New Consumer Funding Source: 401(k)s

As the housing market has deteriorated, some observers expected to see a slowdown in consumer spending, since mortgage equity withdrawals have provided a boost in a period of stagnant real wages for average workers (last year, an exception to a longstanding trend, saw a wee pickup).

But defying this logic, consumer spending has continued to be fairly robust. What gives?

It turns out that there are signs that consumers are raiding a different piggybank, namely, their retirement accounts. And while 401(k) plans do permit borrowing, most advisers recommend against it, since the interest isn't tax advantaged and failure to repay results in nasty penalties.

It's too early to tell if the increase in 401(k) borrowings and redemptions is a small uptick or the beginning of a sustained, and therefore more troubling trend.

From the Wall Street Journal:

Despite potential tax and investment consequences, more individuals have been borrowing from their 401(k) plans or taking hardship withdrawals in recent months, some retirement-plan providers say.

Not all plans have seen jumps, and more-comprehensive statistics won't be available until next year. But a number of plan providers that follow month-to-month patterns, including T. Rowe Price Group Inc., Hewitt Associates and Hartford Financial Services Group Inc., have seen a small but noticeable uptick.

"I don't think it's a groundswell, but it's enough to be noticed," says Rick Meigs, president of 401khelpcenter.com, which provides information on 401(k) plans.

To be sure, the indications are preliminary, and some big providers, such as Fidelity Investments, say they haven't seen any increase in 401(k) borrowing. About 20% of Fidelity 401(k) investors have a loan, a figure in line with the industry.

Even those firms that are seeing increase in 401(k) borrowing aren't sure what to ascribe it to, though financial advisers say it could be due to the effects of the credit crunch and slumping housing prices....

Tom Foster, a national spokesman for Hartford's retirement plans, says that he considered borrowing from his 401(k) when he was saddled for more than a year with an extra mortgage, but decided against it.

"Most Americans see this as a panacea, but instead it erodes time in the market and adds a new payment," he says.

Even a person who pays such a loan back on time, and therefore avoids the 10% penalty, is getting taxed twice, says Bill Arnone, a partner at Ernst & Young LLP -- once when repaying the loan with after-tax dollars, and a second time when the money is withdrawn at retirement.

People who take the loans also lose out on potential retirement earnings while the money isn't invested.

Should you lose your job, the costs could be even higher. Borrowers who are fired, laid off or quit typically have to pay off the loan within 90 days, or face additional taxes and penalties, says Stuart Ritter, a financial adviser at T. Rowe Price.

David Wray, president of the Profit Sharing/401(k) Council of America, a not-for-profit association of companies that sponsor plans, expects that higher payments on adjustable mortgages will have people "looking for ways to make up that gap," and "a significant number of people with 401(k) plans are going to be affected."

Floyd Norris: A Skeptic of the Job Creation Stats

I must have problems with authority. One of my forms of recreation is looking out for statistics, particularly government releases, that don't seem to comport with reality.

Fortunately, I have plenty of good company in this endeavor, including (but far from limited to) Barry Ritholtz, Michael Shedlock, Dean Baker. A frequent target is the nonfarm payrolls report (see here and here for past examples), particularly its dubious "birth/death model" which attempts to allow for jobs created by new firms (or conversely, lost due to businesses closures).

Oddly, the usual suspects refrained from attacking the validity of Friday's report. Perhaps they felt the fact that it has been revised significantly and frequently is starting to speak for itself (last month's 4,000 loss, for example, has somehow morphed into an 89,000 gain).

This month, the criticism comes from an unexpected quarter: the restrained and evenhanded Floyd Norris of the New York Times, in a blog post, "Assuming Jobs". While he maintains his levelheaded tone, he makes no bones about not liking the data:

The employment report is being hailed as good news, proof that the economy is stronger than it appeared after last month’s bad report.

Well, maybe.

As reported, the last six months have seen an average job gain of 112,000 — the lowest such figure for any six-month period in three and a half years. But that is probably overstated.

The most interesting part of the report to me is that the government now thinks it overstated job growth in the year through March 2007 by 297,000 jobs. It will later restate those months.

The employment numbers come from a survey of employers, but the numbers put out by the government are not what the survey found. Instead, the statisticians add a fudge factor, to account for jobs created by new companies that the government does not know about, less those lost when employers went out of business and did not respond to the survey.

In the 12 months through March, that fudge factor added 1,073,000 jobs to the total reported. The government now thinks that about a quarter of those jobs did not exist.

Chances are that most of the overstatement came in the later months of that period, as the economy began to weaken, and that it is continuing now.

Since March, the fudge factor has added 839,000 jobs to the total. And the total increase it has reported, before seasonal adjustment, is 1,709,000.

What all this means is that a significant part of the employment gains this year came from the fudge factor, or the birth-death model, as the government prefers to call it.

Of those 839,000 jobs added, 150,000 were in the construction industry. Anybody want to bet that the number of jobs created by new construction companies, less those lost from failed builders, is that high? Anybody want to bet it is positive?

Comparing pre-seasonal adjustment figures to figures after adjustment is risky, and the fudge numbers are not available on a seasonally adjusted basis. But it is worth noting that, after seasonal adjustment, the government thinks that over the last six months the economy has added 671,000 jobs — fewer than the fudge factor has added before the adjustment.

The bottom line is this: Job growth this year is mediocre if you accept the figures as reported. But we have good reason to think they are overstated, and will be revised lower at some point.

Today’s figures were better than many expected, but they do not indicate a strong economy, and they should not provide a reason for the Federal Reserve to conclude all is well with the economy.

Update, 3:45 AM: Whoops. Dean Baker is indeed on to this item, and due to the difference in his style and readership, is more pointed than Norris:

However, it is worth noting another item in the report. The September report included preliminary benchmark revisions to the establishment survey based on state unemployment insurance records. These records, which provide a virtual census of payroll employment, show that the establishment survey overestimated job growth by 297,000 in the 12 months from March of 2006 to March of 2007, an average overestimate of approximately 25,000 per month.

The obvious culprit in this overestimate is the imputation for job growth in nearly created firms that could not be included in the survey. It would seem that the Bureau of Labor Statistics (BLS) overestimated job growth in new firms last year.

This fact is relevant to the September jobs data because BLS has actually imputed slightly more jobs into the establishment survey in the last three months than it did over the same period last year. If the imputation led to an average overestimate of job growth of 25,000 last year, it is reasonable to believe that the overestimate may be at least as large this year, since the economy seems weaker by most measures.

Reported job growth has averaged 97,000 over the last three months, so if BLS is overstating job growth by 25,000 a month due to a faulty imputation for jobs in new firms, the error would account for a substantial portion of reported job growth. We'll know the answer to this one in September of 2008 when next year's benchmark revisions are first released, but it is worth keeping an eye on this issue.

2007 Ig Nobel Winners

The Ig Nobel Prize is given annually by the Journal of Improbable Research to "celebrate the unusual, honour the imaginative - and spur people's interest in science, medicine and technology".

From the BBC, whose favorite award was for the "gay bomb":

2007 Ig Nobel Winners

Medicine - Brain Witcombe, of Gloucestershire Royal NHS Foundation Trust, UK, and Dan Meyer for their probing work on the health consequences of swallowing a sword.

Physics - A US-Chile team who ironed out the problem of how sheets become wrinkled.

Biology - Dr Johanna van Bronswijk of the Netherlands for carrying out a creepy crawly census of all of the mites, insects, spiders, ferns and fungi that share our beds.

Chemistry - Mayu Yamamoto, from Japan, for developing a method to extract vanilla fragrance and flavouring from cow dung.

Linguistics - A University of Barcelona team for showing that rats are unable to tell the difference between a person speaking Japanese backwards and somebody speaking Dutch backwards.

Literature - Glenda Browne of Blue Mountains, Australia, for her study of the word "the", and how it can flummox those trying to put things into alphabetical order.

Peace - The US Air Force Wright Laboratory for instigating research and development on a chemical weapon that would provoke widespread homosexual behaviour among enemy troops.

Nutrition - Brian Wansink of Cornell University for investigating the limits of human appetite by feeding volunteers a self-refilling, "bottomless" bowl of soup.

Economics - Kuo Cheng Hsieh of Taiwan for patenting a device that can catch bank robbers by dropping a net over them.

Aviation - A National University of Quilmes, Argentina, team for discovering that impotency drugs can help hamsters to recover from jet lag.

Best Securities Reform Proposal

I am kicking myself that I didn't come up with the proposal made by Brandeis professor Stephen Cecchetti in today's Financial Times. His opinion piece, "A better way to organise securities markets," is the single best idea for securities reform I have seen in a very long time. It is simple, elegant, and addresses many of the problems we are facing now. It also doesn't have to be implemented at once, but is an objective regulators can work towards over time.

So what is this great idea? Force as much financial trading as possible on to exchanges.

What problems does this proposal solve? Some of the biggest ones we see now, namely transparency, worries over counterparty risk, and regulatory oversight. Keep in mind that the troubles in the markets are happening solely in what are called over the counter markets, like the credit markets, where investors buy and sell from various dealers and the dealers trade among themselves.

While information services like Bloomberg operate in many of these markets, allowing dealers post prices on instruments they trade. However, these are indicative prices, typically on the more liquid instruments . You need to call the dealer to see what the price is on the amount of you want to buy or sell. And once you've done the trade, only you and the dealer know the price and size. Thus in these markets, there is considerable ignorance on very basic parameters, such as overall trading volumes, ownership, etc. The only way to get it would be to aggregate it across dealers, a monumental task for regulators even if they have the authority to compel the dealers to cooperate (worse, regulatory authority tends to fall along industry lines, say bank versus securities firm, rather than by instrument. Thus who has authority over, say, credit default swaps is muddy indeed).

Now that isn't to say this process would be easy. In fact, the OTC incumbents will fight it tooth and nail since OTC trading, managed well, is very profitable (except in a down market when market makers find themselves taking sizable inventory losses). It would also gut the investment banks' profitable prime brokerage business (the exchanges would have margin requirements; investment banks could selectively provide additional leverage to hedge funds, but this would be a smaller and riskier activity. Note that the new exchanges would presumably be owned by the old OTC dealers, but owning a part of a utility is likely to be less attractive than the current regime. Greater transparency generally means lower profits).

In addition, a few markets, such as the commercial paper market, don't have secondary trading (commercial paper is placed and investors hold it to maturity) and thus will not fall under this regime.

Nevertheless, Cecchetti's idea is a goal regulators can pursue. For example, they can put measures into place that require new investment and hedging vehicles to be traded on exchanges. And if there were to be a real crisis, which would inevitably lead to calls for tougher rules, this sort of proposal, of greater regulation of markets, would probably be regarded as more attractive than more comprehensive control and oversight of the institutions themselves.

Another development favoring Cecchetti's recommendation is that the investors themselves are becoming harder to supervise. Making the markets more transparent is an important counterbalance. As Thursday's Financial Times reported:

Global financial markets face a permanent shift in power from traditional money managers to opaque groups such as petrodollar investors, Asian central banks, hedge funds and private equity groups, according to a study out today.

These power brokers had amassed $8,400bn in assets by the end of 2006, three times what they held in 2000 when they were "little more than fringe players" in the capital markets, says the report, published by McKinsey Global Institute

Their holdings now represent 5 per cent of the world's $167,000bn of financial assets. If current trends continue, they could control assets worth $20,700bn, or nearly three-quarters of the size of global pension funds, by 2012.

However, the study says the four investor groups often lack transparency and are out of the reach of regulators.

"It is true that there is not the kind of light shed on some of these activities in the way we are used to," said Diana Farrell, director of MGI and one of the authors of the report.

"The Anglo-Saxon model of capitalism will be challenged. We need to evolve in terms of regulatory oversight."

From Stephen Cecchetti's article in the Financial Times:

In September 2006 Amaranth Advisors, a US-based hedge fund specialising in trading energy futures, lost roughly $6bn (£3bn) of the $9bn it was managing and was liquidated. With the exception of its shareholders, most people watched with detached amusement. Eight years earlier, reaction to the impending collapse of Long-Term Capital Management was very different: people were horrified and the financial community sprang into action. One big difference is that Amaranth was engaged in trading natural gas futures contracts on an organised exchange, while LTCM’s exposures were concentrated in thousands of interest-rate swaps.

After LTCM’s collapse, people thought hard about the structure of financial institutions. What information disclosure should be required? What rules should officials implement to ensure that an institution’s failure does not put the entire system at risk?

But the recent turmoil suggests we should think again. Comparing 1998 and 2006 suggests that this time we should look for lessons about the way securities markets are organised.

The difference between futures and swaps is that futures are standardised and exchange-traded through a clearing house. This distinction explains why Amaranth’s failure provoked a yawn, while LTCM’s triggered a crisis. It suggests that regulators, finance ministries and central bankers should be pushing as many securities on to clearing house-based exchanges as possible. This should be the standard structure in financial markets.

A critical part of any financial arrangement is the assurance that the two parties to it meet their obligations. In organised exchanges, the clearing house insures that both sides of the contract will perform as promised. Instead of a bilateral arrangement, both buyers and sellers of a security make a contract with the clearing house. Beyond reducing counterparty risk, the clearing house has other functions. The most important are to maintain margin requirements and “mark to market” gains and losses. To reduce its risk, the clearing house requires parties to contracts to maintain deposits whose size depends on the contracts. At the end of each day, the clearing house posts gains and losses on each contract to the parties involved: positions are marked to market.

Since margin accounts act as buffers against potential losses, they serve the role that capital requirements play for banks. Marking to market offers a way to monitor continuously the level of each market participant’s capital.

Finally, exchange-traded securities are standardised, creating transparency: buyers and sellers know what they are buying and selling.

Returning to the comparison of Amaranth and LTCM, we can see why the former did not provoke concerns of a systemic crisis. Amaranth was required to hold margin to maintain its position in futures markets. When it started to sustain losses, the clearing house forced the sale of the positions into a liquid market; counterparties sat calmly, knowing their interests were protected. By contrast, the swaps LTCM held were with specific institutions. Since interest-rate swaps are not exchange-traded, selling them was not feasible. The collapse of LTCM would have led to defaults on the contracts and put other financial firms at risk.

