 2003-2006 has not led to a massive bout of over-investment in physical capital, except in a few emerging markets like China. The only sectoral exceptions in the industrial countries are residential construction in the US, Spain, Ireland, the Baltics and a few other emerging markets in CEE, and overexpansion of the financial sector almost everywhere. In countries that have been riding a housing construction boom, the contractionary effects of lower residential investment is now being felt (the US) or will be soon (Spain). But in the most systemically important of these countries, the US, residential construction accounts for barely 4.5 percent of GDP. The damage even a complete collapse of house prices can do through the residential construction channel is therefore quite limited.

There is therefore little threat of widespread excess capacity from the ‘supply side’ of the economy. The financial position (balance sheets and financial deficits) of the non-financial corporate sectors throughout the industrial world is strong. The bulk of the financial excess has stayed inside the financial sector or has involved the household sector.

The key question then becomes whether and to what degree the decline in housing wealth (in the US) and the general tightening of the cost and availability of credit will adversely affect household spending in the advanced industrial countries. While the sign of the effect is clear – consumption will weaken – its magnitude is not. The increasing cost and decreasing availability of household credit is likely to affect and constrain mainly those households wishing to engage in new or additional borrowing. The increased burden of servicing outstanding household debt, especially unsecured debt, is as likely to lead to higher defaults as to reduced consumer spending. Personal bankruptcy is, especially in the US, such an easy and relatively painless option, that it is the shareholders of the financial institutions that have made the unsecured loans rather than the households that took out these loans that will suffer the brunt of the financial impact of the increased cost and decreased availability of credit. If these shareholders are, unlike the defaulting borrowersty, typically not liquidity-constrained, the net effect on consumption should be mild. There can be further effects on spending through the credit channel if the financial institutions whose debt has been defaulted on become capital-constrained as a result and curtail further lending. As always, those most affected will be new would-be borrowers, households and corporates.

It is still likely, in my view, that the economic fall-out from the financial crisis will be contained mainly within the financial sector and the residential construction sector. It is clear that, following the overexpansion of the residential construction sector in the US and in a few European countries, and following the massive overexpansion of the financial sector just about everywhere during the past decade, there is now likely to be a retrenchment in both sectors, through lower employment, lower profits and lower valuations.

From the point of view of the efficient allocation of resources in the medium and long term, the relative (probably even absolute in the short run) contraction in the size of the financial sectors of the advanced industrial countries is a desirable development, as for a number of years now, the private returns in the financial sector have exceeded the social returns by an ever-growing margin. Too much scarce analytical and entrepreneurial talent has been attracted into activities that, while privately profitable and lucrative, were socially zero-sum at best. In the short run, this cutting down to size of ‘Wall Street’ and ‘the City’ will inevitably have some negative side effects for Main Street also. However, the entire financial sector in the UK accounts for only about 7.5 percent of GDP, and the banking sector for no more than five percent of GDP. A sectoral depression will be painful, but of limited macroeconomic significance. In the medium and long term, moreover, a more balanced sectoral allocation of the best and the brightest will be beneficial.

The short-run pain, concentrated in the financial sector, and especially in the commercial and investment banking sector and its off-balance-sheet offspring, is not suffered in silence. There is an army of reporters and newscasters standing by to report each groan and moan from every CEO whose bank has just written down another chunk of careless CDO exposure. But as long as the monetary authorities take their mandates seriously – including their duty to act, at a price, as lenders of last resort and market makers of last resort – and as long as the growing financial market hysteria does not spread to the real economy, the financial market kerfuffle should result in no more than a mild cyclical downturn around a robust upward trend.

In a market economy where asset markets and expectations about the future can have such a major impact on current economic activity, it is always possible to talk yourself into a recession or depression. Reducing the likelihood that a recession/depression born of fear and lack of confidence will take hold, when the fundamentals also support a much more positive outcome as an equilibrium, is the task of policy makers, especially central bankers, finance ministers and those in charge of avoiding trade wars. Let’s hope they are up to the challenge.