This brings us to the present crisis. The defining feature is that there are securities out there no one knows how to value. We discovered this when potential investors refused to accept certain mortgage-backed securities as collateral in the issuance of commercial pap er. A failure of investors to monitor the originators of these securities had led to the creation of complex and non-transparent securities. If these were ex change-traded through a clearing house, these problems would largely disappear.

There are many ways to encourage people to move trading into clearing houses. Are there tax and regulatory incentives that are doing the opposite? Are banks, insurance companies and pension funds being rewarded for holding difficult-to-value securities that are not exchange-traded?

The goal is to structure financial markets in a way that minimises system-wide risk. Yet we also need to remember that there are gains to asset-backed securitisation. When the system works, it turns illiquid bank loans into readily marketable securities. This should reduce the overall riskiness of the financial system. Shifting these securities to exchanges with clearing houses would help ensure that these benefits materialise.

Extreme Measures IV: Sheila Bair of the FDIC on Subprimes

By way of background, an Extreme Measure is a recommendation to take a radical and, upon examination, unworkable approach to a pressing problem. We've only been on this beat recently, but so far, the Extreme Measures we've seen have had to do with the US housing crisis or the credit contraction.

The first was from Bill Gross at Pimco, who suggested that the US government "rescue" the 2 millionish homeowners who stood to lose their homes. A second came from Gillian Tett, the capital markets editor at the Financial Times, who argued that investment bankers should decompose CDOs and other structured credits into their constituent parts. Third was an article by Cambiz Alikhani of Arundel Iveagh Investment Management in the Financial Times, "Banks should form a bail-out vehicle to ease the credit crisis." All ideas had considerable high-concept appeal but broke down when inspected closely.

The latest comes from Sheila Bair, chairman of the FDIC, who proposed yesterday that mortgage servicers freeze all adjustable rate mortgages facing resets at their current rates. From the Wall Street Journal:

A top bank regulator urged loan servicers to consider wholesale conversions of certain adjustable-rate subprime loans into fixed-rate products to prevent major housing problems from escalating.

"We don't have a lot of good options here," Federal Deposit Insurance Corp. Chairman Sheila Bair said in an interview after addressing an investors conference in New York. "And just to foreclose on all of these properties is not a good option for anybody."

Such rate changes are difficult, though, because many of these subprime mortgages were securitized and packaged into trusts. As the loan quality has deteriorated major, Wall Street banks have experienced sizable losses.

Nevertheless, her comments reflect the heightened pressure policymakers are trying to convey to a fragmented and slow-moving mortgage industry.

Moody's Investor Service released a study last month that showed that most servicers had modified only 1% of a sample of loans that reset into higher monthly payments this year. It also found that subprime servicers weren't reaching out to borrowers to rework loan terms.

Subprime adjustable-rate mortgages valued at close to $600 billion are expected to reset into higher monthly payments by the end of next year.

Ms. Bair recommended making the wholesale adjustments for owner-occupied mortgages where borrowers are current on the loans. This would exclude homes bought by speculators.

Her suggestion would most likely affect loans that have a low starter rate for two or three years and reset to much higher rates. Many of those loans are adjusting now and have helped push a record number of homeowners into the foreclosure process.

"Keep it at the starter rate," Ms. Bair said at the Clayton Annual Investor Conference. "Convert it into a fixed rate. Make it permanent. And get on with it."

Ms. Bair and other federal regulators likely couldn't force servicers to make these changes, but her message might be interpreted as a warning to loan servicers about potential legislation, said Howard Glaser, an industry consultant based in Washington.

Congress is responding in other areas. The House approved legislation providing tax relief to homeowners facing foreclosure.

The bill, approved 386-27, would let a homeowner exclude from income the value of debt forgiven if the owner reworks the terms of a mortgage with his or her lender. Currently, forgiven debt is treated as income and subject to tax.

The bill was backed by business groups but received measured support from the White House, which objects to making the tax break permanent. President Bush is pushing an alternative that would protect homeowners from the debt-forgiveness tax for three years.

This may sound like an elegant solution, since it addresses the problem raised in the Financial Times yesterday, namely, that mortgage servicers don't have the staff capacity (or a financial incentive) to renegotiate troubled mortgages, since it's a time-consuming, one-on-one process. Bair's suggestion is a one-size-fits-all approach that would presumably work in many cases.

In fact, many of these deals were so dodgy that they were underwater almost from the outset, so this remedy wouldn't be as effective as it might seem. As Dean Baker told us in his "News Flash: The Problem With ARMs is Not Resets":

Most of the news reporting on the subprime meltdown has focused on the problems that borrowers face when their loans reset from low teaser rates to much higher fixed rates. While this is a big issue for millions of borrowers, resetting subprimes are just a single wave in an ocean of bad mortgage debt.

This can be seen from the fact that many of the subprimes were seriously delinquent or in foreclosure long before the mortgages reset to higher rates. In an analysis done early this year, the FDIC found that 10 percent of the subprime adjustable rate mortgages issued in 2006 were seriously delinquent (missed three or more payments) or in foreclosure within 10 months of issuance.

Since no mortgages had reset at the 10-month point, clearly there were other problems. Either borrowers could not afford even the low teaser rates or they were defaulting because they realized that their homes were worth less than their mortgages. The latter problem will only get worse as house prices continue to decline in response to the glut of housing on the market (the inventory of unsold new homes is 50 percent above the previous record and the number of vacant ownership units is almost twice the previous peak) and tightening credit conditions curtailing demand.

Hhhm. Bair doesn't seem to know her own agency's data.

But that's actually a minor problem, believe it or not. The real problem is that there is absolutely no way that her proposal could possibly be acted upon.

The reason is simple. Mortgage servicers have no obligation to borrowers. Zero. Zip. Nada. They are the agents of the investors (technically, the agreement is with the legal entity that holds the mortgages). The only basis for them to do a loan modification is first, if it is permitted by the trust indenture (many restrict "loss mitigation" mods, the kind that help borrowers) and second, only if it appears likely to improve returns to the investors.

If a borrower is having trouble, modifying a loan may merely serve to forestall the inevitable. And in a deteriorating housing market, delay means a foreclosure sale at a lower price.

The article notes that banking regulators can't require mortgage servicers to take those steps, but an industry consultant opined that they might do so to forestall legislation.

Dream on. The servicing agreements are contracts governed by state law. The Feds can't willy nilly override them. To do so would raise fundamental federal/state law issues, which in turn would lead to years of court challenges.

Moreover, what is the basis for this intervention in private contracts? Essentially, this is a forced redistribution from investors to borrowers. Perhaps I am not thinking broadly enough, but I can't recall a precedent for Congress enacting a law to redistribute the results of contracts executed between private parties. The only basis I know of for the government to take wealth from a private party (aside from taxation or seizure of property obtained by criminal means) is eminent domain, when the government seizes property for public use (although that notion has been strained by cases where real estate has been turned over to private parties for development).

As much as I wish an idea like Bair's could be put into practice, we need to recognize what it is: an expropriation of investor assets. As such, it will never happen. Ir faces way way too many legal obstacles, as well as huge resistance from the securities industry and investor groups. Anyone worried about the competitiveness of US markets would be dead set against a move like this. Who would ever buy a US security after it was established that the government could rewrite its terms?

The ECB Ignores Inflation For Now

The Financial Times notes in a story today,"Credit squeeze pushes ECB to peg rates," that the European Central Bank refrained from its inclination to increase rates to combat increasing inflation. One has to wonder whether the failure to increase rates is out of the recognition that a hike would put more downward pressure on the dollar. Similarly, the ECB may hope that the high euro in and of itself will moderate growth and provide some price relief.

From the Financial Times:

The credit turbulence that began in the US mortgage market put European policymakers on the spot on Thursday as the European Central Bank all but dropped plans for an interest rate rise and the Bank of England decided to leave its main rate unchanged.

Speaking after the ECB held its main interest rate at 4 per cent at a meeting in Vienna, Jean-Claude Trichet, president, went further in stressing the downside risks to growth in the eurozone.

Although the ECB would not let up in the battle against inflation, significant changes in the wording of Mr Trichet’s statement hinted strongly that the central bank saw little case for further rises in borrowing costs. Before the credit squeeze, the ECB had been planning to raise interest rates last month.....

Economists believe increasingly that UK and eurozone interest rates have peaked, after a series of tightening moves in the past year. The chances of an early cut in the UK were growing, analysts said.

Financial markets have also started talking about a fall in eurozone borrowing costs next year. But Holger Schmieding, economist at Bank of America, said: “It would probably take a dramatic, protracted and wholly unexpected downturn in the economic data to trigger any rate cut discussion in Frankfurt.”

The ECB’s task has been complicated because inflation in the 13-country region has started to rise and is expected to stay above its target of an annual rate “below but close” to 2 per cent well into next year. But recent economic data have also pointed to a marked slowdown in economic growth, almost certainly exacerbated by the global credit squeeze and a stronger euro.

Barry Ritholtz, ever vigilant for signs of "inflation ex inflation" had a different take on Trichet's remarks:

But what really caught my was what Jean-Claude Trichet, President of the ECB, had to say about "core" inflation:

As regards price developments, according to Eurostat’s flash estimate, the annual HICP inflation rate increased strongly to 2.1% in September 2007, from 1.7% in August. As we have already indicated on previous occasions, we are now entering a period during which unfavourable effects from energy prices will have a strong impact on annual HICP inflation rates. Owing mainly to such effects, as a result of the marked decline in energy prices a year ago combined with the recent substantial increase in oil prices, we expect the inflation rate to remain significantly above 2% in the remaining months of 2007 and in early 2008, before moderating again. Largely as a consequence of capacity constraints and relatively tight labour market conditions, inflation is expected to be around 2% on average in 2008.

Risks to the outlook for price developments remain on the upside. They continue to include the possibility of further increases in the prices of oil and agricultural products as well as additional increases in administered prices and indirect taxes beyond those announced thus far. Taking into account the existence of capacity constraints, the favourable momentum of real GDP growth observed over the past few quarters and the positive signs from labour markets, stronger than currently expected wage developments may occur, and an increase in the pricing power in market segments with low competition could materialise. Such developments would pose upward risks to price stability. It is therefore crucial that all parties concerned meet their responsibilities. (emphasis added)

In other words, the non-core inflation level is rising, its significant, and its a threat to price stability. Focus too much on the Core to your own economy's detriment . . .

The Prudent Investor also noted that Eurozone inflation, at 2.1%, is above the 2% target.

The Prudent Investor, now in Vienna, is suffering from personal inflation well in excess of the ECB's published rates. Note these increases all took place since April:

City parking fees rose 50%.
Public local transport rose 13.3%.
Bread costs now 3 Euros for half a kilo, roughly 1,200% more than when I started monitoring bread prices 35 years ago (and 10plus percent only in 2007.)
Pizza in my favourite place rose 14.9%.
Gasoline costs about 20% more.
Milk and milk products rose around 15%.
Butter rose 25%.

Now imagine if you annualized those rates....

Vietnam and Qatar Retreat From Dollar

In a further blow to the dollar's standing, Vietnam and Qatar both announced that they are cutting their holdings of dollar assets. Note that this isn't merely "diversifying away from the dollar" which could be accomplished by effectively reducing ongoing dollar purchases (both run trade surpluses which oblige them to buy dollars) via exchanging them, say, with euros. As FT Alphaville reports, they are taking the far more aggressive move of selling existing dollar holdings:

Announcements on Thursday from the Qatari and Vietnamese governments that they are rapidly divesting in dollar denominated securities will not come as good news to the US government. Overseas investors hold half of America’s $4,400bn of marketable government debt, up from a third in 2001 according to the US Treasury department.

Qatari Prime Minister, Sheikh Hamad bin Jassim bin Jabr al-Thani said on US TV that the government-backed $50bn Qatari Investment Authority (QIA) now had less than 40 per cent of its investments in dollars, down from a high two years ago of 99 per cent.

Given that the Emirate’s oil and gas revenue is in dollars, the latest troubles in the US economy have accelerated the need to diversify investments into non-dollar markets. Currencies such as the Euro, the British Pound and the Swiss Frank, are all looking far more stable as investments for the QIA, said Sheikh Hamad.

Such was the Qatari PM’s concern about the sliding dollar, that he even said an oil price of $125 per barrel would not be unreasonable.

On Thursday, the State Bank of Vietnam quietly let slip it would be ending its dollar purchase schemes, which it has been using to hold down the Vietnamese currency....

Cue dollar sale.

Asian investors have already pulled out of US Treasuries - as FT Alphaville reported in September, foreign government holdings of T-Bills fell 3.8 per cent in August.

Note that we have commented earlier on the Chinese and the Saudis moving away from the dollar.

Both Alphaville and the Telegraph stressed that Vietnam's shunning of the dollar is more serious that it might seem on the surface, since it may encourage other Asian countries, which have been pegging their currencies against the dollar. It's become increasingly difficult for these countries to continue with this practice, since all those dollar purchases have led to inflation (it is rampant in China).

From the Telegraph:

The Saigon Times said this morning that the State Bank of Vietnam was abandoning the attempt to hold down the Vietnamese currency through heavy purchases of dollars. The policy is causing the economy to overheat, driving up inflation to 8.8pc.

Vietnam, which has mid-sized reserves of $40bn, is seen as weather vane for the bigger Asian powers.

Together they hold $3,575bn of foreign reserves, over 65pc of the world's total. China leads with $1,340bn, but South Korea, Taiwan, Singapore, and even Thailand all built up massive holdings.

The concern is that once one or two members of the region jump ship, it could set off a broader scramble. None of them want to be the last one left holding a devalued asset. Vietnam's central bank said this week that it would move "gradually" to a floating currency.....

"OPEC and Asia have been the two blocks funding the US current account deficit," said Hans Redeker, currency chief at BNP Paribas.