Offhshoring, the practice of companies sending work overseas (whether to their own operations located in other countries or to foreign outsourcing companies) has become the new worry of the white collar class. The business media regularly reports on software development, legal research, and Wall Street grunt work being sent to India. And it seems that roughly half the customer support calls these days are similarly routed overseas. Worse, Princeton economist Alan Blinder has estimated that as many as 29% of US jobs are offshorable. Will the only safe havens be one like hairdressing, retail, hotel operations, and divorce counseling?

Two recent posts at VoxEU give some hope to the besieged office worker. The first, “Service offshoring: Same old trade with a new label?” by Keith Head, Thierry Mayer, and John Ries, finds that service offshoring isn’t as easy to execute as proponents imagine, and distance serves as a barrier. Some key findings:

How much should service-sector workers in rich nations fear offshoring competition from much lower paid workers in India? New research suggests that distance still provides signification protection, almost as much in services as it does in goods. Once again the death of distance has been greatly exaggerated.

Pundits regularly invoke the notion of a world economy that is either “shrinking” or becoming “flat.” Explanations of this alleged flattening include technological innovations in transportation and communication that have enabled goods and ideas to flow more freely. The offshoring of service jobs, particularly call centers and computer software in India, has grabbed recent media attention. In his bestseller The World is Flat, New York Times columnist Thomas Friedman (2005) wrote of how he had “interviewed Indian entrepreneurs who wanted to prepare my taxes from Bangalore, read my X-rays from Bangalore, trace my lost luggage from Bangalore and write my new software from Bangalore.”….

Most economists, cognizant of the gains from trade, do not view a “flat” world as an alarming prospect…

Just as mainstream trade theory identifies gains from trade, it also shows that real wages of some workers tend to fall as a consequence of freer trade…

Our research investigates whether geographic separation limits offshoring trade, thereby shielding domestic workers from direct competition with their foreign counterparts. We develop a model that envisions employers searching globally for the most suitable workers for any given task and posits that distance raises the costs of using foreign workers. These higher costs reflect travel, training, or translation time associated with using workers that reside far from where their services will be consumed. Firms choose workers that offer the lowest costs after adjusting wages for productivity and distance-based service delivery costs…..

Those results indicate that geographic barriers offer high-wage workers substantial insulation from low-wage competitors based in remote countries. Distance has long acted as a serious impediment to international transactions. Unfortunately, most of what we know about the effects of distance on international transactions is based on studies of trade in goods. A consensus appears to be forming that freight costs cannot explain the strength and functional form of the distance effect for goods.1 Instead, physical distance seems to be picking up some combination of the barriers imposed by cultural differences, the continued desire for face-to-face communication, and the geographically-biased structure of social and business networks. These factors apply to services as well as goods…

How much should high-wage workers fear competition from much lower paid workers in India and China? Our findings suggest that distance still provides signification protection. Since these estimates reflect averages across a range of services, there are surely services where competition is especially acute. Moreover, service delivery costs associated with distance appear to have fallen over the last decade to a level that is slightly below the level estimated for goods. Unfortunately, the data do not clearly indicate whether distance costs for services will continue their downward trend or level off. We suspect that persistent cultural differences, as well as locally-biased social networks, will maintain distance costs at a high enough level to forestall the small, flat world envisioned by some journalistic accounts.

A second post, using empirical data rather than a model, reaches similar conclusions. Indeed, this work is particularly powerful because the study used data from Italy, a country that had suffered declining productivity and therefore ought to show strong improvement from outsourcing. Yet the researchers, Francesco Daveri and Cecilia Jona-Lasinio, concluded in “Offshoring, not enough to beat Italy’s productivity slowdown,” that while sending work abroad boosted productivity for manufacturing, it occurred only for certain types of goods. Conversely, offshoring did not help service productivity; indeed, in some cases, it appeared to reduce it:

The public debate on offshoring has created more heat than light to date, but researchers are beginning to get a picture of its real economic impact. New evidence from Italy, based on firm-level data and a direct measure of offshoring, shows that offshoring of parts and components boosts domestic productivity while offshoring of services does not.

The offshoring of activities of manufacturing firms and industries often features at the centre-stage of the political arena for its allegedly negative effects on domestic employment. During the 2004 US presidential campaign, the concern that outsourcing had gone too far creating more hardships than necessary for American unskilled workers was one of the hot political issues. Not by chance academic research on this topic (Feenstra and Hanson, 1996 and 1999, being perhaps the most celebrated contributions in this area)1 has mostly focused on such effects.