"Vietnam is a relatively small country but it is symptomatic of Asia. The entire region is seeing inflation move up as a result of mercantilist policies of holding down their currencies with 'dirty floats', which are designed to help their export sectors. They need to change monetary policy, " he said.

America is in danger of getting what it wished for. It has been pressuring China to let the yuan float, and threatening trade sanctions if it doesn't. But if the dollar falls sharply, not only would it be destabilzing to the world economy, but it could end the dollar's status as the world's reserve currency. One consequence is that US debtors would increasingly have to fund not in US dollars but in other currencies, meaning they would have to bear the foreign exchange risk.

And even if the US is lucky and has an orderly rather than disorderly fall in the dollar, Andy Xie (when he was still at Morgan Stanley) pointed out that US corporations would also take a hit. From MacroBlog:

I estimate that a significant share of the profits of S&P 500 companies come from mark-ups on cheap Chinese products. If the US Congress passes a serious protectionist measure against the China trade, the US stock market could be hit hard and the property market could follow.

The dominoes are falling, although not in the sequence Xie anticipated (but he also wrote this before the blowout phase of subprime mortgage issuance).

It Pays to be a Metrosexual

According to Bloomberg (hat tip 2Blowhards), well-groomed men do better financially than their rumpled peers. And contrary to popular perception, the impact is greater for men than women. Note that the study measured time spent on primping, and made no effort to assess the efficacy of those efforts.

Perhaps the seemingly lower economic impact of personal care on women is due to women having a higher baseline (pretty much all women in a office setting wear makeup, for instance), so the investment in incremental advantage yields a lower payoff.

Note also that the research doesn't prove that the relationship between personal care and compensation is causal. For example, people who are going through a rough patch (think divorce) might let their appearance slip, and the external stress. Or it might be that more sociable men care more about grooming, and thus the factor for success is the sociability, not the investment in appearance. Interesting nevertheless.

From Bloomberg:

There has long been an adage that it isn't what you know that's important for getting ahead in the business world, it's who you know. Now it appears that what really counts is what you look like.

According to research by U.S. economists, the more time you spend combing your hair and polishing your shoes in the morning, the more money you are likely to earn once you finally make it into the office. And, perhaps surprisingly, the effect is more pronounced for men than it is for women.

That backs up a growing body of economic literature that tells us that the better looking you are, the more likely you are to do well in life.

And yet, what that says about the way modern business works is rather worrying: People are shallow in their judgments, they value showmanship over ability, and they are creating a culture of narcissism, in which the vain triumph over the worthy.

``There is a general understanding that people are judged on their appearance,'' said Fiona Line, diversity adviser to the U.K.'s Chartered Institute of Personnel and Development. ``What is important is that companies should be recruiting based on talent, not on what people look like, however strong an instinct that might be.''

Leaving aside the rather obvious counter-example of Bill Gates, who didn't exactly forsake a career in Hollywood to get into the computer industry, there is no disputing the basic data.

Jayoti Das and Stephen DeLoach of the Martha and Spencer Love School of Business at Elon University in North Carolina took the 2005 American Time Use Survey, which studied how 13,000 individuals filled up their day. They then compared that with earnings data.

``Extra time spent grooming has a positive and significant effect on both men's and women's earnings, but the effect is considerably larger for men,'' they said in a paper called ``Mirror, Mirror on the Wall: The Effect of Time Spent Grooming on Wages.'' ``For men, every extra 10 minutes daily grooming increases their weekly wages by 6 percent. However, women would have to nearly quadruple their daily grooming time to receive that much in additional wages.''

In countries from the U.S. to the U.K., Australia and China, research has shown that those of us who might be mistaken for the back end of a bus are likely to earn much less than people who regularly find themselves mistaken for George Clooney.

And yet, aside from pepping up our portfolios with some shares in the cosmetics maker L'Oreal SA, what does this obsession with how people look tell us about the business world?

Of course, nobody wants staff turning up in the office if they look like they spent the night sleeping on the streets. Their co-workers won't appreciate it. Neither will the customers.

Likewise, putting some effort into your appearance might well be taken as a sign of commitment to your work and organization. It's certainly reasonable for employers to reward the people who try hard over those who can't really be bothered about their appearance or their work.

More importantly, ``don't judge a book by its cover'' contains a healthy element of truth. By and large, people can't do very much about how they look. Shouldn't companies find a fairer way of assessing their workers?

Within most large corporations, showmanship is now rated more highly than ability or intrinsic worth. Presumably, businesses are assessing staff according to their looks because appearance rather than substance is what they are mostly about.

While there may be some justification for that -- salesmanship is an important part of the success of any organization -- it can get out of hand. In reality, concentrating only on appearances was how we ended up with companies such as Enron Corp. -- it looked great, but there was nothing inside.

Lastly, all those men spending extra time on their personal grooming every morning, and being rewarded with extra pay, are likely to be self-obsessed not just in getting ready for the office, but when they get there as well.

We all know the type. They spend the whole day boasting about their achievements (often non-existent), taking credit for other people's work, and schmoozing with the directors. They may be the ones who are getting the promotions. That doesn't mean they are the best people to be running the business.

In short, fakery rules. If you want a pay increase, invest in a better haircut. That's how things work in a business culture dominated by vanity and pretense.

Signs of improvement in Commercial Paper Market

Bloomberg reports today that commercial paper outstandings rose for the first time in eight weeks. However, the increase was a very modest $4.5 billion (by contrast, the decline in the first two weeks of the fall was roughly $90 billion per week, and the third week's decline was just shy of $60 billion). Upcoming weeks will show whether there is meaningful recovery, or whether this week's change is merely noise around a new, lower market level.

From Bloomberg:

The market where companies routinely borrow for periods of three months or less expanded for the first time in eight weeks as investors regained their appetite for some asset-backed debt.

U.S. commercial paper debt maturing in 270 days or less rose $4.5 billion in the period ended yesterday to a seasonally adjusted $1.86 trillion, ending the biggest decline in at least seven years, according to the Federal Reserve in Washington. Asset-backed commercial paper fell $6.1 billion.

Businesses rely on short-term debt to fund daily activities. Sellers of paper backed by assets such as mortgages were frozen out of the market in August and September as investors balked at debt linked to subprime home loans. The sudden shutdown fueled concerns that the housing slump would slow the economy, prompting the Fed to cut its benchmark interest rate on Sept. 18.

``We're getting there very slowly,'' said Mary Beth Fisher, an interest-rate strategist at UBS AG in Stamford, Connecticut. ``Most of the bad stuff should be gone and everything left should roll over.''

Commercial paper had fallen by $368.1 billion, or 17 percent, since early August as investors retreated to the safety of government debt. Money market funds and mutual funds that invest in short-term debt securities are among the biggest buyers....

Overnight commercial paper yields 47 basis points more than the Fed's target rate for overnight loans between banks. While the gap has narrowed from 4.76 percent on Aug. 10, it remains above the 18 basis point average over the past 12 months, signaling investors still have ``nervousness,'' Fisher wrote in a note to clients today.

The Fed lowered its benchmark federal funds rate by a half percentage point to 4.75 percent and reduced its discount rate, which it charges to lend to banks, a second time to encourage buyers of commercial paper after the market seized up for sellers of the debt.

Last week, the decline in the commercial paper market slowed, as the Fed's move began to shore up confidence in the credit markets.

``These data, combined with persistent declines in commercial paper rates, are clear evidence of stabilization in the commercial paper market,'' said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co. in New York, in a note to clients.

The amount of commercial paper for all categories remains at its lowest since August 2006.

Asset-backed commercial paper has fallen $277 billion since Aug. 8 to $906.2 billion, the lowest since May 10, 2006, according to the Fed.

Sellers of asset-backed commercial paper use the cash to buy mortgages, bonds, credit card and trade receivables, as well as car loans. Some of the programs are backed by subprime loans, issued to borrowers with poor credit or high debt.

As defaults on subprime loans rose to record highs, investors retreated from any debt potentially linked to the mortgages.

About 16.3 percent of holders of subprime loans in bonds created in 2006 are more than 60 days overdue, based on the weighted average of 611 mortgage pools, according to data compiled by Bloomberg.

``Everyone's just left the sector entirely,'' Fisher said. ``Everything that's asset-backed and even vaguely mortgage- related has just been dumped.''

On the Fragile State of the Credit Markets

Despite the evidence of some recovery in the credit markets, such as the sale of some formerly-hung LBO debt (at admittedly lower prices) and the return of buyers to the structured credit market, the patient is far from healthy. An article "Is the storm over? Credit market conditions look changeable," by Gillian Tett in the Financial Times and a joint post by London School of Economics professor Willem Buiter and professor Anne Sibert of Birkbeck College point to the tenuous nature of this rebound. In particular, both worry about the high rates for three month LIBOR, which says banks don't trust their counterparties to be solvent even over a comparatively short term.

Why such a cautious stance? Many banks gave backup lines of credit to secured investment vehicles (SIVs), which were off balance sheet entities that lent long (they held mortgage paper, in some cases subprime) and borrowed short in the commercial paper market (using something called ABCP, or asset backed commercial paper). After two German banks had to be rescued due to subprime exposure, suddenly no one wanted to hold ABCP, and these vehicles could no longer roll their CP. They had to use their backup lines of credit (in some cases, the parent bank might not have be required to support the SIV, but have decided to anyhow out of concern for their reputation). Thus the belief is that these banks are hoarding cash for their own needs, to the detriment of normal market operation.

First, from the Financial Times:

But the problem that haunts both the politicians and banks is that while the signs of a rebound may be tangible, they remain patchy – and, above all, decidedly fragile. That suggests that the current apparent calm could quickly give way to another bout of turmoil if any new shocks emerge.

“Fragile” is probably the best word to use,” says one central banker. Or as a senior private sector banker admits: “We are on a knife-edge ... there are still worrying signals in the markets.”

One issue provoking worry is that there is still alarmingly little evidence of genuine trading under way in many of the complex securities that were at the heart of the summer credit storm. While bargain hunters, such as hedge funds, have started snapping up corporate debt, the same does not appear to be happening much in derivatives linked to mortgage securities. Meanwhile prices in that sector – insofar as there are any prices – are still falling. Last week, a derivatives index linked to US mortgage loans touched a new low.

Another – potentially more pernicious – problem is the state of the interbank market. In recent weeks, the cost of borrowing funds overnight has dropped in Europe and the US as central banks have flooded the money markets with funds. However, in the three-month money market, rates remain very high because banks are apparently hoarding their funds rather than lending them out.

“Overall, central banks have been successful in stabilising conditions at the short end of money markets,” says Lena Komileva of Tullett Prebon, the inter-dealer broker. “But persistent tightness in [three-month] funds suggests that developments in the overnight market create an illusion of normality.”

This is alarming for those central banks that have been flooding the markets with money, since it will be hard for the financial system to function healthily again while the interbank market remains frozen. It also has troubling implications for investors: the interbank freeze in effect suggests that banks do not believe their own rhetoric that the outlook is improving. In public, in other words, they may seem upbeat but they are not putting their money where their mouth is.

Some observers hope this discrepancy simply reflects technical phenomena that should disappear soon. More specifically, one reason why banks are hoarding funds is that they fear that a flood of assets, such as loans, will roll back on to their balance sheets because these instruments can no longer be sold in the credit markets.

But while the scale of this potential roll-back is huge, it should not continue indefinitely: Société Générale, for example, thinks that once the current financial year has ended, banks will become more willing to lend to each other. “We expect the pressures on the money markets to reverse [soon],” it says.

But the problem with this optimistic projection is that there appear to be other factors that are also provoking unease – not just among bank treasurers but other investors too.

One is the continued uncertainty as to where all the rot related to the subprime mortgage sector now lies. Although some banks, such as UBS and Credit Suisse, have already revealed losses, there are widespread suspicions that other large and small banks and asset management groups are still concealing problems – not least because it remains hard to value complex credit securities while markets remain paralysed.

“There is still an information logjam in term of ‘who owes what to whom?’ and ‘what are the assets really worth?’ ” says Andrew Milligan, head of global strategy at Standard Life Investments. Or as Marco Annunziata of Unicredit echoes:“At the root of the current crisis is an information crunch that cannot be easily resolved.”

A second set of concerns revolves around “deleveraging” – the banking term for the process by which investors and institutions cut their levels of debt. This issue is crucial because in recent years many investors and financial institutions have sharply increased their borrowing in order to buy loans and other assets. Many are now cutting this, either because they have suffered painful losses on their investments or because the banks themselves are no longer willing to supply funds, and the cost of capital is rising.

Citigroup estimates that back in January a hedge fund that owned an AA rated debt instrument could typically post that as collateral with an investment bank and borrow 10 times that value of funds. Now it can typically borrow only five times the value of this collateral, or less for riskier assets. “From one asset class to another, everyone is strapped for cash,” says Matt King, analyst at Citigroup.

This shift could force many investors to sell assets in the coming months. Worse, it is difficult to tell how this deleveraging process will play out, since many of these markets and their investors are opaque: little is traded publicly. Thus, while some observers hope the worst of the deleveraging is past, others fear the full impact will emerge only over the next year.

This, in turn, creates a third huge uncertainty: the impact of this summer’s turmoil on the real economy. Thus far, there have been few signs that the credit upheavals and the associated rise in funding costs have triggered corporate panic. That may be because the global economy remains in a healthy state and most companies are enjoying strong balance sheets and good earnings. Moreover, while borrowing costs have risen, they are not at all high by historic standards – not least because they were so abnormally low last year.

But this sense of calm could be illusory, owing to a time-lag effect. Financial history suggests that whenever funding costs have risen in previous cycles, it has typically taken several months for the full impact on companies or consumers to show up. Indeed, behind the scenes, banks are preparing to cut their lending. A survey of loan officers in the US by the Federal Reserve, for example, suggests that banks are imposing the tightest lending criteria in their mortgage business for 16 years.

Merrill Lynch believes, on the basis of research among its own client base, that two-thirds of lending officers in Europe and the US are planning to cut credit. “The days of cheap and easy money for sub-investment grade companies are over,” says Merrill’s Karen Olney, who points out that “normally defaults follow tightening by about 12 months”.