Yet the fear of potentially adverse labour market outcomes of offshoring ended up obscuring in the public debate the very reason that pushes a company to delocalize its activities: the search for efficiency gains. Luckily, an array of McKinsey2 and other business consultancy studies have also found that offshoring has been a crucial ingredient to enable the American economy to take full advantage of the potential productivity gains brought about by the IT revolution. And consistent with this evidence, the statistical analysis for US firms and industries (see Amiti and Wei, 2006)3 has also indicated that the offshoring of services and, less strongly, of intermediates has been associated with productivity gains. The same correlation seems to hold in the French and German manufacturing sector and in the British and Irish business services.

In a recent paper,4 we provide empirical evidence on the relation between offshoring and productivity growth in the Italian manufacturing industries. In the last few years, Italy has been on a declining productivity path. Yet this occurred in parallel with an acceleration of the opening up of the economy, also implemented by delocalizing abroad the manufacturing activities previously carried out within the domestic borders. Hence our research question is whether manufacturing offshoring has counteracted or possibly added to the declining productivity trends lately experimented by the Italian economy.5…

Overall, our statistical evidence shows a remarkably consistent pattern of correlation between offshoring and labour productivity growth with various statistical techniques. First of all, it appears that not all types of offshoring positively correlate with productivity growth. The type of good being outsourced indeed matters: the offshoring of intermediates is positively related to productivity growth, while the international outsourcing of services is either not related or – at times – even negatively related to productivity growth….

Our analysis is based on an original data set inclusive of input-output tables recently released by the Italian statistical institute. Such tables, by splitting the imported and domestic content of the inter-industry transactions of goods and services in the economy, allow us to directly measure the extent of intermediate and services off-shoring on the part of manufacturing industries. This is different and – in our opinion – preferable to using the methodology previously employed by Feenstra and Hanson (and repeatedly used in the other studies in this area). Since their measure is unobserved, the extent of outsourcing has to be inferred from trade data assuming that any purchasing industry would import intermediates or services in the same proportion as any other industry in the economy.

Our calculations do not have to rely on such assumptions that are restrictive and which our data suggest are unwarranted. We provide a direct measure of offshoring not based on untested assumptions and then we econometrically test whether using our indicator or the Feenstra-Hanson indicator makes a big difference. It seems it does. We find a positive relation between intermediate offshoring and productivity growth when using our (direct) measure of offshoring. However, the correlation disappears altogether when the standard Feenstra-Hanson measures of external outsourcing are employed.

We find our results of general interest, over and above the discussion of the case of Italy and we intend to pursue this line of research further in the close future.

I normally don’t do links (not that I don’t see way way more good stuff than I can possibly use, I just never seem to have the time to tag and organize them) but a few tonight were choice:

Did I Just See a Dead Cat Bounce? Information Arbitrage

FDIC: Provisions for Loan Losses Failing to Keep Pace with Delinquencies Housing Wire

Scary graph Brad Setser’s Blog

Ah, someone, namely jck at Alea, finally nailed the economics of the Abu Dhabi investment in Citigroup. I have to confess that when I read Andrew Clavell’s analysis, I was sufficiently chastened so as not to think about it further. But jck points out the obvious flaw: Clavell decomposed the deal in to put and call options when there is not much optional about this deal. The Abu Dhabi Investment Authority is required to convert its preferred into common in 2010-2011 within a pre-set range of conversion prices.

So the advantage to Citi is that this preferred dividend is tax deductible, while common dividends aren’t, so the cash flow impact is more or less a wash (assuming the common dividend doesn’t get cut, which in my view is optimistic). And because the share issuance is deferred, it doesn’t depress the price of the common short-term (indeed, the information content of the investment perked up not only the stock but the entire market).

However, I keep coming back to the fact that this is a good deal for Citi only under the circumstances. Selling stock at a 7% yield is a very steep price and reflects the climate of doubt around financial companies in general and Citi in particular. The real reason that this is good for Citi is that the odds are high that the credit markets will deteriorate further, and any funding down the road would be on considerably worse terms.

ADIA was encouraged to do the deal because Prince Alwaleed earned a juicy return on his purchase of a 20% stake in Citi in the early 1990s. But then the stock was trading at under $10 and many believed it was on its way to zero. The time to buy into troubled companies is when there is blood on the streets. ADIA’s investment is likely to be premature.

From Alea:

They are called “Upper DECS Equity Units“, not that it will stop the blogosphere from promptly analysing the deal as if it was a bond actually a “reverse convertible” no less…

No, ’tis not a reverse convertible, if it was, given the current volatility, it would be the steal of the century from Citi’s point of view.With a reverse convertible you are long a bond and short a put. The coupon is the maximum return you can hope for.If the stock price is below the strike price of the put at expiration you get the stock otherwise you get your cash back.
Clearly not the case here.ADIA is just plain long $7.5 billion of Citi equity.No put option, no call option.The trust preferred equity has tax advantages for Citi so the real cost is 11%*0.615 = 6.76% , pretty much in line or even slightly lower than the current [uncertain] dividend yield. For ADIA, the uncertainty over the actual number of shares they will get upon the mandatory conversion above current market prices gets compensated by some extra guaranteed yield unlike plain equity where the dividend may be impaired in the future.But at the end of the day they are long equity, period.

Let’s get some authority in here, John Bilson, a finance professor at the Illinois Institute of Technology’s Stuart School of Business in Chicago said to Bloomberg:

“Abu Dhabi is on the hook to buy Citigroup stock. This thing does not have any option attached. This is more like a forward contract to purchase the stock.”

Exactly…great and clever deal for both sides, given the current market state.

Public funds often make for great stuffees, as this story from Bloomberg (hat tip Ann Beaulieu) recounts.

In brief: the Florida State Board of Administration runs roughly $42 billion of short-term investments on behalf of various government entities, including a “short term investment pool” of roughly $27 billion, as well as the state’s $137 billion pension fund. The pool has been hit by $8 billion of withdrawals due to the disclosure that it holds $700 million in defaulted debt.

The withdrawals are sufficiently large that the fund may be forced to declare bankruptcy.

The reporting on this isn’t as crisp as I’d like (the story also refers to the pool as a “money market fund” and later clarifies that they are “modeled on money market funds”) and one has to read a way into the story (or pull out a calculator) to ascertain the size of the troubled fund, which is $27 billion.

Similarly, the article cites $700 million in unspecified defaulted debt in the pool that has suffered the redemptions at the top of the article, later says it is $900 million and gives details, and at another point reports that there is $2.4 billion in defaulted asset backed commercial paper in the $42 billion investment portfolio, of which the “short term pool” is apparently a part. But if that is correct, that means that the $15 billion balance of that portfolio contains $1.5 billion of defaulted paper if you use the $900 million loss figure, which is 10% of assets, a higher level than in the pool suffering the redemptions. Whose investments are those, and why aren’t they heading for the hills too?

This drama hasn’t yet been picked up by the Wall Street Journal, so we’ll get more detail soon.

From Bloomberg:

Florida local governments and school districts pulled $8 billion out of a state-run investment pool, or 30 percent of its assets, after learning that the money-market fund contained more than $700 million of defaulted debt.

Orange County, home of Disney World, removed its entire $370 million from the pool on Nov. 16, two days after the head of the agency that manages the state’s short-term investments disclosed the defaulted debt in a report delivered to Governor Charlie Crist.

“Our primary goal is to protect our funds,” said Jim Moye, Orange County’s chief deputy comptroller, from his office in Orlando. The county’s school board withdrew $388 million this week, following other local governments that pulled funds, including Miami-Dade County and Pompano Beach. The withdrawals, made since Nov. 14, were disclosed to Bloomberg News in a response to an open-records request.

The State Board of Administration manages about $42 billion of short-term investments, including the pool, as well as the state’s $137 billion pension fund. Almost 6 percent, or $2.4 billion, of its short-term investments consist of asset-backed commercial paper that has defaulted. Those holdings include $425 million in Axon Financial, a structured investment vehicle, or SIV, according to state records.