Most economists think the global economy will be able to weather a moderate rise in corporate defaults or fall in house sales. But if anything else hurts sentiment, such as an associated crash in house prices or the dollar, the panic could rise.

That, in turn, might create a vicious feedback loop, where a decline in economic activity leads to more credit losses – which prompt the banks to tighten lending further, triggering further borrower pain. There is risk, in other words, that the developments of this summer were merely the first chapter of a long saga of pain.

Almost nobody in the political or banking world will publicly admit that they are preparing for this worst-case scenario. But if nothing else, the events that started in August have reminded investors that the worst-case scenario can sometimes play out, however unlikely.

Investor psychology, in other words, has changed. As long as uncertainties remain about issues such as deleveraging, subprime losses and the risks to economic growth, a sense of fragility will endure. The days of ultra-easy credit will not return soon – on the JPMorgan trading desks or anywhere else.

From Buiter and Sibert:

There are four explanations for the sizable spread of three-month LIBOR over the Bank Rate. The first is an expectation that the Bank Rate will rise over the next three months, but this highly unlikely. Second, there could be a pure term premium, but this must be tiny over such a short horizon. Third, there is a risk that borrowers will default. This is clearly not zero, but it is difficult to believe that there is a one percent probability that a typical UK money centre bank will default with a zero recovery rate during the next three months. Finally, there is a liquidity risk and we attribute the lion’s share of the recent spread of three-month LIBOR over Bank Rate to liquidity factors.

Currently liquid banks may be reluctant to make three month loans, not because they are afraid that their borrowers will be insolvent in three months, but because they are afraid that both they and their borrowers will be illiquid in three months. If enough banks have these fears, an interbank ‘lending strike’ results.

Banks everywhere are gearing up to take on their balance sheets the illiquid assets of conduits, other SIVs and other off-balance sheet SPVs that they are exposed to through credit lines or reputational considerations. Fear of future illiquidity is widespread and banks are hoarding excess liquidity rather than lending it out in the interbank market, even at nearly seven percent. The Bank could address this unfortunate situation by injecting liquidity, through repos with, say, a three-month maturity to eliminate the liquidity premium. Such repos are likely to be more effective if they are against a wider range of eligible collateral that what the Bank currently accepts, including illiquid assets.

Note that the entire post, which is wide-ranging, is very much worth reading. It has a very nice recap at the beginning of why securitization hasn't turned out to have unexpected pitfalls (short answer: information loss); a summary of their "market maker of the last resort" recommendation, and interesting tidbits on the Northern Rock failure and Bank of England and ECB actions to address the credit crunch.

Dire Outlook for the Tasmanian Devil

In case you haven't been following this story, the Tasmanian Devil population has been ravaged by a contagious tumor. As a BBC report earlier this year explained:

Devil facial tumor disease (DFTDA) was first documented by a wildlife photographer in 1996. The animals have powerful jaws able to crunch through the bones of much larger animals and are known to bite each other's faces during fights and courtship behaviour.

The devils usually have a life expectancy of about five years, but it is now unusual to see an animal over the age of three. Researchers estimate the wild population has fallen from 140,000 in the 1990s to 80,000.

A severely diseased devil is a grotesque sight: large tumours protrude from the face and neck, sometimes pushing out teeth and invading eye sockets.

As the tumours interfere with feeding, the animals become emaciated and usually die within six months of showing lesions.

But while many scientists had suspected a virus, Anne-Marie Pearse, a researcher for the state of Tasmania who co-wrote the article in Nature, found abnormalities in the chromosomes of the cancer cells were the same in every tumor.

Pearse and her colleague Kate Swift discovered that, while the normal complement of chromosomes in the devil is 14, the tumours contained 13, which were grossly abnormal. These chromosomal rearrangements were identical in tumours from all 11 animals studied by the scientists.

This offers support for the idea that the disease apparently began with a single sick devil, probably in the mid-1990s, that directly spread the cancer cells by biting other animals. The authors propose that cancer cells are dislodged from one animal and essentially transplanted to another as a result of bites inflicted around the mouth.

"Devils jaw wrestle and bite each other a lot, usually in the face and around the mouth, and bits of tumor break off one devil and stick in the wounds of another," said Ms Pearse.

"We've found out how the disease is transmitted, which is a breakthrough in how we manage the wildlife population.

She added: "Finding a vaccine would be the ultimate goal."

While that report offered some hope, more recent findings suggest that the devil is likely to be severely afflicted by other infections due to a lack of genetic diversity, which in turn means its prospects for long-term survival are poor. From PhysOrg:

Australian scientists say the ongoing fight to save Tasmanian devils from extinction may be doomed.
Researchers have been battling to find a cure for a deadly facial tumor disease that has decimated the numbers of the rare animals -- found only in Australia's island state of Tasmania.

But now scientists at Sydney University have suggested a lack of genetic diversity because of inbreeding will doom the devils in any case.

Geneticist Kathy Belov, leader of the university scientific team, told the Australian Broadcasting Corp. the devils had been found to have "very low levels of genetic diversity in really key immune genes."

"What this means is that they are going to be susceptible, not only to this horrible cancer that is decimating them at the moment, but potentially to all sorts of other diseases, because they simply don't have the genetic diversity in their genes, which will enable them to respond to any new diseases that are thrown at them," she said.

A deadly facial cancer already has killed half of the devil population because the animals have no resistance to the disease which they catch from biting each other -- fighting over food or mates at breeding time.

Belov said even though scientists hoped to save the Tasmanian devil from extinction through breeding a captive "insurance" population, it would be hard to protect them from any epidemic in the future.

Monkey See, Monkey Do (Climate Change Edition)

A MarketWatch story says that there is a surprisingly effective motivation for people to conserve energy: keeping up with the Joneses. Research indicates that setting an example is more effective than one might think. So whether it's owning a Prius, using florescent bulbs, or eating more plant proteins (fish and meat are higher up the food chain and therefore take vastly more food energy to produce than grains and vegetables), others follow your lead more than you might imagine.

The other reason for including this story is that it illustrates a pet peeve: the fact that researchers often rely on survey data despite its complete and utter uselessness as a predictor of consumer behavior (note that there are more reliable techniques). Surveys are a notoriously bad way to assess, for example, how a new product might fare (people lie about money, and they also lie to please the researcher and look good compared to other participants), yet they are too often the fundamental tool for assessing consumer receptivity.

From MarketWatch:

In the battle to get Americans to conserve energy, one researcher has found, it seems a most unlikely tactic works best: peer pressure.

Robert B. Cialdini, a social psychologist and Regents' Professor of psychology and marketing at Arizona State University in Tempe, has been researching relationships between psychology and pro-environmental action since the early 1990s. He addressed the House Science and Technology Subcommittee on Research and Science Education last week with some of his recent findings.

Cialdini pointed to a pair of studies that he conducted that began with a simple survey distributed to about 3,000 Californians. It asked respondents to select which of four factors would best motivate them to conserve energy: conserving because it saves money; conserving to preserve the earth; conserving in order to be a socially responsible citizen; and conserving because most others in the neighborhood were conserving.

"They indicated that their neighbors' behaviors would be of little impact on their own," Cialdini said of the survey's respondents. But when he looked at what they did, compared to what they said, "the only factor that had any significant impact on whether they conserved energy was their perceptions of what their neighbors were doing."

Surprised, Cialdini did a follow-up experiment in which his team of researchers hung signs on doors of homes in San Marcos, Calif., asking homeowners to conserve energy. Each sign contained a message that reflected one of the four factors examined in the survey.

Yet again, the only message that had any effect on the homeowners' behavior was the one that stated the majority of others in the neighborhood were choosing to conserve. And this time, the evidence was measurable: Homeowners who received the sign asking them to conserve because most others in their neighborhood did reduced their energy-use by two kilowatt hours.
As effective as peer pressure appears to be,, the technique has yet to be harnessed in real-world situations.

"The people who generate the messages don't believe that this simple information can be so motivating," Cialdini said. "There is a great tendency to underrecognize the power of social norms, what those around us are doing and approving of."

When told of the Cialdini's studies, Howard Page, chair of the Mississippi Chapter of the Sierra Club said they "make sense."
But just as Cialdini found, Page also said that the Sierra Club doesn't employ such "peer pressuring" tactics when urging conservation. Instead, Page said, the Sierra Club primarily attempts to appeal to people's ethics and desire to save money. Both, Cialdini demonstrated, had minimal effect on people's actions.

Page did say he saw the advantages of peer pressure in spreading conservation messages, and can envision the Sierra Club one day utilizing Cialdini's findings.

"I can absolutely see the social pressures working," Page said. "If you're a mom in a neighborhood where everyone else on your block drives an SUV, you probably don't feel too bad. But if everyone else drives a hybrid, well, that pressure works both ways."

For those of you who don't know of him, Cialdini is the author of the classic Influence: The Psychology of Persuasion.

Why Subprime Mortgages Aren't Getting "Mods"

From time to time, we've written that the hope of many policymakers, that struggling subprime borrowers would be salvaged by loan modifications, aka "mods", would likely be disappointed. A Financial Times story, "Mortgage lenders in subprime ‘traffic jam’," bears this thesis out.

Let's back up and note that loan modifications are often the best course of action for troubled borrowers, Even though the bank must write down the loan if it modifies the terms so as to lower the borrower's payments (we'll omit the sham of adding the foregone payments to principal), it also faces a writeoff if it forecloses. In the stone ages when banks held loans to maturity, they often concluded the borrower was worth more to them alive than dead.

But in our Brave New World of securitized finance, the fate of the borrower lies not with the lender but with the mortgage servicer. And despite the entreaties of various banking regulators for servicers to take more proactive steps to salvage borrowers, like contacting them before rates reset to higher levels to work out a plan, little of that sort of thing has happened.

One reason is that in many cases, the servicers' hands are tied. Most agreements restrict loan modifications, and our impression is that in many cases that extends to loss mitigation mods (it's standard to restrict mods that aren't related to loss mitigation; you don't want the servicer enabling what is tantamount to refinance to take advantage of falling interest rates, for instance. The servicer would get the same fee as before, but you the investor would get less income). A Bloomberg story notes:

Even if loan-servicing companies want to make changes, their contractual obligations may block them.

Eight of the 31 subprime-mortgage deals that Credit Suisse Group bond analyst Rod Dubitsky looked at for an April report capped the amount of loan modifications that can be done at 5 percent of either the total loan number or their balances.

Banks and borrowers also may be worse off if they delay inevitable foreclosures because slumping home prices may create even lower resale prices, according to Josh Rosner, managing director at the New York investment research firm Graham Fisher & Co.

The last point, that delaying foreclosure may be a bad strategy financially, is important. Servicers would be reluctant to take actions that could easily be argued to have been to the investors' detriment. So that is a further deterrent to mods in a falling housing price environment.

Today's Financial Times article looks at a completely different sort of obstacle: operational and profit considerations of the servicer. The servicing companies don't have the staff or the margins to take on a customized, time consuming activity (remember, the key to profitability as a servicer is running an efficient factory, which means standardizing and automating tasks whenever possible).

This story seems to be an effort to get to the bottom of the survey finding announced by Moody's on September 21, that lenders have relaxed terms on only 1% of subprime mortgages. Contrast this with the roughly 20% level of subprime defaults (and that was as of May) and you can see this mod level is so low that it can only be called cosmetic.

From the Financial Times:

US mortgage companies are being overwhelmed by the large numbers of homebuyers who need to renegotiate their loans to avoid default, creating a “subprime traffic jam” that could frustrate efforts by regulators to prevent foreclosures, experts say.

Mortgage servicers, the operations that collect loans, say they are having trouble making profits because of record levels of late payments and delinquencies. Litton Loan Servicing estimates that costs have increased 20 per cent in the last year for mortgage servicers, who even in good times depend on razor-thin profit margins.

The result is that few subprime mortgages are being renegotiated. Moody’s, the ratings agency, found that lenders had eased terms on just 1 per cent of subprime loans resetting at higher interest rates in January, April and July this year.

“Servicers have failed because there’s a huge resourcing issue,” said Barefoot Bankhead, managing director at Navigant Consulting. “As lenders have gone out of business, the servicing arms have been in transition without the resources to handle the enormous number of requests for loan modifications and restructuring.”

The problem could grow more severe as more than $350bn in adjustable-rate mortgages reset at higher rates in the next 18 months.

“Servicer inactivity could turn the subprime traffic jam into a monumental pile-up, because the longer people wait to make decisions, the worse the situation gets,” said Don Brownstein, chief executive of Structured Portfolio Management, a hedge fund.

Moody’s found that few servicers made telephone calls to borrowers facing interest-rate resets in the near future. It said the majority of large servicers continued to rely on letters to contact borrowers.

Moody’s said this was of “particular concern” given the potential size of the problem. Moody’s said servicer data showed that borrowers who were making payments before the reset and did not have their loans modified fell into arrears at a rate of up to 10 per cent. Analysts estimate that resets could boost payments for borrowers by between 30 and 50 per cent.

Another complication in renegotiating mortgages is that most loans have been packaged into securities and sold to investors. Some modifications are being held up by disputes between investors with differing interests in the same pool of loans.

Republicans Join Free Trade Skeptics

A page one story in tomorrow's Wall Street Journal tells us that a Wall Street Journal/NBC poll found that Republicans have joined Democrats in having a negative view of "free" trade. As we have discussed in earlier posts, more open trade can be a good thing, but not if entered into naively. Our system is more accurately characterized as managed trade, in which we negotiate trade pacts to promote corporate interests (as opposed to those of workers, while most of our counterparts pursue other objectives, such as maintaining a trade surplus, protecting jobs, or shielding young but high potential industries.

From the Journal:

By a nearly two-to-one margin, Republican voters believe free trade is bad for the U.S. economy, a shift in opinion that mirrors Democratic views and suggests trade deals could face high hurdles under a new president.

The sign of broadening resistance to globalization came in a new Wall Street Journal-NBC News Poll that showed a fraying of Republican Party orthodoxy on the economy....

Six in 10 Republicans in the poll agreed with a statement that free trade has been bad for the U.S. and said they would agree with a Republican candidate who favored tougher regulations to limit foreign imports. That represents a challenge for Republican candidates who generally echo Mr. Bush's calls for continued trade expansion, and reflects a substantial shift in sentiment from eight years ago.

"It's a lot harder to sell the free-trade message to Republicans," said Republican pollster Neil Newhouse, who conducts the Journal/NBC poll with Democratic counterpart Peter Hart. The poll comes ahead of the Oct. 9 Republican presidential debate in Michigan sponsored by the Journal and the CNBC and MSNBC television networks.

A Wee Notice to Readers (Consulting Porn Edition)

Oh, you are such a good reader! You either care about this site enough to look at notices and/or you found "consulting porn" worthy of attention (probably because you found the expression to be an oxymoron).

Like it or not, if you are in a large, or even a medium sized organization, you may have to use a management consultant someday. I'm a bit embarrassed to admit to being in the business, since many people in the industry practice forms of shamanism, but rest assured there are some good professionals out there.

I thought I'd take the liberty of telling you about one group (yes, I am biased, and yes, this is an ad of sorts). If you are tempted to stop reading here, I advise otherwise, since this piece is brief and will make you sharper about hiring and using professionals.

The firm in question is Aurora Advisors. I'm affiliated with them (although you won't see my bio on their website; I prefer to remain behind the scenes); they've been around for 18 years and focus on finance and financial services. They have several offerings. One is management consulting (strategy, growth/market entry, performance improvement, joint ventures/franachises, as well as project management) to financial services firms (mainly the securities industry and wholesale banking), typically at the business unit level.

Another is corporate finance advisory, mainly on the buy side, for financial institutions, funds, and very substantial individuals (Forbes 400 level). Industry experience includes financial services, media, and niche technologies. Their services range from fundamental industry analysis to valuation, due diligence, and post-deal planning. They have considerable success in valuing businesses in industries where there is a great deal of uncertainty. They have also acted as house skeptic and have been engaged to review the work of major investment banks.

Why consider them?

They are good. McKinsey refers business to them. If you know McKinsey at all, you will know that it virtually unheard of, particularly over such a long period ( the firm's inception through 2007).

They give money-making recommendations. In one case, the difference in outcomes was $2 billion; in several others, several million dollars.

They are cross-disciplinary. One of the unfortunate trends in consulting over the last 20 years is specialization. The dirty secret is that it benefits the consultant more than the client. The consultant sells a packaged product which gives the client the illusion of certainty, but also too often deprives him of fresh thinking, since inherently many of the same ideas and approaches are used on other clients. And these packaged products are more profitable to the consultant than more customized approaches.

In addition, while narrow specialization can be useful, it throws the burden of diagnosis back on the client. So if the client goes to a focused consultant but hasn't zeroed in on the real root issue, the consultant is unlikely to tell the client they've framed the problem incorrectly. They'll accept the client's parameters in order to get the work (and this may not be disingenuous; they may not know any better).

They are efficient, pragmatic, and tenacious. Even though their rates are middle of the road to high-ish due to the seniority of their staff, their project prices are almost always the low end in a competitive process because they are highly motivated to take the most efficient path through a problem (many consultants, particularly less seasoned ones, have a propensity to boil the ocean). They are also highly productive.

They are particularly good at difficult/unusual problems, particularly when the problem is thorny but the budget is constrained. Often, they have been engaged after the client has gone through an exhaustive search to find a suitable firm and has kissed a lot of frogs. Some examples:

A Fortune 100 company asked Aurora to identify consumer lifestyle trends in the America, Europe, and Asia, to help them design reward programs and advertising campaigns. Aurora understood that the trick here wasn't identifying trends per se but determining how to screen them to find ones that were relevant for the client's products and image. The client launched one global product and two ad campaigns (plus fine tuning of existing campaigns) based on the recommendations, which was completed for less than 1/10th of what trend experts said it would cost.

Another client, a media company, had a 50/50 joint venture in which it appeared that it would have the opportunity to buy out its partner. Aurora determined the value of the company (approximately $1.5 billion) and analyzed the attractiveness and likely terms of various financing options (public stock, high yield and bank debt) and assisted in assessing alternatives from a financial and tactical standpoint. They concluded that the other side's price expectations were excessive, and, instead recommended ways to renegotiating the business terms of the partnership.

Martin Wolf on Resurrecting Securitization

Martin Wolf, the Financial Times' economics editor, may have called the demise of securitization prematurely in his article, "Securitisation: life after death."

This is an odd piece for the normally thoughtful and pragmatic Wolf. On the one hand, he gives a succinct and colorful of assessment of the credit crisis, depicting it as yet another instance of banks-as- lemmings. He stresses that one of the two big causes was that securitization encouraged sloppy lending since (duh) the originator could be cavalier about the risks.

Much of this is familiar ground, but Wolf give a tidy precis and makes a number of acute observations in passing.

But the piece goes a bit pear shaped when it comes to recommendations. Wolf says that securitization offers too many benefits to try to roll the clock back to the old-fashioned model of having banks hold the loans they sourced. Yet his remedies are woefully inadequate. He says that originators of securitized liabilities need to care about their reputations (and he also has a vague exhortation that securitization should become as normal as selling junk bonds).

Reputation? Does anyone care in this day and age when Martha Stewart goes to prison and her business carries on as before with nary a dent? It hasn't even occurred to two Wall Street firms that pretend to care most about their image, Goldman Sachs and Morgan Stanley, that there might have something unseemly about their role in packaging mortgage paper, particularly collateralized debt obligations. Investors are grown ups, they can do their own due diligence. Caveat emptor.

Similarly, Bank of America invested in Countrywide, an institution that is guaranteed to be up to its eyeballs in liability. A generation ago, no respectable institution would have touched a Countrywide until it was on the verge of collapse and the old management was promptly shown the door. In the bad old days, strategic investors cared more both about litigation risk and the possibility of tarnishing their reputation by association. No more.

So Wolf's recommendation is uncharacteristically quixotic. Perhaps he is loath to embrace measures that have more teeth, such as having liability extend to anyone who knowingly on-sells a questionable credit. As we noted back in April, citing a Financial Times story, It's possible to extend the scope of liability in ways that frankly aren't crazy, given the extended sales chain in many securitizations (particularly given resecuritizations like CDOs), but they have been demonized:

The concept is "assignee liability," and at least for now, both Democratic committee chairman Barney Frank and the ranking Republican Spencer Bacchus support it:

Spencer Bachus, Mr Frank's Republican counterpart, has backed an "assignee liability" system that would mean investment banks that repackage mortgages into bonds would be liable to pay compensation to borrowers if loans turned out to have been mis-sold.

Why is this a radical idea? Packagers are currently at risk for the securities they sell, but their liability is to investors, basically to make sure that the securities are what the offering documents say they are. However, Wall Street firms do that by making clear legally how much of the document was provided by them (typically only the offering price and any language that might relate to the offering process, as opposed to the description of the securities or the issuer). The agreement with the issuer also limits the investment bank's maximum liability to its fees.

The proposed legislation would make packagers like investment banks who acquire subprime mortgages from brokers and banks liable for abusive practices. And it's almost a given that they won't be able to limit liability to their fees. (Separately, I wonder how "mis-sold" would be defined.)

From Martin Wolf in the Financial Times:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Chuck Prince, Financial Times, July 10 2007.

“A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” John Maynard Keynes, 1931.

The dance has stopped: Mr Prince’s Citigroup has just announced $6bn (€4.2bn, £2.9bn) in write-downs and losses for the third quarter of 2007. He is far from alone. More bad news is no doubt to come. As Keynes foretold, the banks joined Mr Prince’s dance together and are leaving it together. Until the dance ends, nobody knows what a bank’s profits are: bankers report (and pay themselves) on the basis of profits that are normally offset by write-offs when the bad lending comes to light.

What is remarkable about the present crisis is how traditional it is, despite the modern paraphernalia of securitised lending. We are seeing old-fashioned bad lending and old-fashioned mispricing of risk. What is remarkable, in addition, is the severity of the consequences. The US market in asset-backed paper contracted by 21 per cent between August 8 and October 1. The flight from risk also brought about big divergences between interest rates on commercial paper and US Treasury bills and between central bank interest rates and those in interbank three-month markets. This disruption, moreover, has taken place at the core of the world economy: the US housing market and debt markets of advanced countries.

I admit to both surprise and disappointment. No, I am not surprised by the repricing of risk. On the contrary, together with a host of outside observers, I was astonished by the willingness of yield-seeking investors to take on risks for small reward. If anything, the repricing has been remarkably small, at least so far: equity markets are buoyant; spreads over US Treasuries of emerging market bonds in the JPMorgan emerging market composite bond (EMBI Plus) index rose by a mere 39 basis points between July 6 and October 1; on Baa-rated corporate bonds, they rose by 59 basis points; and even on Caa-rated bonds, they rose by no more than 191 basis points.

What I am surprised by is how toxic securitisation of subprime mortgages has turned out to be for the financial markets. I admit that I thought securitisation had attractive features: it should allow banks to remain in the mortgage business as originators and intermediaries without taking too much of the interest-rate, term and liquidity risks on to their own highly leveraged books; it should allow banks to transfer those risks on to investors who want longer-term, higher-yielding assets; and, in the process, riskier borrowers should have access to more credit than before.

In 2005, Alan Greenspan himself, then Federal Reserve chairman, remarked that advances in technology had revolutionised lending: “where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending.”* Oops!

So what went wrong? There are two chief answers. The first has nothing to do with securitisation itself: it is that a fit of all-too-familiar euphoria overwhelmed both lenders and borrowers at a time of low interest rates and rapid rises in the prices of the underlying collateral (namely, housing). But the second has a great deal to do with securitisation: it is that the process of removing lending from the books of the initiators encouraged sloppy lending (“it is not going to end up on our books”) and greater belief that banks were free of the risk (“this special purpose vehicle has nothing to do with us”) than turned out to be the case.

Why did this happen? As Robert van Order of the universities of Aberdeen and Michigan points out, securitisation necessarily creates a chain of transactors where bank lending interposes just one institution between the borrower at one end and the depositor at the other. Such chains depend on trust or, as he puts it, “reliance on originators and servicers to originate good loans and service them properly”. The trust proved misplaced and has duly vanished: credit means “he (or she) believes”. Alas, he no longer does.

In trust’s absence, ignorance not only of what securitised assets are worth but also of who holds them has dried up asset-backed paper markets. That has forced banks to lend directly to the conduits, special purpose and special investment vehicles they created. The need to fund these has dried up lending and, above all, the provision of liquidity to interbank markets. One result (among many) was the collapse of Northern Rock’s business model in the UK.

An obvious reaction to this debacle is to recommend going back to the old bank-based lending model. But that would be a big mistake. The potential advantages of securitisation, vis a vis “plain vanilla” bank lending, remain, because banks are inherently so fragile. But if these markets are to recover, the errors must be fixed: first, a way must be found to demonstrate integrity of lending; second, transparency of the securities will have to increase; and, third, banks must insure themselves adequately against the need to provide liquidity to their off-balance-sheet vehicles. It is not impossible to sell complex products safely: Boeing and Airbus manage it. But only companies that demonstrably care about their reputations are able to do so. It is up to originators of securitised liabilities to do the same.

A great deal of dust still has to settle in housing markets, financial markets and the world economy. The world that emerges will look different, in many ways. But there is no reason securitisation should not become as normal and reliable an element in financial markets as corporate “junk bonds” and loans to emerging markets have also turned out to be. It is always possible to have too much of a good thing. In this case, the world has had far too much of something that was not as good as it ought to have been. But securitisation is a good thing, all the same. It can re-emerge, provided the lessons of the financial markets’ dance are learnt.

Countrywide Hires Expensive Cheerleader

Psychologists, when working with patients, need to differentiate between two types of people: internalizers and externalizers. Internalizers are very responsible and tend to blame themselves for Things That Happen, whether they are their fault or not. They fit well in jobs that demand professionalism and personal responsibility. By contrast, externalizers blame everyone else for their problems. They often bounce back faster, but they are incapable of learning from their experience. They are typically good salesmen, precisely because they take nothing personally. Extreme internalizers are depressives; extreme externalizers are sociopaths.

A story in today's Wall Street Journal reveals Countrywide to be an archetypal externalizer. Rather than consider that they might have done something to create the mess they are in, and address the problems in their business practices, they instead are circling the wagons and treating critics as hostile, malign outsiders rather than people who might be telling them uncomfortable truths.

The firm is so committed to its internal reality that it has hired Burson Marsteller to shore it up and then sell it to the outside world. This is a highly misguided set of priorities for a firm that clearly has a rapacious, diseased culture.

From the Wall Street Journal:

For Countrywide Financial Corp., this time it's personal. At least that's what a top executive says.

Having suffered a barrage of negative headlines while battling to shore up its finances and shrink its work force of 60,000 by as much as 20%, the nation's largest home-mortgage lender is launching a PR blitz aimed at repairing its reputation. And it starts inside the company.

For the demoralized employees who remain, the new campaign means wristbands with the phrase "Protect Our House" and pep talks promising to keep "amply" rewarding the most successful among them amid a struggle with the sharp drop in mortgage lending as defaults soar and house prices decline.

Leading the counterattack is Andrew "Drew" Gissinger III, a former offensive lineman for the San Diego Chargers football team who serves as executive managing director, residential lending, at Countrywide.

The transcript, prepared from a phone call with 250 "opinion leaders" at Countrywide on Sept. 26, offers a peek inside one of the biggest crisis-management efforts under way in an American corporation. Along with Mr. Gissinger on the call was Jason Schechter from WPP Group's Burson-Marsteller, a public-relations firm with a long history of crisis management.

"We wanted to assure you that my firm and I have brought companies through the worst type of publicity," Mr. Schechter said, according to the transcript. He added that a six-person Burson team was ensconced at Countrywide's Calabasas, Calif., headquarters, and about 25 people overall were working on the campaign.