About $19 billion remained in the pool this week after the unprecedented wave of withdrawals, which came after the State Board of Administration reported its holdings of downgraded debt to Crist at a Nov. 14 public meeting of his cabinet in Tallahassee. The disclosures followed a month of inquiries by Bloomberg News to Florida officials.

“Knowing other people were pulling out, and that word was spreading, we looked at the potential for a run on the pool,” said Orange County’s Moye.

Coleman Stipanovich, the State Board of Administration’s executive director, didn’t return telephone calls seeking comment yesterday or today.

Should the withdrawals continue, Florida’s pool may have to consider filing for bankruptcy protection, says John Coffee, a securities law professor at Columbia Law School in New York. “A bankruptcy could handle these kinds of problems if they feel they’ll become insolvent,” he said.

Coffee predicts the pool will likely file lawsuits to recover losses. “I’d expect the pool is going to sue the people who sold them the commercial paper, saying the risks were hidden,” he said.

Lehman Brothers Holdings Inc. sold Florida most of its now-default-rated asset-backed commercial paper. Lehman spokesman Randall Whitestone declined to comment.

Thousands of school, fire, water and other local districts across the U.S. keep their cash in state- and county-run pools. These public accounts, modeled after private money market funds, are supposed to invest in safe, liquid, short-term debt such as U.S. Treasuries and certificates of deposit from highly rated banks.

The Florida pool, which was the largest of its kind in the U.S. at $27 billion before the recent spate of withdrawals, has invested $2 billion in SIVs and other subprime-tainted debt, state records show. Connecticut, Maine, Montana and King County, Washington, are among other governments holding similar investments, in smaller quantities.

The Florida pool’s $900 million of defaulted asset- backed commercial paper now amounts to almost 5 percent of its holdings. The paper, which carried top ratings from Standard & Poor’s, Moody’s Investors Service and Fitch Ratings as recently as August, was downgraded after declines in the value of collateral affected by the subprime mortgage slump.

The pool owns $168 million of debt from KKR Atlantic Funding Trust cut to D, or default, from B by Fitch Ratings on Oct. 8. It also has $356 million issued by KKR Pacific Funding Trust, cut to D from B by Fitch Ratings on Oct. 2.

Florida’s pool has another $180 million of paper from Ottimo Funding, cut to D from C by S&P on Nov. 9. The pool also holds $175 million of short-term debt issued by Axon Financial Funding, an SIV. It was cut to D from C by S&P yesterday…

At Crist’s Nov. 14 cabinet meeting, Stipanovich said that while there was “disappointment” over recent downgraded investments, no local government had ever lost money in the pool since its creation in 1982.

“I want Orange County to be first in a lot of things, but I don’t want Orange County to be the first to lose money in the state’s Local Government Investment Pool,” said Martha Haynie, the county’s comptroller, in an interview today.

Stipanovich also assured Crist and Florida Chief Financial Officer Alex Sink at that time that the pool maintained the confidence of its depositors.

“There are a lot of rumors flying around,” testified Stipanovich. “I’m not aware that there have been any material outflows.”

Moye said Orange County pulled out of the pool this month because the State Board of Administration failed to provide adequate or timely disclosure to pool participants about its troubled investments.

On Nov. 20, Pinellas County yanked its entire $300 million from the pool.

“My first job is to safeguard principal,” said Ken Burke, Clerk of the Pinellas Circuit Court. A certified public accountant, Burke controls the county’s cash. He said a quarterly newsletter for pool participants, published Nov. 1, which mentioned downgrades but not defaults, wasn’t candid about the pool’s predicament.

“If some bad news comes out, the first thing I’d do is contact my customers and give them my side. The newsletter didn’t tell us the full story,” said Burke. “It made it sound like a bump in the road.”

Neither the newsletter nor Stipanovich’s testimony disclosed that the pool owns $650 million of certificates of deposit from Countrywide Bank FSB, a unit of Countrywide Financial Corp., that now amounts to more than 3 percent of the pool’s assets. The bank’s rating was cut to Baa1, three levels above junk, by Moody’s on Aug. 16.

When local governments withdraw funds from the pool, the state must sell off holdings to raise the cash. Because Florida’s pool has been forced to quickly raise billions of dollars to meet withdrawal demands, it won’t get top dollar for its asset sales, says Joseph Mason, professor of finance at Drexel University.

“When funds like this are liquidated, the Street will take advantage of their desperation. They don’t care if you’re a hedge fund or a school district,” said Mason, who completed an 18-month appointment as a scholar in residence at the Federal Deposit Insurance Corporation in January.

Mason, who has studied the history of bank failures, understands the rush by Florida municipalities to pull their money from the pool.

“The first people in the withdrawal line get 100 percent of their money,” he said. “The loss is suffered by the people behind them in line. Since nobody wants to be at the end, you get a run on the pool.”

Mason says while the state of Florida has a moral duty to cover any losses suffered by the pool participants, its own shaky finances will make that difficult. The fourth most-populous state, hurt by the housing slump, cut its revenue projections by 3.9 percent for the fiscal year ending June 30, and 5.2 percent for the following year.

“The state appears to have breached the trust of the investors by putting money in new kinds of debt its managers didn’t fully understand, in their search for higher yields,” Mason said.

The rating agency Fitch for some time has warned of lax lending practices in the commercial real estate market. Bloomberg reports today that prices of derivatives protecting investors against default of the highest-rated commercial real estate securities have appreciated sharply in the last month, signaling the expectation of defaults ” rising to the highest level since the Great Depression.” Not surprisingly, sales of newly-issued commercial real estate debt have also slowed to a trickle and that in turn has led to a near-halt in commercial real estate transactions.

Commercial real estate brokers claim the grim views are overdone, that tenants are “rock-solid,” and defaults are well below the ten-year average. But the Fitch reports earlier indicated that some deals were being done on terms that. like subprime, required a refinancing and price appreciation to work. Since the underlying market is now in a downturn, some deals will go bad. Similarly, vacancy rates are already at 7.6% in Manhattan, and Wall Street layoffs have only begun. Whether the damage will be as bad as the derivatives prices suggest remains to be seen.

Nouriel Roubini forecast that losses in commercial real estate could reach the $100 to $150 billion level. The derivatives market appears to agree with his view.

From Bloomberg:

In the bond market, commercial property investors are about as creditworthy as U.S. homeowners with subprime mortgages….

The cost of derivatives protecting investors from defaults on the highest-rated bonds backed by properties more than doubled in the past month, according to Markit Group Ltd. Prices suggest traders anticipate defaults rising to the highest level since the Great Depression, according to analysts at RBS Greenwich Capital in Greenwich, Connecticut.

The seven-year rally in offices and retail properties ended in September when prices fell an average of 1.2 percent, according to Moody’s Investors Service. Banks worldwide are holding $54 billion of unsold commercial mortgages, according to data compiled by New York-based Citigroup Inc. that includes fixed and floating-rate debt.

Lenders are struggling to sell loans to investors after losses on debt backed by subprime mortgages to people with poor credit caused financial markets to seize up in July and August. Bonds with AAA ratings secured by properties ranging from the Sears Tower in Chicago to trailer parks in Delaware yield about 203 basis points more than similar maturity Treasuries, up from 92 basis points on Oct. 12, according to Morgan Stanley indexes.

The benchmark CMBX-NA-AAA index of derivatives tied to the safest commercial mortgage securities rose to 102 basis points from 44 a month ago. It costs $102,000 a year to protect $10 million of bonds backed by property loans against default, up from $44,000 a month ago. Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as the weather or changes in interest rates.

Sales of debt secured by commercial mortgages tumbled 80 percent to $3.9 billion in October from a year earlier, data compiled by Bloomberg show. New securities backed by loans on buildings will fall 50 percent in 2008 from $220 billion this year, Moody’s said Nov. 2.

Real estate deals are coming apart at the fastest pace since September 2001, when the U.S. economy was shrinking, because banks are tightening standards for loans, said Robert White, president of Real Capital Analytics, a New York-based research firm.

About $15 billion of commercial property transactions of $10 million or more are under contract in the U.S., compared with about $70 billion at mid-year, White said. That’s unusual because the number usually rises at year-end, he said.

More than 75 have been withdrawn because banks aren’t lending, and that estimate is “probably conservative, because not all deals that blew up were well-publicized,” White said.