Rick Simon, a Countrywide spokesman, said the transcript was sent to employees Friday. It says that employees are expected to sign a pledge to "demonstrate their commitment to our efforts," and Mr. Simon says about 11,000 have signed. Each employee who signs up receives the Protect Our House wristband made of green rubber. "We believe there's a great story about the strength of the business," says Mr. Simon.

To counter criticism that its lending practices are to blame for a surge in foreclosures, Countrywide plans to emphasize its "mission" of helping Americans become homeowners, the transcript says. "I want employees to look down at their wristbands and remember our fundamental mission to help customers achieve the American Dream, and to help them withstand those malicious outward attacks and to motivate them to continue on our journey with unwavering conviction," the transcript quotes Mr. Gissinger as saying.

The company also is reaffirming its pugnacious side. "We're competitive to a fault," he says in the transcript, adding: "Our divisions will have clear goals, built on our ruthless attack strategies to continue to grow profitably. Growing, winning and being the best is also hard wired into our DNA."

International Investors Tell SEC That US Corporate Governance is Too Weak

Ah, time for a reality check on the Wall Street Journal/Administration party line. Here we've been told how horrible Sarbanes-Oxley is, and how those tough corporate governance measures are bad for the competitiveness of US markets.

Like many of the things the officialdom in Washington has been telling the public, this line of reasoning doesn't appear to hold water. It turns out foreigners like regulations that strengthen corporate governance because they recognize those rules protect their interests. Specifically, foreign institutional investors are telling the SEC that its opposition to giving investors more power to change boards is wrongheaded (other countries have the sort of laws that the SEC is trying to block). Further note that this international group sees the SEC's moves to reduce investor protection as retrograde rather than progressive.

From the Financial Times:

International investor confidence in US markets will be damaged unless regulators rethink plans to give shareholders only limited powers to change the make-up of US company boards, a group of leading investors has warned.

The investors, who include the Australian Council of Super-Investors and the UK’s National Association of Pension Funds and manage $2,100bn in assets, have criticised the proposals from the Securities and Exchange Commission on board nominations by investors.

“The harsh reality is that US corporate governance practices are on a relative decline,” the group said in a letter to the SEC. “Political winds in the US have recently swung toward rolling back investor protections. This does not give us confidence about future rights of shareholders in the US.”

The letter was sent as Annette Nazareth, Democratic commissioner at the SEC, announced her resignation. It followed the resignation of Roel Campos, a fellow Democratic commissioner, known to support greater shareholder rights on board composition.

“Rights to provide real director accountability to shareholders are sorely needed in the US,” said Daniel Summerfield, co-head of responsible investment at the Universities Superannuation Scheme, the UK’s second-largest pension scheme and a signatory to the letter to the SEC.

The group has joined investors urging the SEC to rethink two plans put forward in July on rules on shareholder rights to nominate directors. They contrasted the US, where rights are limited, with other markets – such as the UK and Australia – that allow shareholders to dislodge ineffective directors.

The issue has come to a head this summer after the SEC put forward two proposals. The first would allow companies to veto shareholder proposals to nominate candidates to boards.

The second would allow shareholders who have held more than 5 per cent of a company for more than a year to put forward changes to bylaws or articles, enabling them to nominate board candidates. The SEC has also added conditions. Shareholders said this was “onerous” and “unworkable”.

US executives believe that opening up board elections would make companies vulnerable to “special interest” lobby groups, for example labour unions, who could push their own agendas.

Bankruptcy Filings Rising

Credit Slips tells us that bankruptcy filings are increasing, but the new bankruptcy law has succeeded in keeping them below the 2005 level (the law became effective late October 2005). They dispute the idea that this represents progress.

From Credit Slips:

According to the folks at Automated Access to Court Electronic Records (AACER), preliminary figures show total U.S. bankruptcy filings in September at 67,286. That represents an increase from the 76,959 filings in August. Huh? Well, the September filings were spread over only 19 business days, but the August filings were over 23 business days. Thus, on the basis of filings per day, September filings were 3,541 as compared to 3,346. That's a 5.8% increase in September over August. One cannot read a lot into monthly variations, but that is the highest daily filing rate since the enactment of the 2005 bankruptcy law....


None of this should surprise us. The architects of the 2005 bankruptcy law set out to make bankruptcy more expensive and more time-consuming and less effective for people once they got there. The point was to drive away people from the bankruptcy courts. It looks like they got what they wanted. Of course, it's hardly a success to claim that bankruptcy filings are down. Consumers are hurting just the same, maybe more. Claiming victory by keeping people out of the bankruptcy system is like claiming victory over illness by closing the hospital.

IBM Seeks to Patent Checking a Box

Well, at least it's checking a box via a GUI (graphical user interface).

You can't make this stuff up. From the US Patent and Trademark Office:

Mode switching for ad hoc checkbox selection

Abstract
Controlling checkbox status by selecting and deselecting checkboxes in a GUI according to a mode of operation, the GUI having displayed upon it a set of checkboxes comprising a multiplicity of checkboxes, wherein each checkbox comprises a selection status indicating whether each checkbox is selected; detecting a mode selection event; and changing the mode of operation in dependence upon the detected mode selection event. In some exemplary embodiments each checkbox comprises a drag status and the method includes toggling the status of the first checkbox and statefully toggling the selection status of checkboxes experiencing drag event in dependence upon drag status, the new state of the first checkbox, and the original state of the current checkbox.

Inventors: Bosma; John Hans Handy (Cedar Park, TX), Walker; Keith Raymond (Austin, TX), Chen; Yen-Fu (Austin, TX)
Assignee: International Business Machines Corporation (Armonk, NY)

Existing Home Sales Fall; MIlken Says Recovery a Long Way Away

Two gloomy sightings on the housing front at Bloomberg. The first was the release of wretched existing homes sales data for August, which followed a July that also showed serious deterioration. The only possible positive spin is that the rate of decline was lower in August than in July, but the August figures were an all-time low.

The second was a measured but pessimistic forecast on housing from former junk bond king Michael Milken (although Milken is more positive about the economy overall).

First, from the Bloomberg piece on existing home sales:

The number of Americans signing contracts to buy previously owned homes dropped to the lowest level on record in August as the housing recession deepened.

``The existing homes market is now in freefall,'' said Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd., in Valhalla, New York. ``The downside from here is still substantial.''

The National Association of Realtors' index of signed purchase agreements fell 6.5 percent from the previous month, the group said today in Washington. The decline was more than economists anticipated and pushed the measure to the lowest level since the organization began tracking purchases in 2001. The gauge plunged 11 percent in July....

Compared with a year earlier, pending home sales were down 22 percent. Purchases declined in all four regions of the country, led by a slide of 9.5 percent in the South. The smallest drop was in the West, which notched a fall of 2.7 percent.

So far, the Fed's half-point rate cut on Sept. 18 has failed to lower mortgage rates and boost demand. Average 30- year, fixed-rate mortgage rates ended last week at 6.42 percent, compared with an average 6.3 percent the prior week, according to Freddie Mac.

Buyers have been further constrained by the tighter lending standards and the shutdown of mortgage lenders such as American Home Mortgage Investment Corp. in early August that closed off access to credit.

``Fewer contracts were being written because of mortgage- availability issues,'' said Lawrence Yun, a senior economist at the real estate agents group. ``More than 10 percent of sales contracts fell through at the last moment in August, primarily the result of canceled loan commitments'' from lenders.

A Bloomberg survey of 30 economists forecast the index would decline 2.1 percent from July. Projections ranged from a decline of 4.7 percent to a gain of 3.4 percent.....

``There is still no bottom in sight,'' said Joshua Shapiro, chief U.S. economist at Maria Fiorini Ramirez Inc., a New York forecasting firm. ``Sales will continue to fall until there is a greater price capitulation by sellers. It still appears that we have not reached market-clearing prices to reduce the inventories of unsold existing homes.''

In keeping, Mike Milken thinks the housing market will take a long time to rebound:

The U.S. housing market is unlikely to recover soon from the worst slump in 16 years, according to Michael Milken, the junk bond billionaire turned philanthropist.

It will be ``quite a while before we have a robust housing market again,'' Milken said in an interview today. ``The idea that any loan against real estate is a good loan has never been a rational thought.''

The ``basic assumption'' that home prices will continually increase is wrong, said Milken, chairman of the Milken Institute, an independent economic think tank based in Santa Monica, California....

The U.S. economy will withstand the slide in housing, propelled by global growth, said Milken, 61, the former high- yield bond chief from Drexel Burnham Lambert Inc.

``Today the strength of the world's economy is helping America and the United States, and I think that will soften the blow of our downturn in housing,'' he said. ``We have to realize, similar to the time of Galileo, that the whole world is not necessarily revolving around the United States and the amazing story of America.''

Mirable Dictu! The Journal is Skeptical About the Stock Rally

The normally cheerleading Wall Street Journal, contrary to its usual form, voices considerable doubts about the near-200-point runup in the Dow yesterday:

Stocks soared to a new all-time high....suggesting that investors already are shrugging off the problems that rocked global financial markets only weeks ago..... The scamper to new highs comes despite surging mortgage defaults, the collapse of big buyout deals, a plunge in the dollar and growing fears of a recession.

Just yesterday....Citigroup Inc. announced a $5.9 billion hit....UBS AG said it was taking $3.41 billion in write-downs....

Rather than disrupting financial markets, the revisions seemed to bolster investor confidence that banks are taking their lumps and losses are mainly in the rearview mirror. Both banks saw their shares rise.

The optimists' key assumption is that the Federal Reserve has the situation under control....

Yet housing, the source of the market's late-summer woes, remains unstable. Over the next 12 months, Americans holding home mortgages with a total value of nearly $480 billion will face revised interest rates, typically as the low "teaser" rates that drew them in are reset at higher, market rates, according to data from Moody's Economy.com. About 55% of these mortgages, or $260 billion, are loans given to subprime borrowers, generally people with poor credit, the data show.

Normally the stock market reflects expectations for the economy's direction, which is why housing skeptics are scratching their heads over the Dow's surge. One factor may be that, amid low interest rates and the freezing of credit markets, people with cash to invest feel little alternative but to put it in stocks.

It also may be that stocks are experiencing a false dawn. On several occasions during the collapse of the technology bubble early this decade, investors grasped at straws to argue the crisis had passed. Instead, the stock market's down trend lasted for 2½ years, and the real resolution came after tech and telecommunications companies had completed several painful rounds of shedding debt and refocusing their businesses....

If more mortgages go bad, that could force banks and other financial firms to take repeated write-downs of the value of securities backed by mortgages. That could further roil debt markets and affect the stock market, given that financial institutions comprise 30% of the profits of the companies in the Standard & Poor's 500 stock index.

"I think you're going to get this constant flow of hits going forward, spread out over multiple quarters," said Bill Laggner, a partner at hedge fund Bearing Fund LP, which has bet against financial institutions and other stocks involved in the housing market.

"A lot of people think that it doesn't matter what happens, that the Fed will rush in and find some way to save some of these larger institutions and the various assets that they own," Mr. Laggner said. "But I don't see how there's going to be a market for a lot of this paper for a long, long time."

This much openly-stated skepticism in a front-page Journal story is a big near term bullish signal. Even if you don't believe in this rally, I'd give it at least a couple of weeks based on this story alone.

"What Happened to the Quants in August 2007?"

Paul Kedrosky (of Infectious Greed fame) points to a a terrific paper by Amir E. Khandaniy and Andrew W. Lo of MIT, "What Happened to the Quants in August 2007?". I'll confess that I have only skimmed it, but it looks thoughtful, has all the right caveats (the researchers admit they may not have and can never get the right data), but by looking at the data they can access and building an indicative model, they've come up with some plausible theories. And if they are wrong, their arguments might provoke insiders to offer some corrections.

We'll give some excerpts below, but their most interesting finding is that de facto, hedge fund strategies have become more correlated. This is precisely what you don't want to see if you are a hedge fund investor; you are supposedly paying for alpha, meaning manager ability to beat the market, rather than what amounts to a general hedge fund return, which Khandaniy and Lo call "hedge fund beta." (And if you are an institutional investor, you also think you are paying for a particular hedge fund style, such as distressed debt or global macro, and they in turn are supposed to have distinctive profiles that are usefully not highly correlated with your other holdings).

A troubling factoid is that the Fed had taken note of increased correlation of hedge fund returns back in May and attributed it to low volatility, which means in effect they dismissed any risk. Khandaniy and Lo instead note the use of much higher leverage as competition has made it harder to achieve target returns (which means credit risks are more tightly linked, which in turn means that adverse events can force investors in different strategies to the exits at the same time, thus producing correlated results in seeming uncorrelated investment approaches).

But it's been an open secret for some time that hedge funds may not really be delivering alpha after all. As we noted in an earlier post:

The rationale for hedge funds’ eyepopping fees is that investors are paying for “alpha,” that is, the excess return (meaning the return in excess of the “market” return). Investors are willing to pay for alpha because it is considered to reflect an investment manager’s skill, and managers who can regularly outperfrom the market are rare indeed....

Targeting a particular risk/return tradeoff isn’t an alpha proposition at all. It is instead “synthetic beta,” (or “alternative beta”). And synthetic beta can be produced comparatively cheaply.

A 2005 survey (http://www.edhec-risk.com/edhec_publications/RISKArticle.2005-08-10.3923/view, free subscription required) found that 70% of the investors recognized the role of alternative beta in overall hedge fund results. But this knowledge hasn’t yet translated into a recognition that they are overpaying.

From Khandaniy and Lo:

From these empirical results, we have developed the following tentative hypotheses about
August 2007:
1. The losses to quant funds during the second week of August 2007 were initiated by the temporary price impact resulting from a large and rapid \unwinding" of one or more quantitative equity market-neutral portfolios. The speed and magnitude of the price impact suggests that the unwind was likely the result of a sudden liquidation of a multi-strategy fund or proprietary-trading desk, perhaps in response to margin calls from a deteriorating credit portfolio, a decision to cut risk in light of current market conditions, or a discrete change in business lines.

2. The price impact of the unwind on August 7{8 caused a number of other types of equity funds|long/short, 130/30, and long-only|to cut their risk exposures or "de-leverage", exacerbating the losses of many of these funds on August 8th and 9th.

3. The majority of the unwind and de-leveraging occurred on August 7-9, after which the losses stopped and a significant|but not complete|reversal occurred on the 10th.

4. This price-impact pattern suggests that the losses were the short-term side-effects of a sudden (and probably forced) liquidation on August 7{8, not a fundamental or permanent breakdown in the underlying economic drivers of long/short equity strategies. However, the coordinated losses do imply a growing common component in this hedge-
fund sector.

5. Likely factors contributing to the magnitude of the losses of this apparent unwind were: (a) the enormous growth in assets devoted to long/short equity strategies over the past decade and, more recently, to various 130/30 and active-extension strategies; (b) the systematic decline in the profitability of quantitative equity market-neutral strategies, due to increasing competition, technological advances, and institutional and environmental changes such as decimalization, the decline in retail order flow, and the decline in equity-market volatility; (c) the increased leverage needed to maintain the levels of expected returns required by hedge-fund investors in the face of lower profitability; (d) the historical liquidity of U.S. equity markets and the general lack of awareness (at least prior to August 6, 2007) of just how crowded the long/short equity category had become; and (e) the unknown size and timing of new sub-prime- mortgage-related problems in credit markets, which created a climate of fear and panic, heightening the risk sensitivities of managers and investors across all markets and style
categories.

6. The fact that quantitative funds were singled out during the week of August 6, 2007 has less to do with any specific failure of quantitative methods than the apparent sudden liquidation of one or more large quantitative equity market-neutral portfolios. This rapid unwind impacted all equity market-neutral funds, and such funds are, by necessity, quantitatively managed (it is virtually impossible to manage a market-neutral equity fund of more than 100 securities using pure discretion and human judgment, and the funds that were affected typically hold over 1,000 securities on any given day).

7. The differences between the behavior of our test strategy in August 2007 and August 1998, the increase in the number of funds and the average assets under management per fund in the TASS hedge-fund database, the increase in average absolute correlations among the CS/Tremont hedge-fund indexes, and the growth of credit-related strategies among hedge funds and proprietary trading desks suggest that systemic risk in the hedge-fund industry may have increased in recent years.

8. The ongoing problems in the sub-prime mortgage and credit sectors may trigger additional liquidity shocks in the more liquid hedge-fund style categories such as long/short equity, global macro, and managed futures. However, the severity of the impact to long/short equity strategies is likely to be muted in the near future given that market participants now have more information regarding the size of this sector and the potential price-impact of another resale liquidation of a long/short equity portfolio.

More juicy stuff:

By comparing August 2007 to August 1998, in Section 5 we observe that, despite the many similarities between the two periods, there is one significant difference that may be cause for great concern regarding the current level of systemic risk in the hedge-fund industry|our microscope revealed not a single sign of stress in August 1998, but has shown systematic
deterioration year by year since then until the outsized losses in August 2007. We attempt to trace the origins of this striking difference to various sources. In particular, in Section 6, we consider the near-exponential growth of assets and funds in the long/short equity category, the secular decline in the expected rate of return of our test strategy over the years, and the
increases in leverage that these two facts imply.

With the appropriate leverage assumptions in hand, we are able to produce a more realistic simulation of the test strategy's performance in August 2007, and in Section 7 we lay out our "unwind hypothesis". This hypothesis relies on the assumption that long/short equity strategies are less liquid than market participants anticipated, and in Section 8 we estimate the illiquidity exposure of long/short equity funds in the TASS database. We find evidence that over the past two years, even this highly liquid sector of the hedge-fund industry has become less liquid. And in Section 9, we investigate the changes in simple correlations across broad-based hedge-fund indexes over time and find that the hedge-fund industry is a more "highly connected" network now than ever before.

After arguing that their work says that the tsuris of August were not an indictment of quant strategies per se, the authors present some additional conclusions:

Second, the contrast between August 1998 and August 2007 has important ramifications for the connectedness of the global nancial system. In August 1998, default of Russian government debt caused a flight to quality that ultimately resulted in the demise of LTCM and many other fixed-income arbitrage funds. This series of events caught even the most experienced traders by surprise because of the unrelated nature of Russian government debt and the broadly diversified portfolios of some of the most successful fixed-income arbitrage funds. Similarly, the events of August 2007 caught even the most experienced quantitative managers by surprise.

But August 2007 is far more significant because it provides the first piece of evidence that problems in one corner of the nancial system|possibly the sub-prime mortgage and related credit markets|can spill over so directly to a completely unrelated corner: long/short equity strategies. This is the kind of "shortcut" described in the theory of mathematical networks that generates the "small-world phenomenon" of Watts (1999) in which a small random shock in one part of the network can rapidly propagate throughout the entire network.

The third implication of August 2007 is that the notion of "hedge-fund beta" described in Hasanhodzic and Lo (2007) is now a reality. The fact that the entire class of long/short equity strategies moved together so tightly during August 2007 implies the existence of certain common factors within that class. Although more research is needed to identify those
factors (e.g., liquidity, volatility, cash flow/price, etc.), there should be little doubt now about
their existence. This is reminiscent of the evolution of the long-only index-fund industry, which emerged organically through the realization by most institutional investors that they were all invested in very similar portfolios, and that a significant fraction of the expected returns of such portfolios could be achieved passively and, consequently, more cheaply.

Of course, hedge-fund beta replication technology is still in its infancy and largely untested, but
the intellectual framework is well-developed and a few prominent broker/dealers and asset-management firms are now offering the rst generation of these products. To the extent that the demand for long/short equity strategies continues to grow, the increasing size of assets devoted to such endeavors will create its own common factors that can be measured,
benchmarked, managed, and, ultimately, passively replicated.

Finally, the events of August 2007 have some useful implications for regulatory reform in the hedge-fund sector. Recent debate among regulators and legislators have centered around the registration of hedge funds under the Investment Advisers Act of 1940. While there may be compelling arguments for registering hedge funds, these arguments are generally
focused on investor protection which is, indeed, the main impetus behind the '40 Act.

But investor protection is not necessarily related to systemic risk, and the best ways to deal with the former may not be optimal for the latter. In fact, registration does not address the systemic risks that hedge funds pose to the global financial system, and currently no regulatory body has a mandate to monitor, much less manage, such risks in the hedge-fund
sector. Given the role that hedge funds have begun to play in nancial markets|namely, active providers of liquidity and credit|they impose externalities on the economy that are no longer negligible.

In this respect, hedge funds are becoming more like banks, and the reason that the banking industry is so highly regulated is precisely because of the enormous social externalities banks generate when they succeed, and when they fail. Unlike banks, hedge funds can decide to withdraw liquidity at a moment's notice, and while this may be acceptable if it occurs rarely and randomly, a coordinated withdrawal of liquidity among an entire sector of hedge funds could have disastrous consequences for the viability of the nancial system if it occurs at the wrong time and in the wrong sector.

This observation should not be taken as a criticism of the hedge-fund industry. On the contrary, hedge funds have created tremendous economic and social benefits by supplying liquidity, engaging in price discovery, improving risk transfer, and uncovering non-traditional sources of expected return. If hedge funds have increased systemic risk, the relevant question
is "by how much?" and "do the benefts outweigh the risks?". No one would argue that the optimal level of systemic risk for the global financial system is zero. But then what is optimal, or acceptable?

The first step to addressing this issue is to develop a better understanding of the likelihood and proximate causes of systemic risk; one cannot manage that which one cannot measure. The proposal by Getmansky, Lo, and Mei (2004) to establish a National Transportation Safety Board-like organization for capital markets is one possible starting point. By establishing a dedicated and experienced team of forensic accountants, lawyers, and financial engineers to monitor various aspects of systemic risk in the financial sector, and by studying every financial blow-up and developing guidelines for improving our methods and models, a Capital Markets Safety Board may be a more direct way to deal with the systemic
risks of the hedge-fund industry than registration.

In the aftermath of the Second World War, a group of socially minded physicists joined to form the Bulletin of Atomic Scientists to raise public awareness of the potential for nuclear holocaust. To illustrate their current assessment of the appropriate state of alarm, they published a "Doomsday Clock" indicating how close we are to "midnight", i.e., nuclear
annihilation. Originally set at 7 minutes to midnight in 1947, the clock has changed from time to time as we have moved closer to (2 minutes to midnight in 1953) or farther from (17 minutes to midnight in 1993) the brink of nuclear disaster. If we were to develop a Doomsday Clock for the hedge-fund industry's impact on the global nancial system, calibrated to 5
minutes to midnight in August 1998, and 15 minutes to midnight in January 1999, then our current outlook for the state of systemic risk in the hedge-fund industry is about 11:51pm.

For the moment, markets seem to have stabilized, but the clock is ticking...

Thomas Palley: Why Conventional Trade Theories Don't Work Any More

Thomas Pally has an elegant little post, "Jack Welch’s Barge: The New Economics of Trade," which explains why the Ricardian model of trade based on comparative advantage has been made irrelevant by the modern corporation's ability to move capital and technology across borders. In fact, it puts corporate interests at odds with national interests. As a result. he makes recommendations that may sound radical, like eliminating the favorable tax treatment of foreign earnings, and making it illegal for US companies to reincorporate outside the US, but are logical given this perspective.

What makes this piece compelling is that it is such a straightforward yet devastating dismissal of the core logic of most of the thinking around free trade. Mind you, that isn't to say that trade can't be beneficial, but it isn't the panacea that most advocates make it out to be. This line of reasoning also fits with the views of economists like Alan Blinder, who were once staunch defenders of open trade, but have changed their minds as they have seen that what works in theory may not operate as well in fact.

From Palley:

The classical theory of comparative advantage has driven US trade policy for the past fifty years. That policy, in combination with technical innovations that have lowered costs of transportation and communication, has opened the global economy. Yet paradoxically, this opening has rendered classical trade theory obsolete. That in turn has left the US economically vulnerable because its trade policy remains stuck in the past and based on ideas that no longer hold.

The logic behind classical free trade is that all can benefit when countries specialize in producing those things in which they have comparative advantage. The necessary requirement is that the means of production (capital and technology) are internationally immobile and stuck in each country. That is what globalization has undone.

Several years ago Jack Welch, former CEO of General Electric, captured the new reality when he talked of ideally having “every plant you own on a barge”. The economic logic was that factories should float between countries to take advantage of lowest costs, be they due to under-valued exchange rates, low taxes, subsidies, or a surfeit of cheap labor. Globalization has made Welch’s barge a reality. However, in doing so it has made capital mobility rather than country comparative advantage the engine of trade. And with that change, “free trade” increasingly trades jobs and promotes downward wage equalization.

The U.S. and European response to Welch’s barge has been competitiveness policy that advocates measures such as increased education spending to improve skills; lower corporate tax rates; and investment and R&D incentives. The thinking is increased competitiveness can make Europe and the US more attractive to businesses.

Unfortunately, competitiveness policy is not up to the task of anchoring the barge, and it can even be counter-productive. The core problem is corporations are globally mobile. Thus, government can subsidize R&D spending, but the resulting innovations may simply end up in new offshore factories. Moreover, competitiveness policy easily degenerates into a race to the bottom. For instance, if the US cuts corporation taxes, other countries may match to stay competitive. The result is no gain for the US, while profit taxes are lowered and tax burdens shifted on to wages, which widens income inequality.

Worse yet, capital mobility prompts countries to adopt unfair policies to increase their relative business attractiveness. These policies include disregard of environmental damage; suppression of labor to keep wages low; direct subsidies; and under-valued exchange rates. All are visible in China, which is the poster-child for such abuses.

A critical consequence of Welch’s barge is the creation of a “corporation versus country” divide. Previously, when corporations were nationally based, profit maximization by business contributed to national economic success by ensuring efficient resource use. Today, corporations still maximize profits, but they do so from the standpoint of their global operations. Consequently, what is good for corporations may not be good for country.

When companies raise profits by rearranging production according to global cost patterns, those shifts can lower country income. For instance, when Boeing transfers production to China, the US loses high value adding jobs and national income can fall. Moreover, though Boeing makes larger short-run profits on its Chinese production, even it may lose in the long run if it inadvertently creates a rival Chinese aircraft producer.

From an American worker perspective, the global economy has always had abundant supplies of cheap labor. In the past American workers were still able to compete and benefit from trade. The critical difference today is American corporations are taking their capital and technology offshore and equipping low-wage foreign workers. Those investments undermine American workers because that foreign production is intended for the US market.

The emergence of barge-like corporations has reduced the scope for effective competitiveness policy, increased the temptations for unfair policy, and created a wedge between corporate and national interests. This poses two critical policy challenges. First, there is need for rules against unfair competition, which is where exchange rate rules and labor and environment standards enter.

Second, there is need to close the wedge between corporation and country. In the U.S. that calls for such measures as ending preferential tax treatment of profits earned offshore; making it illegal for corporations to reincorporate outside the US to escape US tax laws; and new tax arrangements that encourage jobs and value creation within the US.

Addressing globalization’s challenges poses enormous analytical difficulties. Unfair competition must be prevented and companies re-anchored. But this must be done without losing the benefits of real trade based on comparative advantage or ending investment that fosters development.

These economic challenges are compounded by political difficulties. In Washington, elite policy thinking is funded and lobbied for by corporations. Consequently, corporations control trade policy at a time when corporate interests differ from the national interest. That is also increasingly true in Brussels. Fifty years ago what was good for GM may really have been good for the US. With Jack Welch’s barge, that may no longer hold.

Bill Gross: Does the Fed Understand the Brave New World of Finance?

Bill Gross. chief investment officer of bond investment giant Pimco, uses his monthly newsletter to tackle the question of whether the Fed and the Treasury really understand what they are up against. Although he reaches no definitive conconclusion, he suggests they have a bank-centric, and therefore badly outmoded, view of the world.