“The commercial real estate market is imploding,” said James Ortega, who manages $150 million at Saenz Hofmann Fund Advisory in Sao Paulo. Ortega has set trades to profit from a decline in property companies’ shares. “We’re about to experience a very significant correction.”

Mortgage brokers say traders are overreacting. Defaults are running at 0.4 percent in the U.S., below the average of about 1 percent over the past 10 years, according to Moody’s. That’s a fraction of the 15.2 percent of subprime home loans that are at least 60 days in arrears, an index by the New York-based ratings company shows.

“I always think Wall Street does panic better than anybody I know,” said John Levy, president of Richmond, Virginia-based commercial mortgage broker John B. Levy & Co.

The decline in prices of the safest types of commercial mortgage-backed securities mostly reflects a slump in credit markets, not expectations of defaults on loans backing the securities, said Michael Sun, an analyst at Wachovia Corp.’s Tattersall Advisory Group in Charlotte, North Carolina, which manages about $5 billion of commercial mortgage securities.

“They are, credit-wise, a no-brainer,” Sun said. “Nobody disagrees they are rock-solid credits.”

For the highest-ranking commercial-mortgage securities to stop paying, defaults on the underlying loans would have to soar to 81 percent, according to RBS Greenwich analyst Lisa Pendergast, based on assumed 40 percent losses on foreclosures. Investors are unwilling to buy the notes because of concern that “capital challenged” banks and investment funds may be forced to sell the securities, pushing prices lower before any recovery, she said.

“The market is priced as if it might melt down, yet real cash investors absolutely don’t expect that to happen,” Citigroup analyst Darrell Wheeler in New York said in an interview today. Dwindling sales of mortgage securities should help the market rally, he said.

In Manhattan, the world’s largest office market, the vacancy rate rose to 7.6 percent in October, the highest in a year, property brokerage Colliers ABR said. Rents increased 1.4 percent on average to $64.08 a square foot from September, the second-smallest month-to-month increase since June 2006.

The Bloomberg Real Estate Investment Trust Index measuring the stocks of 126 publicly traded property companies dropped 30 percent from its peak in February.

Developers such as billionaire Harry Macklowe, whose properties include the General Motors Building on New York’s Fifth Avenue, have struggled to finance deals.

William Macklowe, Harry’s son and president of Macklowe Properties Inc., said in a September interview the firm may have to sell some real estate to pay back $3.4 billion of short-term debt used to buy seven buildings in New York. He didn’t return calls this week.

Record-low interest rates in the past five years encouraged banks to loosen underwriting standards and caused prices to rise as much as 35 percent a year.

Banks provided loans that allowed borrowers to pay only interest, not principal, and lenders offered financing that exceeded property values, according to Moody’s. The average loan-to-value ratio reached a record high of 117.5 in the third quarter for mortgages that were turned into bonds, from 90 in 2003, said Moody’s, which bases its calculations on its own estimates of rental value.

Those are some of the same practices hurting the $10.7 trillion residential mortgage market, according to an annual survey in October by accounting firm PricewaterhouseCoopers and the Urban Land Institute in Washington.

An index of credit-default swaps on 20 residential mortgage securities with BBB- ratings, known as the ABX-HE-BBB- 07-1 index, fell to 16.84 this week from 97 in January. Credit- default swaps are used by investors to speculate on the risk of a borrower failing to meet obligations. The index falls as concerns about credit quality increase.

Bondholders helped feed demand for loans by purchasing a record $273 billion of securities backed by commercial mortgages this year, up from $95 billion in 2004, based on data compiled by Trepp LLC, a New York-based research firm.

Demand has dried up since July, when securities linked to subprime home mortgages contaminated credit markets and caused financial institutions to report losses or writedowns of more than $66 billion.

Banks also have about $283 billion of debt they provided to help finance leveraged buyouts in the U.S. and Europe that hasn’t been sold, according to research by Charlotte, North Carolina-based Bank of America Corp.

Banks are preparing to sell $15.5 billion of commercial mortgage-backed bonds, according to Citigroup, the largest U.S. financial company by assets. That compares with an average $27 billion a month through October, based on Trepp’s data. Howard Esaki, head of global commercial mortgage securities research at Morgan Stanley in New York, said U.S. sales may fall 60 percent to 70 percent next year.