We've raised this issue repeatedly in the past, back in the days when members of the Fed were cheerfully extolling the virtues of risk diversification and the role of derivatives. (And to be clear about our view, we're not opposed to the techniques of modern finance. What bothers us is that regulators have ceded not merely control, but even oversight and reporting of these activities. As a result, due to competitive pressures among money managers, you have institutional investors using instruments they don't understand fully, and sometimes have not been tested in adverse markets. That behavior is risky and arguably speculation ras opposed to investing, yet it is all too common).

To illustrate, consider this excerpt from a March post on a speech by the president of the New York Fed:

Compared to other Fed governors, Timothy Geithner is straightforward and more than usually willing to talk about bad things. So when he gives a speech that is comparatively upbeat, as he did earlier this week ("Credit Markets Innovations and Their Implications") it should be reassuring.

So why did this speech bother me? It wasn't as if Geithner was overselling his case. He described both the risks (more credit issuance outside the banking system; more debt held by institutions with a propensity to trade rather than buy and hold) and the benefits (greater range of product, better pricing of risk, more diversified portfolios among investors) and thus deemed financial innovation to be a plus.

Perhaps I have an eye for problems, but I saw in Geithner's straight-up-the-center description plenty of cause for worry. First, banks, the financial institutions that are most closely regulated, hold only 15% of the "nonfarm nonfinancial" debt outstanding (remember financial institutions do lend to each other, so that is excluded). By contrast, hedge funds are becoming increasingly important players, and their investing operations are unregulated, unsupervised, and largely unreported. So while the Fed has good information about what its banks are doing, and can send in extra examiners when warranted, it has no idea what is up with the biggest players in the credit markets.

Second is that the variety and complexity of instruments has exploded. Geithner believes this is a plus, giving issuers and investors more choice, and investors greater ability to diversify and fine tune their risks. Yet we've been told that one of the effects is that very complex and risky instruments have wound up held by weak institutions that really don't understand them. This is not a pretty picture.

Third, Geithner indicates that while disintermediation (borrowers going directly to investors rather than via banks) has been around for some time, new instruments and vehicles have proliferated. He indicates that the Fed has taken steps to assure that mechanisms are in place to make sure that operational as well as credit risks are managed. Yet look at the first concern above. Most of this activity is taking place outside the Fed's purview. All it has to work with is moral suasion, not regulatory authority. That is not a position of strength.

Finally, Geithner has no objective foundation for his rosy view. He has essentially admitted the Fed and other regulators lack a complete, or even good, picture of what is happening. We've had money supply growth well in excess of GDP growth, and loose monetary conditions can obscure underlying weaknesses. His argument boils down to,"Our current structure and distribution of risks is outside the bounds of anything in financial history. We can muster some arguments as to why this should be OK, and so far, it has been OK." I don't find that terribly convincing. And I find one quote particularly troubling:

....these broad changes in financial markets may have contributed to a system where the probability of a major crisis seems likely to be lower, but the losses associated with such a crisis may be greater or harder to mitigate.

Back to Gross. While he approves of and lobbied for the Fed's 50 basis point cut in September, he points out multiple elements of the Fed's conundrum. While a fall in housing prices will have a much greater impact on the economy than a stock market decline, it's not clear a Fed rate cut will do much to shore up that market. And he didn't even mention the real dead body in the room, namely, the dollar.

In addition, he observes that the target for a Fed easing cycle is real short rates of 1% or less. If you assume inflation is 2 1/2%, that means the Fed's goal is around 3.75% ish, which means they don't have much room for further cuts. And if you believe, as many do, that inflation is higher than the "core" inflation stats indicate, the Fed effectively had pretty much done all it can do without debasing the currency. The rate increase on the long end of the yield curve says the markets are already of that view.

The 200 point rally in the Dow today shows that a lot of people don't agree with Gross, but that's why he's a bond man.

From Gross, who starts with a riff on the contrast between the permabull of one generation, the debonair, knowing, and bemused Louis Rukeyser, versus the histrionic Jim Cramer:

As Cramer was railing, I and other PIMCO professionals were attempting to describe to high-ranking Treasury and Fed officials the near-frozen commercial-paper markets and the draining confidence of bond and stock investors worldwide. It was Thursday, August 16. Stocks had closed down 210 points and were expected to open hundreds of points lower on Friday. The country’s largest mortgage originator, Countrywide Financial, was rumored to be in liquidation mode (it survived that crisis). This was to be Ben Bernanke’s first test, an opportunity to prove that he and his board of governors knew “something” as opposed to “nothing.” Pass the test he did, cutting the discount rate the next morning and calming markets in ensuing weeks. When Bernanke’s Fed met officially on September 18, it acted again and joined a convoy of global central bankers maneuvering to restore a semblance of normalcy to credit and equity markets. So far, so good.

Yet the validity of Cramer’s rant remains to be disproved. The modern financial complex has morphed into something unrecognizable to many astute market veterans and academics. Bernanke’s fellow governors and Hank Paulson’s staff at the Treasury spread their roots during an era in which traditional banking activity – lending out deposits backed by a certain level of reserves – was the accepted vehicle for liquidity creation. Remember those old economics textbooks that told you how a $1 deposit at your neighborhood bank could be multiplied by five or six times in a magical act of reserve banking? It still can, but financial innovation has done an end run around the banks. Derivatives and structures with three- and four-letter abbreviations – CDOs, CLOs, ABCP, CPDOs, SIVs (the world awaits investment banking’s next creation; perhaps IOU?) – can now take a “depositor’s” dollar and multiply it ten or 20 times. Reserve banking, and the Federal Reserve that regulates the system, appear anemic in comparison.

I’m sure that Bernanke, Paulson, and their cohorts understand this, but it isn’t yet clear how much they appreciate it. Alan Greenspan admits in his newly published book that he didn’t appreciate until recently the impact adjustable-rate mortgages and their subprime character, accompanied in some cases by outright fraud, would have on the housing market. If the Fed was so slow to grasp the role that subprime mortgages played in the housing boom and bust, do the Fed and the Treasury of today totally comprehend what happens when the nonbanking private system suddenly stops flooding the market with credit? Do they recognize that such a shutdown puts spending for housing and business investment at risk, and job growth as well? The Fed will have to adapt its monetary policy, and the Bush Treasury will have to adjust its fiscal policy to this brazen new world dominated more and more by private rather than public policies and proclivities. To overcome private-market caution, the Fed may need to put on a bold face marked by even more decisive cuts in short-term rates. To prevent a housing-market slump from metastasizing into a cancerous self-feeding tumor, Treasury Secretary Paulson will have to coordinate policies that lend a helping hand to homeowners in distress.

But Paulson’s attempt to assist ailing homeowners will be complicated by the free-market laissez-faire policies of Republican orthodoxy. In addition, the rescue effort will be hampered by an uncomprehending press and public who appear to be more focused on revenge and “just desserts” as opposed to the ultimate negatives ahead for housing prices, employment, and economic growth. To use the old saw in updated form, a recession is when home prices in a neighboring state go down – a depression will be when the price of your home does. Well, if that be the definition of modern depression, then 70 million American homeowners will soon be residing in Bush, not Hoovervilles.

But if Paulson cannot prevent expected declines of 10-15% in national home prices over the next several years, it is problematic as to whether Bernanke can substantially cushion them either. First of all, the aforementioned lack of “appreciation” of a modern-day shadow banking system has put the Fed far behind the 8-ball in its reflexive duty to lower interest rates in an anticipatory fashion. Mortgage credit has been contracting on the ground level for all of 2007 with individual, small, and then national mortgage brokers and originators closing their doors. Legal threats and regulatory pressures have compounded the credit implosion. As a result, home prices, as shown in Chart 1, have been declining for nearly 12 months and only now is the Fed responding to an unfolding crisis.


Bernanke’s Fed may be as opposed to targeting asset prices as was Greenspan’s, but housing and stock market bubbles are birds of entirely different feather. 1987’s equity crash and its negligible effect on economic growth as well as Nasdaq’s fall from 5000 to 1500 in recent years, which led to a very mild investment led-recession, cannot be the textbook examples for Fed asset price policy today. Wall Street, despite its increasing influence in America’s finance-based economy, is not Main Street; and stock prices do not dominate the spending habits and confidence of its consumers in the same degree as do home prices. So Fed policy must, as governor Don Kohn mentioned recently, be as asymmetric as asset prices – emulating an escalator on the way up (25 basis point increases) and an elevator on the way down (50 basis point reductions).

Bernanke, however, may face a problem with this elevator-based ease in monetary policy. As I have pointed out in prior pages and Outlooks, globalization and financial innovation have enormously complicated the job of central bankers. Whereas in prior decades a “one size fits all” policy rate move has coincidentally and democratically affected households and corporations alike, the 21st century has ushered in an innovation revolution favoring corporations with global investment opportunities as opposed to individuals with daily bills to pay. The same 4¾% rate is not and cannot be “neutral” for both sides in today’s U.S. economy. Whereas current yields are not restrictive for investment grade corporations with global opportunities, they are far too high for homeowner Jane Doe and two million of her neighbors facing higher and higher monthly payments on adjustable rate mortgages. Should Bernanke put on a brave face and freeze the elevator and rates in mid-descent, he risks exacerbating a housing crisis in the making. Yet, should he favor the homeowner over the corporation, he risks reigniting speculative equity market behavior, and – in addition – a run on the dollar.

PIMCO’s view is that a U.S. Fed easing cycle historically has required a destination of 1% real short rates or lower. Under a conservative assumption of 2½% inflation, that implies Fed Funds at 3¾% or so over the next 6-12 months. Actually that’s only two, 50 basis point reductions, something that could, but probably won’t, be accomplished by year-end. Don Kohn’s asymmetric elevator will likely be interrupted by false hopes of a housing bottom, fears of a dollar crisis, or misinterpreted one month’s signs of employment gains and faux economic strength. The downward path of home prices, however, will dominate Fed policy over the next several years as will the lingering unwind of related financial structures and derivatives that have yet to be discovered by the public, and marked to market by their conduit holders.

Know nothing? Perhaps they now know more than I or Jim Cramer gave them credit for on that raucous day in August. If they do, however, their options are limited by Republican political orthodoxy, the receding willingness of the private sector to extend credit, and a still exuberant global economy. What do they know? I suspect at the very least they know they’re in a pickle, and a sour one at that.

Tim Duy Weighs in on What the Fed Might Do Next

Tim Duy, economics professor at the University of Oregon, posts from time to time on Mark Thoma's blog, Economist's View, and Fed watching is one of his favorite topics. His latest, "The Fed's Next Move," is particularly thorough and cogent.

He goes through the case for further rate cuts and finds the consensus view, that more reductions are in the offing, to be well founded. He believes that the Fed "is no longer confident it can disentangle housing from financial markets" and therefore will give the housing market considerable weight in its decisions. He then argues that this posture is futile, since cuts won't restore the bubble mentality of faith in ever-rising prices. But deteriorating housing and falling inflation (if you believe those "core" CPI and PPI stats) give a thumb's up to further cuts. He then goes through the caveats (he doesn't buy the view that inflation is tame, but he also discounts hawkish statements by Fed bank presidents).

The foregoing is all very much worth reading in long form, but here is the doozy:

For my part, I am concerned that the Fed appears to have written off the dollar. My concern stems from rising international tensions - the Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies. Moreover, those economies with floating rates become the anti-Dollar bets, forcing the Euro area, Canada, the UK, etc, to be the deflationary counterweights to the inflationary US policy.

Is it a surprise that the ECB is under pressure to support the Euro with a rate cut? The only surprise is that there is not more chatter about an ECB intervention if only to erase the idea buying the Euro is a one way bet.

In my darker moments, I fear that the Fed is forcing their foreign counterparts down one of two paths - either central banks with appreciating currencies throw in the towel and match Fed rate cuts, thereby unleashing a fresh wave of global liquidity, or central banks with fixed exchange rate finally decide that they can no longer bear the inflationary cost of supporting the US current account deficit.

Adding to my concerns is that the Fed is overestimating the downside risk to the economy. Certainly, the past correlation between housing downturns and recessions is nothing to ignore. But too many indicators are not consistent with a recession for me to be embrace a dark outlook. Why are initial unemployment claims flat? Why does the consumer appear to have momentum in the 3Q07? Why are readings on manufacturing activity not solidly on the decline? Why did the inventory to sales ratio slide back to its lows? Why does the Baltic Dry Index continue to reach new highs? Why isn't faltering demand undercutting support for oil prices?

Bottom Line: The housing down / inflation down data flow gives the Fed room to continue cutting on the basis of forecast uncertainty. Presumably, strong data would undermine the case for additional cuts, leaving me wary of blow out ISM and employment reports. There is a risk that the Fed did intend the September move to be a "one and done" action, but unless they want to get into the habit of surprising financial markets, they need to make that clear - or the data need to be strong enough to do it for them.

I think the reason that the economic figures still look solid is 1) some of them do not correspond with reality (per Duy's discussion of inflation earlier in his post) and 2) consumer spending is up in part due to inflation rather than unit growth, and in part due to reluctance to curtail their lifestyle. Spending will hold up only as long as they have access to credit. As the home equity lines begin to be tapped out, or consumer confidence takes more of a beating (which will reduce their inclination to borrow), you will see the slowdown take hold.

Unions on the Rise?

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

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

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

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

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

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

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

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

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

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

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

From the Financial Times:

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

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

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

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

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

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

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

Some Hope for the Dollar?

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

From Bloomberg:

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

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

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

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

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

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

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

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

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

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

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

The Real Problem With Stated Income Loans

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

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

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

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

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

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

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

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

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

UBS: Latest Credit Market Casualty

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Credit Markets Still Shaky (And Don't Think It Doesn't Matter)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

From VoxEU:

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

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

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

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

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

Countrywide's Sham Borrower Rescue Programs

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

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

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

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

Nevertheless, some of the quotes and factoids are compelling:

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

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

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

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

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

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

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

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

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

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

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

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